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. KEY WORDS dynamics of the firm; optimal control; pollution control
In the case where environmental problems develop smoothly and gradually it is well known that market-based approaches, e.g. taxes and marketable permits, have important efficiency advantages over pollution standards, thus restricting pollution emissions directly. ' However, as argued by Hahn and Stavins,* in practice political and technological constraints can occur that lead to a poor performance of these market-based instruments. Therefore it is important to recognize that the nature of individual environmental problems can dramatically affect the choice of preferred policy instruments. Thus, for example, for highly localized pollution problems with threshold damage functions (e.g. Reference 3, Figure .3). source-specific standards may be appropriate, whereas for pollution problems characterized by more uniform mixing over larger geographical areas, market-based approaches may be particularly desirable. This leads to the conclusion that the ideal policy package contains a mixture of instruments, with