The perverse effect of environmental regulation on emissions: The role of product‐mix changes

• Published date: 01 February 2022
• Author: Marc St‐Pierre,Aaron A. Elrod
• Date: 01 February 2022
• DOI: http://doi.org/10.1111/jpet.12541

J Public Econ Theory. 2022;24:197–235. wileyonlinelibrary.com/journal/jpet © 2021 Wiley Periodicals LLC

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197

Received: 14 December 2020

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Revised: 30 July 2021

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Accepted: 30 July 2021

DOI: 10.1111/jpet.12541

ORIGINAL ARTICLE

The perverse effect of environmental regulation

on emissions: The role of product‐mix changes

Marc St‐Pierre |Aaron A. Elrod

Department of Economics and Finance,

The University of the South, Sewanee,

Tennessee, USA

Correspondence

Marc St‐Pierre, Department of

Economics and Finance, The University

of the South, 735 University Ave,

Sewanee, TN 37383, USA.

Email: mastpier@sewanee.edu

Abstract

We study the effect of environmental regulation (taxa-

tion) on emissions when the only available abatement

method consists of product‐mix changes. Firms choose to

produce one or both varieties of a product—a pollution‐

intensive (dirty) and a non‐pollution‐intensive (green)—

and compete in a differentiated Cournot duopoly. We

characterize the equilibrium market structure as a func-

tion of the tax rate and show that increases in the tax can

promote product‐mix changes that lead to a jump in

emissions for some tax range, an effect we call the per-

verse effect of taxation. Our work emphasizes the key role

horizontal product differentiation in this process and

shows that the perverse effect does not require the pre-

sence of vertical product differentiation. Further, the

perverse effect of taxation is especially strong in the

presence of incomplete regulation, that is, when only one

of the markets is subject to taxation.

1|INTRODUCTION

Can environmental regulation increase pollution? Command‐and‐control and market‐based

environmental policies provide incentives for polluting sources to reduce their pollution.

1

1

These incentives are borne out in both theoretical and empirical studies. For example, studies find that carbon taxes

reduce CO

2

emissions (see Lin & Li, 2011 for a thorough review of the literature), that monitoring and enforcement of

the Clean Water Act reduce effluent violations and discharges (see, e.g., Laplante & Rilstone, 1996; Magat & Viscusi,

1990; Shimshack & Ward, 2005), and more recently, that increases in the stringency of environmental regulation

account for the majority of emissions reductions in the US manufacturing sector between 1990 and 2008 (Shapiro &

Walker, 2018).

But environmental regulations may have perverse effects that either diminish the potential for

reducing pollution or, more interestingly, increase pollution altogether.

In this paper, we propose a new and previously unexamined mechanism that may mitigate

the effect of environmental regulation: when firms alter their product mixes as an abatement

method. Product‐mix changes may occur along the extensive margin as firms drop pollution‐

intensive products and/or add less pollution‐intensive products—that is, they “switch”

products—or along the intensive margin as firms decrease production of pollution‐intensive

products and/or increase production of less pollution‐intensive products. To the extent that

changes in product mix affect the market structure, our model helps to further highlight how

changes in market structure affect environmental regulation's ability to reduce emissions. To

isolate the effect of environmental regulation on product‐mix changes, we assume that other

forms of abatement such as installation of cleaner or end‐of‐pipe technology are excluded from

consideration. That is, firms only alter their product mixes in response to regulation.

Our motivationfor examining product‐mix changes is twofold. First, whileboth the industrial

organization and international trade literatures give theoretical treatment to this area,

2

the en-

vironmental economics literature has largely ignored the extent to which environmental reg-

ulation affects this aspect of firm behavior. A second and related motivation comes from recent

but limited empirical research, which finds that firms make product‐mix changes in response to

environmental regulation. However, the overall environmental impact of these product‐mix

changes is unclear.

3

This ambiguity from empirical research warrants a theoretical counterpart.

Therefore, the goals of the current paper are twofold: (1) to construct a framework for

understanding the theoretical relationship between environmental regulation and product

mix—which is currently lacking in the literature—and (2) to use that framework to identify

general cases in which environmental regulation leads to an increase in emissions. Accordingly,

results from our analysis provide practical policy implications for an environmental regulatory

agency like the US Environmental Protection Agency (EPA), whose core mission, as stated in its

strategic plan (EPA, 2018), is to “Deliver a cleaner, safer, and healthier environment”(p. 2) with

policies that “improve air quality”(p. 5) and “improve water quality”(p. 11). Achieving such a

mission is of course less likely if the regulations lead to an increase in overall pollution.

Our formal argument uses a linear differentiated Cournot duopoly model (in the nature of

Singh & Vives, 1984), which explicitly rules out the Levin (1985) type of argument based on

sufficient concavity of the demand. In the model, firms can choose to produce either one or two

existing varieties of a product: a

d

irt

y

(pollution‐intensive) and

green

(non‐pollution‐intensive)

2

See Minniti (2006) for a review of the industrial organization and international trade literatures.

3

In an examination of the US Environmental Protection Agency's (EPA) Clean Air Act Amendments (CAAA) of 1977,

Elrod and Malik (2019) find that more stringent CAAA regulation caused some US manufacturers to alter their product

mixes away from pollution‐intensive products and toward less pollution‐intensive products. Elrod and Malik (2017)

find similar results in an examination of EPA's Cluster Rule (CR)—which combines regulatory requirements from the

Clean Air Act and Clean Water Act—in which manufacturers facing more stringent CR regulation (treatment group)

were more likely to drop pollution‐intensive bleached products relative to less pollution‐intensive unbleached products

compared to manufacturers facing less stringent CR regulation (control group). However, the authors also find evi-

dence that the control group was more likely to add bleached products after, relative to before, the CR, thereby altering

their product mixes toward pollution‐intensive products. Neither study estimates the overall environmental impact of

these product‐mix changes. In fact, Elrod and Malik (2017), in reference to the CR, note that “The net environmental

impact of these product‐mix changes is unclear,”further stating that “… we cannot rule out the possibility that

dropping of bleached products by plants in the treatment group resulted in higher overall discharges of water

toxics”(p. 182).

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ST‐PIERRE AND ELROD

variety (hereafter, we use the terms variety and product interchangeably).

4

The varieties may

differ along both the vertical and horizontal dimensions. From the consumer's point of view,

differences in pollution intensity during the production process create quality differences along

the vertical dimension.

5

For example, non‐organically‐grown (conventional) agricultural pro-

ducts such as fruits and vegetables treated with chemical fertilizers and pesticides or paper that

is bleached is more environmentally damaging than agricultural products grown using sus-

tainable (organic) methods or paper that is not bleached or produced using recycled waste

paper (Conrad, 2005; Kurtyka & Mahenc, 2011). Furthermore, as Kurtyka and Mahenc (2011)

argue, varieties with environmental quality differences “can hardly attract similar tastes due to

different production techniques…” (p. 269), thus providing differences along the horizontal

dimension. Using the same examples, some consumers may prefer conventional fruits and

vegetables because of differences in appearance (Conrad, 2005), while others may prefer or-

ganic fruits and vegetables because of differences in taste, which depends highly on soil cul-

tivation (Kurtyka & Mahenc, 2011). Similarly, some consumers may prefer a whiter and

brighter paper provided by the bleaching process to a more brown variety from unbleached

paper or a more gray variety from paper produced using recycled waste paper. After a (passive)

regulator sets the tax rate on emissions, firms play a two‐stage game: (1) they simultaneously

choose a portfolio of varieties before (2) competing à la Cournot in their respective market(s).

The equilibrium depends on the size of the emissions tax set by an exogenous regulator, and

we use comparative statics to examine the role of taxation in the market structure and emis-

sions. The ability of the regulator to influence the market structure (toward adoption of the

green product) via taxation—something we refer to as the power of taxation—is accentuated by

the presence of diseconomies of scope, as well as the extent in which the difference in emission

intensity favors the green product. Within this context, we further examine situations in which

an increase in the tax affects the equilibrium product mix in a way that triggers a jump up in

emissions as firms adopt the greener variety—something we refer to as the perverse effect of

taxation on emissions. We show that this perverse effect is prone to occur at market structure

transitions which, in turn, are triggered by an abatement desire from the profit‐maximizing

firms. Although not all possible market structure transitions yield such a perverse effect, our

model emphasizes the important role of horizontal product differentiation: we show that the

perverse effect of taxation can occur even when products are not perfect substitutes and even

when vertical product differentiation is absent. Furthermore, the results highlight the im-

portant role of horizontal product differentiation vis‐à‐vis the relative emission intensities, that

is, the ratio of emission intensities between the green and the dirty sector. In our model, the

initial adoption of the green variety leads to a perverse effect of taxation only if the relative

pollution intensity of the green variety is high enough relative to the degree of (horizontal)

substitution; this, in effect, limits the extent of the feedback process, whereas the output of the

dirty market is reduced due to greater competition from the green variety. In contrast, further

adoption of the green variety requires just the opposite since greater competition from the

4

Our model, therefore, examines product switching in a discrete context. This is similar to the approach of Brander and

Eaton (1984) and Chisholm and Norman (2012) but differs from the majority of the literature on endogenous product

selection in imperfectly‐competitive markets (noted in Footnote 6), which models product selection using a continuous

variable.

5

This approach of attributing the pollution intensity from a product's production to the product's quality follows many

recent studies in the environmental literature (see, e.g., Bansal & Gangopadhyay, 2003; Kurtyka & Mahenc, 2011;

Moraga‐González & Padrón‐Fumero, 2002).

ST‐PIERRE AND ELROD

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