Abstract
Opponents of pollution regulation claim that regulations choke businesses, hurt welfare and destroy economic growth. Do pollution regulations in fact hurt producers and the economy? We model two popular regulations – Cap-and-Trade and Taxes – under imperfect competition. We prove that market structure is an important, if over-looked, driver of the economic consequences of pollution regulation. Under imperfect competition, well-chosen regulation can (i) simultaneously improve firms’ profits, consumer surplus and welfare, and (ii) induce firms to perfectly internalize their pollution externalities. The risk of regulatory over-reach due to over-estimates of the pollution damage is allayed, at least in competitive contexts, since the welfare-maximizing tax rate is, in these cases, greater than the marginal pollution damage caused by polluters. Our results suggest that the paramount factor in framing pollution regulations should be their impact on consumers rather than on producers.
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