Friday, April 29, 2011

Using public firms to regulate the environment

There are various approaches to regulate the pollutions of firms. One can regulate them, one can tax them, or one can create a market for pollution permits. Or one can ask the firms to self-regulate them. Or the government can take over one firm and let it set an example. Which option works best depends on market conditions and how emissions can be observed.

Davide Dragone, Luca Lambertini and Arsen Palestini look at a Cournot oligopoly for the last option. We know that when competition is less than perfect, less will be produced, which is good when the externality is negative. To adjust production to the right level, the public firm choose output and price to coerce the private firms to do the right thing. Basically, the latter are forced to internalize the externality. But this only works if there are not too many firms. The public firm reduces output such that the private one reduce as well, due to lower aggregate output and increased market power. One could thus imagine the government simply shutting down firms. But of course, this is valid only if there is no free entry in the industry, a big if.

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