ENVIRONMENTAL REGULATION OF POLLUTING FIRMS: PORTER'S HYPOTHESIS REVISITED

Abstract

This paper provides a theoretical explanation for a regulation-driven win-win situation along the lines of Porter's hypothesis. Using a Cournot duopoly with polluting firms we show that in the absence of government intervention there exist parameter values such that, in the resulting Nash equilibrium, both firms choose the old, high polluting technology even though the adoption of a new, low polluting technology yields higher profits for both firms (prisoner's dilemma). We then show that gobernment intervention in the form of direct emission controls can eliminate the prisoner's dilemma situation and induce both firms to adopt the modern, low polluting technology provided that the regulation is sufficiently strict. In this case, the reduction in market size for polluting firms is storng enough to reduce profits. By investing in a new, low polluting technology, firms avoid any quantity restrictions on output and enjoy higher profits despite the initial cost of investing in the new technology.