Regulating cournot oligopoly with environmental externalities

The objective of this paper is to construct a theoretical model to analyze how the government can regulate and achieve more efficient outcomes when there are environmental externalities in an oligopoly. To make the point clear, we suppose that there are two types of technology to produce an undifferentiated product: cleaner but more expensive technology and dirtier but less expensive technology. In this paper we construct a two-stage oligopoly in which firms choose their technology in the first stage and the quantities in the second stage. The technology choices are known to all the firms after the first stage. We solve the model by backward induction. Without a government regulation, the unique subgame-perfect equilibrium is such that all firms choose the dirtier technology in the first stage. We then introduce the stage zero, in which the government can choose the policy: a tax on the firms with dirty technology, a subsidy on the firms with cleaner technology, a lump-sum fine on the firms with dirty technology, or a permit to label the product produced with cleaner technology (such as ecolabels). The labeling allows the consumers to distinguish which products are made with cleaner or dirtier technology. The efficiency is measured by the social welfare (the consumer surplus plus the summation of firms' profits) with the environmental damage caused by the production with dirty technology. The expected results are such that with more eco-conscious consumers in the market the ecolabels are most effective. For extension, the model can be modified so that the government can choose more than one policy tools at a time.