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Design standards and technology adoption: welfare effects of increasing environmental fines when the number of firms is endogenous

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Abstract

This paper examines the consequences of an increase in the expected fine for non-compliance with an environmental design standard for an industry with Cournot competition and free entry. Our research question is timely and relevant, given recent policy proposals to raise environmental fines. We describe the range, in which changes in the environmental fine have no consequences, and detail the various effects that emerge otherwise. It is established that an increase in the expected fine for non-compliance may have adverse welfare consequences, while it always serves the purpose of inducing a greater share of firms to adopt the prescribed technology. However, when there are limits with respect to the sanctions, it may be welfare-maximizing to have no deterrence at all.

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Notes

  1. See the press release ‘Putting a price on global environmental damage’ by Principles for Responsible Investment, issued October 6, 2010.

  2. In the context of environmental policy, administrative authorities generally have a significant influence on how such regulations are formulated, interpreted, and enforced (e.g., Faure 2009). For example, the USA’s Environmental Protection Agency has considerable discretion, regarding the penalties assessed under the Clean Air Act Amendments of 1977 (Besanko 1987).

  3. See Requate (2005a) for a survey of the literature on the adoption incentives induced by different environmental policy instruments.

  4. Baumann and Friehe (2012) provide a related argument for imperfectly enforced employment protection legislation.

  5. For a survey of the literature on optimal law enforcement, refer to Polinsky and Shavell (2007).

  6. For classic contributions in the technology adoption literature, see Requate and Unold (2003) and the survey presented by Requate (2005a).

  7. The assumption that the cleaner technology imposes higher per-unit production costs is standard in the literature (e.g., Besanko 1987; Mahenc 2007).

  8. It is standard procedure to consider exogenous adoption costs in the technology adoption literature. However, there are other contributions that explicitly address the innovation sector and firms investing in R&D (see the survey by Requate 2005a).

  9. The simplifying assumption of a linear demand function is innocuous for our qualitative results.

  10. As explained below, even the regulator finds out about the type of the firm only after investing monitoring effort and then only with some probability.

  11. Focusing on \( n>3\) allows us to exclude some unimportant case distinctions when we turn to the comparative-statics analysis of the model which rely on a rather large number of firms to allow for an approximation of each single firm’s adoption costs. The restriction on a guarantees positive output levels for a green firm even if all other firms use the brown technology.

  12. In our model, this preferability holds from a social standpoint when the level of environmental harm is suffciently high.

  13. For example, the Dutch Criminal Code sets out a hierarchy of monetary fines depending on the category of the offense. For a survey of criminal sanctions, see, for instance, ‘Criminal Penalties in EU Member States Environmental Law’ available at ec.europa.eu/environment/legal/crime/.

  14. We assume that the expected fine is a parameter that we will vary in our comparative-statics analysis. This is a simplification. For example, Bar-Gill and Harel (2001) discuss the scenario, in which the rate of offending feeds back into the level of the expected sanction.

  15. In Sect. 4, we compare results to a scenario, in which the policy maker can observe an individual firm’s adoption cost and prescribe the technology to be used based on this information.

  16. In our numerical example to be presented after the description of stage 1, market exit is never a profitable option for firms after having sunk the market entry costs.

  17. A more accurate approximation is \( \alpha (m)=(2m-1)/(2n)\), but our simplification is not important for our qualitative results.

  18. Detailed calculations using computational software are available from the authors upon request.

  19. In the determination of \( \widetilde{m}\), it was recognized that an additional green firm implies a decrease in total output X (tantamount to an increase in the market price) and a higher output level of green firms. Both effects dampen the negative impact that results for profits from switching to the green technology. However, these effects are absent in the first line of (27).

  20. In the present example, firms would not want to exit the market even when both their adoption costs and the expected sanction are high.

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Authors and Affiliations

  1. Center for Advanced Studies in Law and Economics, University of Bonn, Bonn, Germany

    Florian Baumann

  2. Public Economics Group, University of Marburg, Am Plan 2, 35037, Marburg, Germany

    Tim Friehe

  3. CESifo, Munich, Germany

    Tim Friehe

  4. EconomiX, Paris, France

    Tim Friehe

Authors
  1. Florian Baumann
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  2. Tim Friehe
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Correspondence to Tim Friehe.

Additional information

We thank Dirk Heine, the participants of the 2014 World Congress of Environmental and Resource Economists in Istanbul, three anonymous referees, and co-editor Y. H. Farzin for very helpful comments.

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Baumann, F., Friehe, T. Design standards and technology adoption: welfare effects of increasing environmental fines when the number of firms is endogenous. Environ Econ Policy Stud 19, 427–450 (2017). https://doi.org/10.1007/s10018-016-0166-1

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