More environmental regulation can increase corporate profits

provided by University of Arkansas

ncreasing environmental regulations can decrease production costs and increase corporate profits, according to University of Arkansas economist Amy Farmer.

    Although there may be cost-saving opportunities, most firms may choose to not adopt a new, potentially cost-saving pollution abatement technology, according to Farmer, associate professor of economics in the Walton College of Business, and economists James Kahn of the University of Tennessee, Judith McDonald of Lehigh University and Robert O'Neill of Oak Ridge National Laboratory. They report their findings in the journal Ecological Economics.

    “Some researchers believe that capital markets or subsidies for production or R&D innovation will cause companies to adopt green technologies,” said Farmer. “However, we found that it is strategic behavior, rather than market failure, that causes companies to not adopt these technologies.”

    If, for example, a pollution abatement technology exists, but the impact of implementation on production is unknown, companies may choose not to implement the technology.

    “The implications of this for environmental policy are straightforward,” said Farmer. “Under certain circumstances firms would not adopt cost-saving green technologies without government intervention. Therefore, stricter environmental policy could raise social welfare not only through improving environmental quality, but also through decreasing the cost of production.”

    By examining the situation as a game-theory problem, the researchers found that a company would choose to not adopt the technology if it could raise the profits of all firms in the industry.

    “If one firm goes forward and adopts the new technology, it bears the sole cost of gathering the information, but its competitors can make their decisions based on superior information,” Farmer explained.

    Should the implementation be successful, other companies can adopt it and realize the profits without incurring costs. However, if the implementation is unsuccessful, or even if it is neutral, no competitors will follow suit and, again, the leading firm bears all of the costs. Either way, from a strategic perspective, the company that takes the lead loses.

    In this situation, it pays to be a follower rather than a leader, according to Farmer. This is counter to standard economic theory that says firms do not need regulations to be induced to undertake profitable activities. The economists looked at several counter-examples to illustrate this strategic behavior.

    For example, given two similar firms competing in the same industry with similar production costs and market demands, both firms may initially choose to follow. However, if one firm refuses to lead, application of game theory shows that the other firm may also refuse to lead. Both firms may choose to maintain the status quo rather than incur the cost of innovation.

    The researchers also considered the problems of determining the optimal level of pollution and the degradation of environmental services that result from pollution. Determining optimal pollution levels is a dynamic problem that requires consideration of the impact of current regulation on future abatement costs.

    From this perspective, the researchers consider strict environmental policy as not only potentially more efficient, but as an investment that may allow future periods to have higher levels of both environmental quality and gross domestic product.

    Ecological services such as waste assimilation, carbon sequestration, biodiversity, watershed protection and soil formation are usually not considered in economic evaluations of environmental degradation. Traditional models have assumed that human-made capital and labor can be substituted for exhaustible resources like oil or coal.

    However, at the scale that ecosystems provide these services, it is impossible to produce these ecological services in human-engineered systems, according to the economists. They also found that ecological complexities and nonlinearities, which are not discussed in the economics literature, add an additional source of irreversibility and uncertainty that “generates the need for more caution when considering the target level of environmental quality of environmental preservation.”

    Because of these factors and business strategies, the researchers argue that environmental policy should be stricter than it is currently.