The current European Union approach to environmental regulation aims to ensure that firms achieve continuous improvement in environmental performance and explicitly encourages firms to integrate environmental concerns into production technology. Such approaches to minimizing pollution often lead to economic as well as environmental benefits. The possibility that regulation can generate a "win win" solution, achieving both environmental protection and economic gains, is rejected by neoclassical environmental economists. Using the neoclassical model of a profit-maximizing firm with perfect information, neoclassical environmental economists argue that profit-maximizing cleaner technology will be adopted by profit-maximizing firms without requiring a regulatory stimulus: regulation can only act as a constraint on firms.
Both this argument and its underpinning theory of the firm have been challenged by Michael Porter and Claus van der Linde (Porter 1991; Porter and van der Linde 1995a, 1995b), who have argued that regulation can promote competitiveness-enhancing technical change. "Companies operate in the real world of dynamic competition, not in the static world of much economic theory. They are constantly finding innovative solutions to pressures of all sorts--from competitors, customers, and regulators" (1995a, 120). Porterian firms cannot pursue profit-maximizing behavior; they face problems of information, control, and organizational inertia. With this conception of the firm there is a role for regulation in directing the attention of firms: "strict product regulations can also prod companies into innovating to produce less polluting or more resource-efficient products that will be highly valued internationally" (Porter 1991, 96).
Porter's hypothesis has brought him into direct conflict with orthodox environmental economists who dispute his arguments. The debate is best exemplified in a pair of papers in the Journal of Economic Perspectives where Porter and van der Linde (1995b) presented the first detailed defense of their position and Karen Palmer, Wallace Oates, and Paul Portney (1995) responded with their theoretical and methodological objections. In this paper I use this debate to show how the divergent positions adopted are based on fundamental differences in assumptions about how firms innovate and compete. The arguments put forward by neoclassical environmental economists to dispute the regulation-innovation link are predicated on a neoclassical, profit-maximizing conception of the firm. Porter's argument is developed from a particular, non-neoclassical conception of how firms compete. I outline how this conception lies at the heart of the critique of Porter by environmental economists.
Porter's significant contribution has been to change the type of questions asked about the impact of environmental regulation, but his research fails to demonstrate robust theoretical evidence of a positive relationship between environmental regulation and firm competitiveness. The reasons for this lie in the original research in which Porter presented a richer and less abstracted conception of the firm but did so within the context of a mode[ which stresses the primacy of the external environment over internal firm characteristics as the factor of interest (1990). I argue the failure of both neoclassical environmental economics and Porter's theory to provide convincing analysis is because of their failure to look inside the black box. The evolutionary theory of the firm, with its emphasis on organizational capabilities as the driver of technical change in firms, provides a framework for the development of a coherent model of the relationship between environmental regulation and firm technical change.
Porter and Neoclassical Environmental Economics
The debate in the Journal of Economic Perspectives has a clear focus on the key question of the relationship between regulation and innovation within the firm. Environmental economists dispute the regulation-innovation link for three main reasons, all stemming from a neoclassical, profit-maximizing conception of the firm. Counterarguments by Porter and van der Linde are located in their non-neoclassical conception of the firm.
Palmer et al. argued that firms maybe aware of environmental innovations and still choose not to pursue them because of more profitable opportunities in other areas (1995). This is a view of profit-maximizing firms with perfect knowledge. Porter and van der Linde did not accept that environmental innovations go unexplored because they have been weighed in the balance and found wanting. Instead they saw that "companies have numerous avenues for technological improvement, and limited attention" (1995b, 99), and so "rather than attempting to innovate in every direction at once, firms in fact make choices based on how they perceive their competitive situation and the world around them. In such a world, regulation can be an important influence on the direction of innovation." Furthermore, "companies are still inexperienced in dealing creatively with environmental issues. The environment has not been a principle area of corporate or technological emphasis, and knowledge about environmental impacts is still rudimentary in many firms and industries."
Environmental economists question why regulations should succeed in recognizing profitable innovations where firms have failed. This is answered by Porter and van der Linde's assertion that it is the form of regulations that is important in promoting innovation and that the right form is for regulations to be as flexible as possible and to "create maximum opportunities for innovation by letting industries discover how to solve their own problems" (1995a, 129). (1)
Palmer et al. recognized that Porter and van der Linde's argument rests on adopting a dynamic approach but persisted in analyzing the theory...