Optimality of Environmental Policy Mixes in the Presence of More than One Externality and of Strategic Firms

Abstract

We first study the optimality of a committed policy mix of tax and subsidy to control pollution when firms are involved in abatement technology R&D that is subject to knowledge spillovers. Then a comparison of tax and subsidy is provided when the policy mix is not available and the regulator can use only one single policy. Two different behavioral assumptions for the firms are examined: when firms are myopic, and when they are strategic, i.e., react to the policies strategically. The results suggest that given that policy mix is available a committed regulator can attain optimality if firms are myopic, but that, a strategic reaction from the firms may compromise the efficiency of the policy mix, but the exact impact of that depends on the production technology and the effectiveness of knowledge spillovers. But if the regulator commits to one single policy, then tax policy has advantages over subsidy. Besides, unlike the policy mix, the single policy is more effective in case of strategic firms rather than myopic ones and it is even possible to achieve optimality with a special tax policy.