Environmental policy instruments in an international duopoly with feedback investment strategies

This paper analyses the effects of the environmental policy instruments taxes and standards on the investment behaviour of firms in the context of an international duopoly. Two production factors are considered: the capital stock and a polluting input. The government of each country values high profits for its firm and a good environmental quality. Through standards on the polluting input firms get commitment on output which is not the case under taxes. Standards thus seem a better environmental policy instrument, because for the same use of the polluting input, taxes lead the duopolists to higher investment with lower profits. This result was derived in a two-stage game model. It was confirmed in a differential game model with open-loop strategies. The paper shows that in a differential game model with feedback strategies an effect occurs that counteracts the first effect. The cause of this is that taxes induce substitution between capital and the polluting input. The conclusion is that, under taxes, firms invest more due to the absence of commitment but invest less due to substitution between the inputs. The net effect depends on the values of the parameters. Taxes are better than standards for low rates of depreciation and discount, for low investment costs and for high productivity of capital. (C) 2001 Elsevier Science B.V. All rights reserved.