Environmental regulation and firm markup: evidence from $$\hbox {SO}_2$$ reduction policy in China

Abstract We estimate the impact of province-specific pollution reduction targets on firms’ markups in the Chinese manufacturing sector. China’s Eleventh Five-Year Plan mandated $$\hbox {SO}_2$$ <mml:math xmlns:mml="http://www.w3.org/1998/Math/MathML"> <mml:msub> <mml:mtext>SO</mml:mtext> <mml:mn>2</mml:mn> </mml:msub> </mml:math> reduction targets that varied across provinces, providing a natural experiment to analyze the effects of environmental regulation stringency on firms’ performance. Using a detailed firm-level dataset covering 85–90% of China’s industrial value-added between 1998 and 2007, we find that more stringent environmental regulations caused a 1.54% decrease in firms’ markups. High-pollution industries, non-exporters, and state-owned firms were particularly sensitive to the regulation stringency. To investigate the underlying mechanisms, we analyze firm-level output and $$\hbox {SO}_2$$ <mml:math xmlns:mml="http://www.w3.org/1998/Math/MathML"> <mml:msub> <mml:mtext>SO</mml:mtext> <mml:mn>2</mml:mn> </mml:msub> </mml:math> emissions and find evidence that firms reduced production and emissions in response to tighter regulation, consistent with a supply-side adjustment. While existing literature predominantly focuses on the relationship between environmental regulations and firms’ productivity, we emphasize the importance of markup effects for a more comprehensive understanding of the overall impacts of environmental regulations on firm performance and market dynamics.