Before evaluating the role of trade in the combined framework, it is worth emphasizing how the combined framework facilitates analysis of the role of environmental policy within and across sectors. First, increased environmental stringency raises the cost of emissions relative to other inputs. Firms respond by shifting resources away from production and increasing their investment in abatement, seen in (2.8), thereby reducing their emissions intensity. Second, other things equal, a rise in costs due to a higher emissions tax raises average prices
and the price index in the polluting sector, given in (2.30), thereby reducing the polluting sector’s comparative advantage and resulting in the shift of resources into the clean sector.
Environmental policy is limited to these two effects under the assumption, common in heterogeneous firm models,17 that entry and production use identical factor intensities. Empirical evidence in related environmental literature calls this assumption into question. Becker et al.(2013b) present evidence that market entrants may face additional environmen- tal stringency, relative to incumbents. Theoretical and empirical work byHeutel(2011) shows that implementing different environmental stringency for new firms, relative to existing firms, for example as is the case for “grandfathering” provisions in the Clean Air Act Amendments, can result in unintended consequences in terms of firm’s production and investment behavior. The combined framework presents a similar message, but working through an endogenous entry and exit of firms that influences aggregate productivity.18 Consider a scenario in which entry does not involve the use of emissions, such that entry costs do not entail payment of an environmental tax and are instead given by, fes
w1−βsiβsνs
(1−αs)·ααs/(1−αs)s
1−αs
. In this case, the free-entry and zero profit conditions under autarky given in (D.3) become:
Vs= fs· tαss δ ∞ Z ϕ∗ s " ϕ ϕ∗ s (σ−1) − 1 # g(ϕ)dϕ = fes (2.22)
and, in contrast with a representative firm model, changes in environmental regulation now also affect the productivity cut-off and influence reallocation of resources across firms and thus firm’s entry and exit decision. In particular more stringent environmental policy raises production costs and raises the profits and productivity cut-off value that firms must have in order to remain in the market. Under this scenario, increases in environmental stringency serve to reduce emissions through a third, extensive margin, by driving the most emissions intense producers from the market. Intuitively, more stringent environmental policy raises the costs for operating firms. The presence of fixed costs means that they cannot pass all of these costs along to consumers in the form of markups, and the least productive firms suffer a revenue loss that forces them to exit. Note that this third effect would work in reverse if, instead, entry entailed more stringent environmental policy than production.
When entry and production are different types of activities, as in (2.22), more stringent environmental policy will raise productivity cut-off more when fixed production costs are high, or entry costs are low. In this case, productivity gains resulting from increased environmental stringency are higher in markets characterized by more entry: when fixed
17See examples inHopenhayn(1992);Melitz(2003);Bernard et al.(2007b). 18Heutel(2011) doesn’t consider the general equilibrium effects of entry and exit.
costs are higher, firms must earn higher profits to remain in the market and the resulting rise in average profits attracts more market entrants, while lower fixed entry costs lower barriers to entry and thus serve to raise the amount of entry. Indeed, absent a reduction in trade costs in this scenario under autarky, environmental regulation serves as the only policy mechanism in this framework that can readily affect productivity.19
2.3.1
Environmental dynamics
On the one hand, relaxing the seemingly strong assumption that entry and production use identical factor intensities does not significantly change the ultimate conclusion: environmental policy works to reallocate resources away from dirty production and reduces sector emissions intensity, however, the level of stringency required to achieve particular environmental goals does depend on these assumptions. When efficiency is a concern, the combined framework also shows that not all of the reductions in emissions intensity result from intra-firm choices regarding abatement investments, but they may also result from the exit of emissions intense producers and thereby entail job loss and resource reallocation across firms. In addition, building on Hopenhayn(1992), the combined framework emphasizes the point that the reallocation across firms driving changes in average productivity and emissions intensity will not be instantaneous. For example, if environmental policy raises the fixed entry cost that firms must cover, there will be less entry. However, because incumbent firms have already sunk that cost, the policy change primarily affects the characteristics of new entrants. Thus, the speed with which the within sector reallocation and resulting reduction in the productivity cut-off will follow depends on additional industry characteristics, like the rate of firm exit, δ. As this scenario shows, changes in environmental policy can induce changes within and across sectors that interact to influence total emissions demand, and that the effects of policy changes across firms will be contingent on the characteristics and competitiveness of the sector.