ABSTRACT We consider a polluting duopoly that sells differentiated goods and is subject to environmental regulation, by means of an emission or a performance standard. The firms simultaneously choose prices and investment in R&D—to improve their abatement technology—and we show that the performance standard leads to lower prices and per‐firm profits, but higher R&D, consumer surplus and social welfare when the goods are substitutes. If the goods are complements, such rankings may be reversed, except for the welfare comparison. We also provide a full comparative statics analysis of the equilibria under both instruments with respect to the stringency of the regulation and the degree of product differentiation. Finally, we show that the entry of firms reduces social welfare and eventually reverses its comparison.
Gama et al. (Tue,) studied this question.