Abstract: The purpose of this study was to design a regulatory policy to solve a nonpoint source (NPS) water pollution problem, . Cost-sharing programs of various kinds have dominated NPS policy since the 19802s. However, such programs are neither efficient nor effective. Economists agree that, in principle, performance-based approaches are preferred to design-based, because they allow firms to choose least-cost abatement practices. However, nonpoint sources are seldom included in performance-based programs since it is very costly to monitor the performance of individual NPS polluters. The NPS pollution problem can be modeled as a generalized principal-agents problem. That is, the principal has to regulate agents while he cannot observe either the types and or the effort level of the agents; only total level of ambient pollution is verifiable. However this kind of problem is very complicated and a general solution has yet to be derived. Simplified models (with either only adverse selection, or hidden action) have been analyzed and first best solutions derived. Nevertheless, these solutions are incomplete, since they fail to solve simultaneously the adverse selection and moral hazard problems. I show that under assumptions consistent with the NPS pollution situation it is possible to decompose the generalized principal-agent problem into two univariate variational problems in the multi-agents case, and to design a two-step contract that solves both the adverse selection and the hidden action problems. I offer a policy-maker2s algorithm that can be used to design a regulatory policy to control NPS pollution. Three steps of a transaction 6 property rights/initial endowment assignment, price and quantity determination, and money/product exchange 6 are considered sequentially; an optimal regulatory intervention is chosen for each step; and then the whole policy is evaluated for consistency and for as-yet-unexamined effects on related markets. Inconsistencies and undesired general equilibrium effects are resolved by modifying the intervention at the appropriate step and re-iterating through the policy algorithm. This research has resulted in contributions in three areas of economic theory: policy design, mechanism design (the generalized principal agent problem), and environmental economics (the nonpoint source water pollution problem).