Capacity utilization and investment in environmental quality

Abstract

This paper characterizes the optimal use of productive capacity and optimal investment in environmental quality when the latter has a positive impact on the production process. For the case of a single country, we find conditions under which capital should or should not be fully utilized, and investment in environmental quality should be positive or zero. We then extend the model to the case of two countries playing a non-cooperative dynamic game. The Nash equilibrium turns out to be a dominant-strategy equilibrium. Since this equilibrium is not Pareto efficient, we show how one country may bribe the other country to achieve a better outcome, for example, by refraining from full utilization of capacity. Under certain conditions, the optimal solution requires that a constant fraction of one country's income be used to bribe the other country to scale down its production.