Environmental Policy in Vertical Markets with Downstream Pollution: Taxes Versus Standards

Abstract

This paper examines the performance of two environmental regulation policies – emission taxes and absolute standards – in a vertical market where an upstream foreign monopolist sells a specific input to two downstream multiproduct firms that generate pollution in the domestic country. Specifically, we use a three-stage game to analyze and compare the two policies for regulating downstream pollution. In the first stage, the domestic government determines an optimal tariff and sets one of the two instruments (taxes or standards) by maximizing social welfare, in stage two, the upstream foreign monopoly sets its input price, and finally, the downstream domestic firms independently make their output and abatement decisions for profit maximization. We find that total emissions are lower under the absolute standard. Nevertheless, the tax dominates the standard in terms of domestic welfare, consumer surplus, and downstream multiproduct firms’ profits. Thus, the tax equilibrium leads to a win-win-win situation compared to the standard equilibrium. These results show the non-equivalence of emission taxes and absolute standards in regulating downstream pollution. The analyses suggest that a pollution tax is an economically and politically feasible policy.

Carbon tariffs and environmental policy: Taxes versus standards

“…Nevertheless, there are win-win outcomes under emission taxes since consumer surplus, firms' profits, and social welfare are all relatively higher. Although our study obtained similar results, it differs from Chang and Sellak (2023) in two ways. First, Chang and Sellak (2023) assumed that downstream firms purchase specific inputs from an upstream foreign monopolist, whereas our study considers carbon tariffs.…”

“…Although our study obtained similar results, it differs from Chang and Sellak (2023) in two ways. First, Chang and Sellak (2023) assumed that downstream firms purchase specific inputs from an upstream foreign monopolist, whereas our study considers carbon tariffs. Second, Chang and Sellak (2023) used a two-country, three-firm model, whereas our setting uses a three-country, twofirm model.…”

“…They find these two policies are equally efficient in a closed economy with no uncertainty. Many papers have reexamined the argument of Baumol and Oates (1988) in various extensions, such as the fixed number of firms and free entry into the market (Lahari & Ono, 2007), the degree of privatization in the mixed duopoly model (Naito & Ogawa, 2009), uncertain pollution reduction costs for symmetric oligopolistic firms (Heuson, 2010), differentiated pollution emission standards (Kato, 2011), cross-ownership between duopolistic firms (Bárcena-Ruiz & Campo, 2017;Dong & Chang, 2020), the number of private firms in mixed oligopoly (Bárcena-Ruiz et al, 2019), open economies (Antoniou et al, 2012;Chang & Sellak, 2023;Chiou & Chen, 2022;Ulph, 1992Ulph, , 1996, and interest groups (Lai, 2003). Although these studies provide several important insights, they overlook the impact of carbon tariff policies imposed by importing countries on the welfare of exporting countries that adopt emission taxes or standards.…”

“…Regardless of whether carbon tariffs are considered, the results do not always hold. Second, Chang and Sellak (2023) found that the environmental quality was relatively high under emission standards. Nevertheless, there are win-win outcomes under emission taxes since consumer surplus, firms' profits, and social welfare are all relatively higher.…”

“…First, Chang and Sellak (2023) assumed that downstream firms purchase specific inputs from an upstream foreign monopolist, whereas our study considers carbon tariffs. Second, Chang and Sellak (2023) used a two-country, three-firm model, whereas our setting uses a three-country, twofirm model. Consequently, we provide alternative theoretical support for the superiority of emissions taxes when considering carbon tariffs.…”