Pollution Regulation of Competitive Markets

TLDR

The study develops a model of oligopolistic firms producing partially differentiated products that generate pollution as a byproduct. The model analyzes Cap‑and‑Trade and tax regulation, allowing firms to respond via abatement, output cuts, emissions trading, or tax payments. The analysis shows that well‑designed regulation can reduce pollution while raising firm profits, consumer surplus, and overall welfare, with regulation Pareto‑dominating laissez‑faire, largely because firms tacitly collude under regulation and competition intensity shapes outcomes. The paper was accepted by Vishal Gaur in operations management.

Abstract

We develop a model of oligopolistic firms that produce partially differentiated products and generate pollution as a byproduct. We analyze and compare two types of pollution regulation: Cap-and-Trade and Taxes. Firms can respond to regulation by any combination of pollution abatement, output reduction, emissions trading (under Cap-and-Trade), or payment of pollution taxes (under Taxes). We prove that well-chosen regulation can, besides reducing pollution, actually improve firms’ profits relative to laissez-faire (unregulated markets), and simultaneously improve consumer surplus and welfare. Thus, regulation Pareto-dominates laissez-faire under a wide range of plausible conditions. These results are driven by an unintended consequence of pollution regulation: Competing firms can use the regulation to tacitly (and credibly) collude to reduce production and improve their profits. We show that the degree of competition plays a critical role in determining the economic consequences of pollution regulation. Our results suggest that the regulator’s primary consideration should be the impact of regulation on consumers rather than producers. This paper was accepted by Vishal Gaur, operations management.