Emission Taxes and Product Differentiation in the Presence of Foreign Firms

• Date: 01 April 2017
• Author: LUIS GAUTIER
• Published date: 01 April 2017
• DOI: http://doi.org/10.1111/jpet.12204

EMISSION TAXES AND PRODUCT DIFFERENTIATION

IN THE PRESENCE OF FOREIGN FIRMS

LUIS GAUTIER

University of Texas at Tyler

Abstract

Industries characterized by differentiated products are important con-

tributors of greenhouse gases and currently subject to market-based

policies such as emission taxes. In the context of developing countries,

fears about foreign investment leaving the country are often used as

an argument not to address industry emissions through emission taxes.

This paper develops a Cournot model with product differentiation in

the presence of abatement efforts where host and foreign firms are sub-

ject to an emission tax. The analysis indicates that abatement efforts

and differences in pollution intensity coefficients across firms may play

a significant role in the characterization of optimal policy. The analysis

also suggests that the government may opt to encourage foreign, less

pollution-intensive firms via higher taxation. Additionally, this paper

examines how an optimal emission tax may be adjusted as products be-

come more differentiated; industry emissions may fall/rise as a result

of more differentiated products. One important contribution of this

paper is that it emphasizes the role of abatement efforts, product dif-

ferentiation, and differences in pollution intensity coefficients across

firms in the characterization of the optimal emission tax.

1. Introduction

There is a wide range of industries characterized by differentiated markets which are

large contributors of greenhouse gases, and which are continuously evolving in order

to differentiate their products (e.g., automobile and energy sectors are important ex-

amples).1Therefore, it is important to analyze environmental policy in the context of

1The U.S. Environmental Protection Agency (http://epa.gov/climatechange/ghgemissions/sources/

industry.html) provides data on trends in greenhouse gas emissions for several industries in the United

States, and the U.S. Department of Commerce (2010) shows evidence of industries where changes

in emissions and pollution intensities have taken place. In many cases these are industries character-

ized by product differentiation. As indicated in Fujiwara (2009), the chemical industry exemplifies an

Luis Gautier, Department of Social Sciences, University of Texas at Tyler, 3900 University Boulevard,

Tyler, TX 75799 (lgautier@uttyler.edu).

I am truly grateful to an anonymous referee, an associate editor, and the editor, Professor John P.

Conley, for very constructive comments and suggestions.

Received June 11, 2016; Accepted June 12, 2016.

C2016 Wiley Periodicals, Inc.

Journal of Public Economic Theory, 19 (2), 2017, pp. 461–489.

461

462 Journal of Public Economic Theory

these industries in order to adjust current policy, if desirable, to varying degrees of prod-

uct differentiation. Moreover, the potential role of incentive-based environmental poli-

cies in developing countries, where industries characterized by differentiated products

may operate, has been recently getting some attention (e.g., Shan and Larsen 1992;

Blackman and Harrington 2000; Tyler et al. 2013).2With these aspects in mind, this

paper develops a Cournot model with product differentiation, cost asymmetries, and

abatement efforts, where host and foreign firms are subject to an emission tax, to exam-

ine, inter alia, how the optimal tax may be adjusted as products become more differen-

tiated.

The literature on environmental taxation under imperfectly competitive markets

is vast (see, e.g., Requate 2006 for a survey). One important strand of the literature

analyzes optimal environmental taxation and the impact of emissions taxes on indus-

try emissions assuming product homogeneity under Cournot competition (e.g., Levine

1985; Ebert 1992; Simpson 1995; Lee 1999).3A second strand analyzes environmental

taxation in the presence of vertically differentiated markets (e.g., Poyago-Theotoky and

Teerasuwannajak 2002; Bansal and Gangopadhyay 2003; Rodr´

ıguez-Ibeas 2006) as well

as horizontal product differentiation (e.g., Poyago-Theotoky 2003; Conrad 2005; Lahiri

and Symeonidis 2007; Fujiwara 2009; McGinty and de Vries 2009; Gautier 2013). A third

more recent strand on foreign direct investment (FDI) and environmental policy has

developed, which shows that even under stricter environmental policy foreign firms

may reallocate to the host country under Cournot conditions (e.g., Dijkstra, Mathew,

and Mukherjee 2011; Sanna-Randaccio and Sestini 2012; Elliot and Zhou 2013). The

contribution of the present work is at the intersection of these three important strands.

The literature on optimal environmental taxation under Cournot oligopoly indi-

cates that either in the long run or short run the optimal tax may be set below, or exceed,

marginal damages; the literature has also studied cases in which taxes may raise emis-

sions. These results depend, among others, on the assumptions made about the strate-

gic interaction of firms, the degree of output distortion, and cost asymmetries across

firms. Part of the literature assumes away abatement efforts by firms, differences in pol-

lution intensity coefficients across firms, and the possibility of differentiated goods. For

instance, Ebert (1992) assumes identical pollution intensity coefficients across firms

and homogeneous goods, and allows for abatement efforts; Levine (1985) and Simp-

son (1995) allow for different pollution intensity coefficients across firms and assume

homogeneous goods, but assume away abatement efforts by firms. Katsoulacos and

Xepapadeas (1996), and Conrad and Wang (1993), for example, analyze the effect of

free entry and exit of a set of identical firms on the optimal emission tax under Cournot

competition and homogeneous goods. The present work contributes to this literature

by incorporating abatement efforts, differentiated products, and differences in pollu-

tion intensity coefficients into a unified framework of analysis. The case of free entry

(with an emphasis on the role of abatement efforts) is analyzed in the context of two

industry characterized by a high degree of product differentiation, whereas the pulp and paper indus-

try is less. See Conrad (2005) for more examples of industries characterized by product differentiation.

OECD (2010) describes the adoption of an emission charges scheme on volatile organic compounds

in Switzerland in the printing, metal cleaning, and paint making industries, which exemplify industries

with some degree of product differentiation.

2Tietenberg (2013) lists, in his Table, Taiwan, Korea, and India as countries which have, or shortly will,

adopt carbon pricing policies.

3There is also an extensive literature which analyzes the strategic interaction of governments when

firms compete `

a la Cournot for the production of a homogeneous good, e.g., Conrad (1993), Barrett

(1994), Ulph (1996), Bayındır-Upmann (2003), Hamilton and Requate (2004), and Requate (2006).