Technology Diffusion with Market Power in the Upstream Industry

This paper compares taxes and tradable permits when used to regulate a competitive and polluting downstream industry that can purchase an abatement technology from a monopolistic upstream industry. Second-best policies are derived for the full range of the abatement technology's emission intensities and marginal abatement costs. The second-best permit quantity can be both above or below the socially optimal emission level. Explicit consideration of the output market provides further insights on how market power distorts the allocation in the downstream industry. The ranking between permits and taxes is ambiguous in general, but taxes weakly dominate permits if full diffusion is socially optimal. In addition, it is analysed how a cap on the permit price affects the diffusion of an abatement technology.