Regulation of Brown and Green Firms: the case of irrational changes in lifestyles∗(V.244)

Consumers do not necessarily understand the economic trade-offs that determine the optimal level of pollution and the functioning of environmental policy instruments. When the optimal policy is implemented, market mechanisms ensure that consumption decisions are guided by correct price signals. However, green consumers may not simply react to these market signals but continue to adjust their willingness to pay for the products as pollution accumulates into the natural environment. The behaviour of green consumers then becomes a source of market failure. We consider a dynamic model of pollution control in which the environmental regulator anticipates consumers’ lack of responsiveness to environmental policy implementation. In this context, a paternalist regulator will design its environmental policy so as to correct both the environmental externality problem and the behavioural market failure. By contrast, a populist regulator will correct the environmental externality problem only. We characterize and compare the tax/subsidy policies that would be chosen by both types of planners to regulate a polluting duopoly. The implementation of the populist policy may lead either to an excessive or an insufficient level of pollution accumulation. Furthermore, it may require to provide higher subsidies to the brown firm in the long-run.