"It's All in the Mix!"- Internalizing externalities with R&D subsidies and environmental liability

January 28, 2014 Abstract Extending previous “tales of two market failures”, we consider a setting in which firms generate environmental externalities and may invest in environmentally friendly technological advancement generating R&D spillovers. We analyze the joint use of environmental liability law and R&D subsidies to internalize the double externality. Two alternative liability rules are considered: strict liability and negligence. In a complete information scenario, the social optimum in terms of emission levels and technical progress may be induced by combining either liability rule with an appropriate R&D subsidy. However, when the policy maker has incomplete information with respect to a firm’s productivity of R&D investments and non-discriminatorily sets a uniform liability rule and a uniform subsidy, only the so-called “double negligence” rule that imposes both an emission and a technology standard can induce the social optimum (if any one). The double negligence rule dominates strict liability with respect to the goal of minimizing social costs under modest conditions, also in cases in which none of the liability rules is capable of inducing first-best behavior among firms. Somewhat counterintuitively, a non-discriminatory double negligence rule can even dominate a (simple as well as double) negligence rule with typespecific norms and compliance-contingent type-specific subsidies.