Effectiveness of environmental regulations: firm’s decisions and welfare implications

Abstract

In this paper, we compare four policy instruments–tax, subsidy, binding emissions and cap-and-trade, to determine which policy is the most effective and whether they are equivalent. We also examine if a firm’s policy preference differs from that of a policymaker. Our motivation stems from the global use of a wide array of pollution instruments. Using a game theoretic approach, we analyze how carbon abatement, production quantity, profitability and welfare vary between different policy tools. We find that the tax policy is equivalent to the binding emission standards while welfare comparison shows that the highest welfare is attributed to either the tax or subsidy policy depending on the levels of environmental damage. We find that both the policymaker and the firm prefer a subsidy policy under lower thresholds of environmental damage. Exploring hybrid policies, we find that a multi-part tariff contract jointly implements the socially optimal outcomes and leads to a win-win situation for both the firm and the policymaker. Our findings offer guidance for policymakers and managers to implement appropriate policies based on the degree of environmental damage and to consider using hybrid policies that achieve higher pollution abatement and improved welfare.