Environmental policies, environmental firms, and transboundary pollution

Abstract Using a general equilibrium model of symmetric countries, this paper analyzes a non-cooperative game in environmental policies under transboundary pollution. Emission taxes on polluting firms and subsidies to environmental firms are available policy instruments. Environmental firms which produce pollution abatement goods and services engage in imperfect competition. Mobile capital is employed in each country by polluting and environmental firms. Compared with the first-best policies, non-cooperative taxes are lower, whereas non-cooperative subsidies are higher. Although excessive subsidies mitigate the distortionary effect of inefficiently low emission taxes, the equilibrium level of pollution is inefficiently high due to overinvestment in polluting firms and underinvestment in environmental firms. This analytical result suggests that there are limitations to what non-cooperative tax and subsidy policies can achieve regarding transboundary pollution.