Command-and-control regulation, incentive for pollution abatement, and market structure

This paper analyzes the effect of command-and-control regulation on firms’ incentives for pollution abatement, market structure, and social welfare. We consider a regulation under which firms are not allowed to produce if they were found in noncompliance with the preset emissions standard during the government’s imperfect inspection. In the case of the ex ante monopoly, a loose standard coupled with an intensive inspection effectively induces perfect compliance. In the case of the ex ante duopoly, the intensified inspection directly creates market entry barriers, but it also induces firms to increase abatement investments for better environmental compliance, which indirectly promotes market competition. Moreover, a firm invests more in pollution abatement if it is initially cleaner or more production-efficient than its rival, or if it has fewer potential rival. We also find that regulatory tightening may harm social welfare by reducing the probability of entry, and social welfare may be higher under monopoly than under duopoly when government inspection is sufficiently intensive.