Green consumers and the choice between emission and output taxes

This paper examines the choice of environmental policy in the presence of green consumers within a framework of imperfect competition and endogenous choice of abatement level. We begin by setting the theoretical model and providing a rigorous discussion on the determination of the environmentally aware consumers' utility function, ensuring that we do not include warm-glow effects. We represent the market outcome as a perfect information game between two strategic players: the regulator, and a monopolist whose production generates a harmful pollutant. The regulator aims at maximizing social welfare by imposing a tax on either net emissions (emissions tax), or on total output produced (output tax). We first confirm that in the absence of policy intervention, there exists a level of consumers' environmental responsiveness beyond which welfare is decreasing as market imperfections become more prominent relative to environmental concerns. We also find that both output and emission taxes are welfare superior to the free-market case. What is surprising however, is that the welfare performance of an optimally chosen emissions tax is monotonically decreasing in consumers' environmental sensitivity, while the opposite is true for an output tax. At low levels of consumers' environmental consciousness an emissions tax is welfare superior, but eventually there is a level of environmental consciousness beyond which an output tax dominates an emissions tax. Therefore, an emissions tax is better suited to societies that have not yet developed high levels of environmental awareness, while societies characterized by high levels of environmental awareness should prefer an output tax. The intuition of these results is simple: as consumers take increasingly good care of the environment by changing their consumption pattern, reductions in the output tax rate are more effective in increasing total quantity, thus leading to a) greater consumption value, and b) greater incentives for fixed investments in pollution reduction.