Pollution control and the dynamics of the firm: The effects of market-based instruments on optimal firm investments

This contribution belongs to a category of papers that attempts to determine the effects of environmental regulation on the growth of an individual firm. It extends the existing literature in at least two ways. First, our pollution function explicitly deals with the fact that it is more difficult to reduce pollution by abatement activities when pollution is already low. Second, according to our knowledge it is for the first time that marketable pollution permits are incorporated in a dynamic model of the firm. In the paper we establish the effects of a pollution tax and marketable permits on the behaviour of the firm. For the tax model as well as the marketable permits model we prove that the steady state is stable and approached monotonically and we derive formulae for optimal investment policies. Owing to non-zero cross-effects in the pollution function, comparative statics analysis shows that an increase in the pollution tax rate or an increase in the permit price does not necessarily lead to a decrease in pollution. Furthermore, a condition is obtained under which long-run firm behaviour is the same when either a tax or marketable permits are imposed.