Prices versus quantities: environmental regulation and imperfect competition
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By exercising market power, a firm will distort the production, and therefore the emissions decisions, of all firms in the market. This paper examines how the welfare implications of strategic behavior depend on how pollution is regulated. Under an emissions tax, aggregate emissions do not affect the marginal cost of polluting. In contrast, the price of tradable permits is endogenous. I show when this feedback effect increases strategic firms’ output. Relative to a tax, tradable permits may improve welfare in a market with imperfect competition. As an application, I model strategic and competitive behavior of wholesalers in a Mid-Atlantic electricity market. Simulations suggest that exercising market power decreased emissions locally, thereby substantially reducing the regional tradable permit price. Furthermore, I find that had regulators opted to use a tax instead of permits, the deadweight loss from imperfect competition would have been even greater.
KeywordsEnvironmental regulation Market based instruments Imperfect competition Electricity restructuring
JEL ClassificationH23 L11 L94
I would like to thank Severin Borenstein, Jim Bushnell, Stephen Holland, Nat Keohane, Barry Nalebuff, Sheila Olmstead, Ben Polak, Chris Timmins, Frank Wolak, Catherine Wolfram and seminar participants at Berkeley, Yale, and NBER.
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