environmental regulation and industry dynamicscontribution of the paper establishes a relation...
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Environmental Regulation and Industry Dynamics
Aditi Sengupta
Southern Methodist University
30th January, 2010
Aditi Sengupta (SMU) Environmental Regulation and Industry Dynamics 30th January, 2010 1 / 24
Question
What is the relationship between environmental regulation andindustry dynamics?
How does the increasing stringency of exogenously givenenvironmental regulation a¤ect:
size distribution,capital formation in �rms,inter-�rm heterogeneity,entry-exit, andshake-out (�early� exit ) of �rms?
Aditi Sengupta (SMU) Environmental Regulation and Industry Dynamics 30th January, 2010 2 / 24
Question
What is the relationship between environmental regulation andindustry dynamics?
How does the increasing stringency of exogenously givenenvironmental regulation a¤ect:
size distribution,capital formation in �rms,inter-�rm heterogeneity,entry-exit, andshake-out (�early� exit ) of �rms?
Aditi Sengupta (SMU) Environmental Regulation and Industry Dynamics 30th January, 2010 2 / 24
Question
What is the relationship between environmental regulation andindustry dynamics?
How does the increasing stringency of exogenously givenenvironmental regulation a¤ect:
size distribution,
capital formation in �rms,inter-�rm heterogeneity,entry-exit, andshake-out (�early� exit ) of �rms?
Aditi Sengupta (SMU) Environmental Regulation and Industry Dynamics 30th January, 2010 2 / 24
Question
What is the relationship between environmental regulation andindustry dynamics?
How does the increasing stringency of exogenously givenenvironmental regulation a¤ect:
size distribution,capital formation in �rms,
inter-�rm heterogeneity,entry-exit, andshake-out (�early� exit ) of �rms?
Aditi Sengupta (SMU) Environmental Regulation and Industry Dynamics 30th January, 2010 2 / 24
Question
What is the relationship between environmental regulation andindustry dynamics?
How does the increasing stringency of exogenously givenenvironmental regulation a¤ect:
size distribution,capital formation in �rms,inter-�rm heterogeneity,
entry-exit, andshake-out (�early� exit ) of �rms?
Aditi Sengupta (SMU) Environmental Regulation and Industry Dynamics 30th January, 2010 2 / 24
Question
What is the relationship between environmental regulation andindustry dynamics?
How does the increasing stringency of exogenously givenenvironmental regulation a¤ect:
size distribution,capital formation in �rms,inter-�rm heterogeneity,entry-exit, and
shake-out (�early� exit ) of �rms?
Aditi Sengupta (SMU) Environmental Regulation and Industry Dynamics 30th January, 2010 2 / 24
Question
What is the relationship between environmental regulation andindustry dynamics?
How does the increasing stringency of exogenously givenenvironmental regulation a¤ect:
size distribution,capital formation in �rms,inter-�rm heterogeneity,entry-exit, andshake-out (�early� exit ) of �rms?
Aditi Sengupta (SMU) Environmental Regulation and Industry Dynamics 30th January, 2010 2 / 24
Contribution of the paper
Establishes a relation between environmental regulation and industrydynamics via investment in compliance technology.
More speci�cally, the e¤ect of the increasing stringency ofenvironmental regulation on industry dynamics i.e., size distribution,investment behavior, heterogeneity, and shake-out of �rms.
Shows that �rms that exit earlier on the industry equilibrium pathhave higher cost of compliance and are smaller in size.
Finds su¢ cient conditions under which on the equilibrium path withmore stringent regulation:
the industry experiences higher shake-out, andthe active �rms have lower cost of compliance.
Aditi Sengupta (SMU) Environmental Regulation and Industry Dynamics 30th January, 2010 3 / 24
Contribution of the paper
Establishes a relation between environmental regulation and industrydynamics via investment in compliance technology.
More speci�cally, the e¤ect of the increasing stringency ofenvironmental regulation on industry dynamics i.e., size distribution,investment behavior, heterogeneity, and shake-out of �rms.
Shows that �rms that exit earlier on the industry equilibrium pathhave higher cost of compliance and are smaller in size.
Finds su¢ cient conditions under which on the equilibrium path withmore stringent regulation:
the industry experiences higher shake-out, andthe active �rms have lower cost of compliance.
Aditi Sengupta (SMU) Environmental Regulation and Industry Dynamics 30th January, 2010 3 / 24
Contribution of the paper
Establishes a relation between environmental regulation and industrydynamics via investment in compliance technology.
More speci�cally, the e¤ect of the increasing stringency ofenvironmental regulation on industry dynamics i.e., size distribution,investment behavior, heterogeneity, and shake-out of �rms.
Shows that �rms that exit earlier on the industry equilibrium pathhave higher cost of compliance and are smaller in size.
Finds su¢ cient conditions under which on the equilibrium path withmore stringent regulation:
the industry experiences higher shake-out, andthe active �rms have lower cost of compliance.
Aditi Sengupta (SMU) Environmental Regulation and Industry Dynamics 30th January, 2010 3 / 24
Contribution of the paper
Establishes a relation between environmental regulation and industrydynamics via investment in compliance technology.
More speci�cally, the e¤ect of the increasing stringency ofenvironmental regulation on industry dynamics i.e., size distribution,investment behavior, heterogeneity, and shake-out of �rms.
Shows that �rms that exit earlier on the industry equilibrium pathhave higher cost of compliance and are smaller in size.
Finds su¢ cient conditions under which on the equilibrium path withmore stringent regulation:
the industry experiences higher shake-out, andthe active �rms have lower cost of compliance.
Aditi Sengupta (SMU) Environmental Regulation and Industry Dynamics 30th January, 2010 3 / 24
Contribution of the paper
Establishes a relation between environmental regulation and industrydynamics via investment in compliance technology.
More speci�cally, the e¤ect of the increasing stringency ofenvironmental regulation on industry dynamics i.e., size distribution,investment behavior, heterogeneity, and shake-out of �rms.
Shows that �rms that exit earlier on the industry equilibrium pathhave higher cost of compliance and are smaller in size.
Finds su¢ cient conditions under which on the equilibrium path withmore stringent regulation:
the industry experiences higher shake-out, and
the active �rms have lower cost of compliance.
Aditi Sengupta (SMU) Environmental Regulation and Industry Dynamics 30th January, 2010 3 / 24
Contribution of the paper
Establishes a relation between environmental regulation and industrydynamics via investment in compliance technology.
More speci�cally, the e¤ect of the increasing stringency ofenvironmental regulation on industry dynamics i.e., size distribution,investment behavior, heterogeneity, and shake-out of �rms.
Shows that �rms that exit earlier on the industry equilibrium pathhave higher cost of compliance and are smaller in size.
Finds su¢ cient conditions under which on the equilibrium path withmore stringent regulation:
the industry experiences higher shake-out, andthe active �rms have lower cost of compliance.
Aditi Sengupta (SMU) Environmental Regulation and Industry Dynamics 30th January, 2010 3 / 24
Contribution of the paper
Explains
the empirical regularities of industry dynamics,the (mixed) empirical evidence on the e¤ect of environmentalregulation on shake-out.
In our model shake-out occurs as a part of socially e¢ cientcompetitive behavior of dynamic equilibrium path of an industry. Itdoes not imply any anticompetitive role of environmental regulation.
Aditi Sengupta (SMU) Environmental Regulation and Industry Dynamics 30th January, 2010 4 / 24
Contribution of the paper
Explains
the empirical regularities of industry dynamics,
the (mixed) empirical evidence on the e¤ect of environmentalregulation on shake-out.
In our model shake-out occurs as a part of socially e¢ cientcompetitive behavior of dynamic equilibrium path of an industry. Itdoes not imply any anticompetitive role of environmental regulation.
Aditi Sengupta (SMU) Environmental Regulation and Industry Dynamics 30th January, 2010 4 / 24
Contribution of the paper
Explains
the empirical regularities of industry dynamics,the (mixed) empirical evidence on the e¤ect of environmentalregulation on shake-out.
In our model shake-out occurs as a part of socially e¢ cientcompetitive behavior of dynamic equilibrium path of an industry. Itdoes not imply any anticompetitive role of environmental regulation.
Aditi Sengupta (SMU) Environmental Regulation and Industry Dynamics 30th January, 2010 4 / 24
Contribution of the paper
Explains
the empirical regularities of industry dynamics,the (mixed) empirical evidence on the e¤ect of environmentalregulation on shake-out.
In our model shake-out occurs as a part of socially e¢ cientcompetitive behavior of dynamic equilibrium path of an industry. Itdoes not imply any anticompetitive role of environmental regulation.
Aditi Sengupta (SMU) Environmental Regulation and Industry Dynamics 30th January, 2010 4 / 24
Structure of the model
T (1 < T < ∞) period deterministic dynamic model.
Homogenous good industry with exogenously given level ofenvironmental regulation (α).Continuum of identical price taking potential entrants, each ofmeasure zero.
Free entry and exit.
Stationary market demand D(p).
Aditi Sengupta (SMU) Environmental Regulation and Industry Dynamics 30th January, 2010 5 / 24
Structure of the model
T (1 < T < ∞) period deterministic dynamic model.Homogenous good industry with exogenously given level ofenvironmental regulation (α).
Continuum of identical price taking potential entrants, each ofmeasure zero.
Free entry and exit.
Stationary market demand D(p).
Aditi Sengupta (SMU) Environmental Regulation and Industry Dynamics 30th January, 2010 5 / 24
Structure of the model
T (1 < T < ∞) period deterministic dynamic model.Homogenous good industry with exogenously given level ofenvironmental regulation (α).Continuum of identical price taking potential entrants, each ofmeasure zero.
Free entry and exit.
Stationary market demand D(p).
Aditi Sengupta (SMU) Environmental Regulation and Industry Dynamics 30th January, 2010 5 / 24
Structure of the model
T (1 < T < ∞) period deterministic dynamic model.Homogenous good industry with exogenously given level ofenvironmental regulation (α).Continuum of identical price taking potential entrants, each ofmeasure zero.
Free entry and exit.
Stationary market demand D(p).
Aditi Sengupta (SMU) Environmental Regulation and Industry Dynamics 30th January, 2010 5 / 24
Structure of the model
T (1 < T < ∞) period deterministic dynamic model.Homogenous good industry with exogenously given level ofenvironmental regulation (α).Continuum of identical price taking potential entrants, each ofmeasure zero.
Free entry and exit.
Stationary market demand D(p).
Aditi Sengupta (SMU) Environmental Regulation and Industry Dynamics 30th January, 2010 5 / 24
Production Cost
Continuously di¤erentiable production cost c(q) where c : R+ ! R+
Upward sloping marginal cost with �xed cost
c (0) > 0, c0> 0, c
00> 0
U-shaped average cost curve.
Aditi Sengupta (SMU) Environmental Regulation and Industry Dynamics 30th January, 2010 6 / 24
Production Cost
Continuously di¤erentiable production cost c(q) where c : R+ ! R+Upward sloping marginal cost with �xed cost
c (0) > 0, c0> 0, c
00> 0
U-shaped average cost curve.
Aditi Sengupta (SMU) Environmental Regulation and Industry Dynamics 30th January, 2010 6 / 24
Production Cost
Continuously di¤erentiable production cost c(q) where c : R+ ! R+Upward sloping marginal cost with �xed cost
c (0) > 0, c0> 0, c
00> 0
U-shaped average cost curve.
Aditi Sengupta (SMU) Environmental Regulation and Industry Dynamics 30th January, 2010 6 / 24
Investment
γ (x): cost of investment where x � 0 is the investment made by a�rm.
γ : R+ ! R+ is continuously di¤erentiable, strictly increasing convexfunction.
γ (0) = 0,γ0> 0 and γ" � 0.
y 2 R+ : the stock of capital of a �rm.If a �rm enters in period τ, then for t > τ,
yt = xτ + xτ+1 + ......+ xt , yτ = 0.
No externality across the �rms arising from cost reducing investment.
Aditi Sengupta (SMU) Environmental Regulation and Industry Dynamics 30th January, 2010 7 / 24
Investment
γ (x): cost of investment where x � 0 is the investment made by a�rm.
γ : R+ ! R+ is continuously di¤erentiable, strictly increasing convexfunction.
γ (0) = 0,γ0> 0 and γ" � 0.
y 2 R+ : the stock of capital of a �rm.
If a �rm enters in period τ, then for t > τ,
yt = xτ + xτ+1 + ......+ xt , yτ = 0.
No externality across the �rms arising from cost reducing investment.
Aditi Sengupta (SMU) Environmental Regulation and Industry Dynamics 30th January, 2010 7 / 24
Investment
γ (x): cost of investment where x � 0 is the investment made by a�rm.
γ : R+ ! R+ is continuously di¤erentiable, strictly increasing convexfunction.
γ (0) = 0,γ0> 0 and γ" � 0.
y 2 R+ : the stock of capital of a �rm.If a �rm enters in period τ, then for t > τ,
yt = xτ + xτ+1 + ......+ xt , yτ = 0.
No externality across the �rms arising from cost reducing investment.
Aditi Sengupta (SMU) Environmental Regulation and Industry Dynamics 30th January, 2010 7 / 24
Investment
γ (x): cost of investment where x � 0 is the investment made by a�rm.
γ : R+ ! R+ is continuously di¤erentiable, strictly increasing convexfunction.
γ (0) = 0,γ0> 0 and γ" � 0.
y 2 R+ : the stock of capital of a �rm.If a �rm enters in period τ, then for t > τ,
yt = xτ + xτ+1 + ......+ xt , yτ = 0.
No externality across the �rms arising from cost reducing investment.
Aditi Sengupta (SMU) Environmental Regulation and Industry Dynamics 30th January, 2010 7 / 24
Environmental Regulation
α 2 R+ : the exogenous level of regulation imposed on the industry inorder to control the pollution generated by these �rms.
It is assumed to be constant over a dynamic path of an industry.
α = 0 implies no regulation.
α can take di¤erent forms of pollution control measures.
Aditi Sengupta (SMU) Environmental Regulation and Industry Dynamics 30th January, 2010 8 / 24
Environmental Regulation
α 2 R+ : the exogenous level of regulation imposed on the industry inorder to control the pollution generated by these �rms.
It is assumed to be constant over a dynamic path of an industry.
α = 0 implies no regulation.
α can take di¤erent forms of pollution control measures.
Aditi Sengupta (SMU) Environmental Regulation and Industry Dynamics 30th January, 2010 8 / 24
Environmental Regulation
α 2 R+ : the exogenous level of regulation imposed on the industry inorder to control the pollution generated by these �rms.
It is assumed to be constant over a dynamic path of an industry.
α = 0 implies no regulation.
α can take di¤erent forms of pollution control measures.
Aditi Sengupta (SMU) Environmental Regulation and Industry Dynamics 30th January, 2010 8 / 24
Environmental Regulation
α 2 R+ : the exogenous level of regulation imposed on the industry inorder to control the pollution generated by these �rms.
It is assumed to be constant over a dynamic path of an industry.
α = 0 implies no regulation.
α can take di¤erent forms of pollution control measures.
Aditi Sengupta (SMU) Environmental Regulation and Industry Dynamics 30th January, 2010 8 / 24
Cost of Compliance
Cost of compliance with the exogenous regulation (α)
φ (q, y , α)
where φ : R3+ ! R+ is continuously di¤erentiable in all the arguments.
Assumptions:φ(q, y , 0) = 0 and φ(0, y , α) = 0
φq > 0, φy � 0 and φα > 0.
γ0(0) < �δφy (q, 0, α) 8q > 0, α > 0 where δ 2 (0, 1)φqq > 0, φqy � 0, φqα > 0, φyy > 0 and φyα � 0.
Aditi Sengupta (SMU) Environmental Regulation and Industry Dynamics 30th January, 2010 9 / 24
Maximization problem
Given α and p = (p1, ....pT ) , a typical �rm i maximizes discounted sum ofpro�t
τ(i )
∑t=τ(i )
δt�τ(i ) [ptqt (i)� c (qt (i))� φ (qt (i) , yt (i) , α)� γ (xt (i))]
with respect to the period of entry τ (i), period of exit τ (i) ,output qt (i) ,and investment xt (i).
Aditi Sengupta (SMU) Environmental Regulation and Industry Dynamics 30th January, 2010 10 / 24
De�nition of Industry Equilibrium
Given the exogenous level of regulation α > 0, an industry equilibriumconsists of period of entry, period of exit, output and investment pro�le of�rms and price vector p such that
market clears in every period,
the output-investment for each active �rm maximizes its netdiscounted sum of pro�ts over its lifetime,
irrespective of the period of entry and exit, all that enter the industryearn exactly zero net intertemporal pro�t over their lifetime in theindustry,
no �rm can make strictly positive intertemporal pro�t irrespective ofits period of entry
There exists an industry equilibrium, and it is (restricted) sociallyoptimal (maximizes discounted sum of consumer and producer surplusin the industry over time).
Aditi Sengupta (SMU) Environmental Regulation and Industry Dynamics 30th January, 2010 11 / 24
De�nition of Industry Equilibrium
Given the exogenous level of regulation α > 0, an industry equilibriumconsists of period of entry, period of exit, output and investment pro�le of�rms and price vector p such that
market clears in every period,
the output-investment for each active �rm maximizes its netdiscounted sum of pro�ts over its lifetime,
irrespective of the period of entry and exit, all that enter the industryearn exactly zero net intertemporal pro�t over their lifetime in theindustry,
no �rm can make strictly positive intertemporal pro�t irrespective ofits period of entry
There exists an industry equilibrium, and it is (restricted) sociallyoptimal (maximizes discounted sum of consumer and producer surplusin the industry over time).
Aditi Sengupta (SMU) Environmental Regulation and Industry Dynamics 30th January, 2010 11 / 24
De�nition of Industry Equilibrium
Given the exogenous level of regulation α > 0, an industry equilibriumconsists of period of entry, period of exit, output and investment pro�le of�rms and price vector p such that
market clears in every period,
the output-investment for each active �rm maximizes its netdiscounted sum of pro�ts over its lifetime,
irrespective of the period of entry and exit, all that enter the industryearn exactly zero net intertemporal pro�t over their lifetime in theindustry,
no �rm can make strictly positive intertemporal pro�t irrespective ofits period of entry
There exists an industry equilibrium, and it is (restricted) sociallyoptimal (maximizes discounted sum of consumer and producer surplusin the industry over time).
Aditi Sengupta (SMU) Environmental Regulation and Industry Dynamics 30th January, 2010 11 / 24
De�nition of Industry Equilibrium
Given the exogenous level of regulation α > 0, an industry equilibriumconsists of period of entry, period of exit, output and investment pro�le of�rms and price vector p such that
market clears in every period,
the output-investment for each active �rm maximizes its netdiscounted sum of pro�ts over its lifetime,
irrespective of the period of entry and exit, all that enter the industryearn exactly zero net intertemporal pro�t over their lifetime in theindustry,
no �rm can make strictly positive intertemporal pro�t irrespective ofits period of entry
There exists an industry equilibrium, and it is (restricted) sociallyoptimal (maximizes discounted sum of consumer and producer surplusin the industry over time).
Aditi Sengupta (SMU) Environmental Regulation and Industry Dynamics 30th January, 2010 11 / 24
De�nition of Industry Equilibrium
Given the exogenous level of regulation α > 0, an industry equilibriumconsists of period of entry, period of exit, output and investment pro�le of�rms and price vector p such that
market clears in every period,
the output-investment for each active �rm maximizes its netdiscounted sum of pro�ts over its lifetime,
irrespective of the period of entry and exit, all that enter the industryearn exactly zero net intertemporal pro�t over their lifetime in theindustry,
no �rm can make strictly positive intertemporal pro�t irrespective ofits period of entry
There exists an industry equilibrium, and it is (restricted) sociallyoptimal (maximizes discounted sum of consumer and producer surplusin the industry over time).
Aditi Sengupta (SMU) Environmental Regulation and Industry Dynamics 30th January, 2010 11 / 24
Main ResultsCharacteristics of dynamic equilibrium path
For a given level of regulation (α), on any industry equilibrium path
prices are non-increasing over time,
no entry occurs after the initial period,
some �rms exit before others (shake-out), and
�rms that exit earlier have lower accumulated investment, highercompliance cost, and smaller in size.
Aditi Sengupta (SMU) Environmental Regulation and Industry Dynamics 30th January, 2010 12 / 24
Main ResultsCharacteristics of dynamic equilibrium path
For a given level of regulation (α), on any industry equilibrium path
prices are non-increasing over time,
no entry occurs after the initial period,
some �rms exit before others (shake-out), and
�rms that exit earlier have lower accumulated investment, highercompliance cost, and smaller in size.
Aditi Sengupta (SMU) Environmental Regulation and Industry Dynamics 30th January, 2010 12 / 24
Main ResultsCharacteristics of dynamic equilibrium path
For a given level of regulation (α), on any industry equilibrium path
prices are non-increasing over time,
no entry occurs after the initial period,
some �rms exit before others (shake-out), and
�rms that exit earlier have lower accumulated investment, highercompliance cost, and smaller in size.
Aditi Sengupta (SMU) Environmental Regulation and Industry Dynamics 30th January, 2010 12 / 24
Main ResultsCharacteristics of dynamic equilibrium path
For a given level of regulation (α), on any industry equilibrium path
prices are non-increasing over time,
no entry occurs after the initial period,
some �rms exit before others (shake-out), and
�rms that exit earlier have lower accumulated investment, highercompliance cost, and smaller in size.
Aditi Sengupta (SMU) Environmental Regulation and Industry Dynamics 30th January, 2010 12 / 24
Why does shake-out of �rms occur on the industryequilibrium path?Social planner�s perspective
Introduction of regulation=) steep marginal cost curve =) large numberof �rms to # the total cost of the industry.
Strictly positive investment =) �atter e¤ective marginal cost overtime.=) # number of �rms in the industry.
Aditi Sengupta (SMU) Environmental Regulation and Industry Dynamics 30th January, 2010 13 / 24
Numerical example 1Three period model
D(p) = 100� p, c(q) = 10+ eq , γ(x) = 0.5x2
φ (q, y , α) = α.e(q, y) = αeq�λy
δ = 0.5 is the discount factor
λ � 0 is the e¢ ciency of accumulated capital in compliance costreduction.
α = 0.03 is the exogenous unit pollution tax rate.
Aditi Sengupta (SMU) Environmental Regulation and Industry Dynamics 30th January, 2010 14 / 24
Example 1: results
Table 1: Dynamic equilibriumt pt D(pt ) nt =
D (pt )qt
nt�nt�1nt�1
1 8.7637 91.2362 42.6125 �2 8.7569 91.2430 42.5474 �0.00153 8.7432 91.2567 42.5366 �0.0002
Aditi Sengupta (SMU) Environmental Regulation and Industry Dynamics 30th January, 2010 15 / 24
Example 1: results
Table 2: Firm that exits at the end of period 2t qt xt πt
1 2.1410 0.1141 �0.00652 2.1434 0 0.0130
Table 3: Firm that exits at the end of period 3t qt xt πt
1 2.1410 0.1588 �0.01262 2.1445 0.0990 0.01803 2.1454 0 0.0142
Aditi Sengupta (SMU) Environmental Regulation and Industry Dynamics 30th January, 2010 16 / 24
Comparative dynamicsExample 2
D(p) = p�1.5, c(q) = 1+ q2, γ(x) = 0.5x2
φ (q, y , α) = αe(q, y), e(q, y) = q1.5(1� y)5
Aditi Sengupta (SMU) Environmental Regulation and Industry Dynamics 30th January, 2010 17 / 24
ResultsExample 2
Table 4
t α q x1 p D (p) n = D (p)q
nt�nt�1nt�1
1 0.03 0.9925 0.0585 2.0299 0.3457 0.34832 0.03 0.9961 0 2.0256 0.3468 0.3481 �0.00041 0.05 0.9876 0.0865 2.0498 0.3407 0.34492 0.05 0.9958 0 2.0392 0.3433 0.3448 �0.00051 0.07 0.9828 0.1094 2.0696 0.3358 0.34172 0.07 0.9962 0 2.0519 0.3404 0.3416 �0.00011 0.10 0.9827 0.1358 2.0588 0.3313 0.33712 0.10 0.9827 0 2.0588 0.3313 0.3371 0
Aditi Sengupta (SMU) Environmental Regulation and Industry Dynamics 30th January, 2010 18 / 24
Main ResultsComparative dynamics
Consider two period model.
Additional assumption: for any given level of regulation, on industryequilibrium path some �rms exit after period 1.
Aditi Sengupta (SMU) Environmental Regulation and Industry Dynamics 30th January, 2010 19 / 24
Comparative dynamics
Su¢ cient conditions under which on the equilibrium path with morestringent regulation active �rms invest more i.e., have lower cost ofcompliance.
Why would a �rm not invest more on the higher regulation path?
With high regulation the compliance cost is high, and thus �rms wantto invest more to reduce that cost.But there is a disincentive e¤ect: If regulation is quite high then thereturn from investment may not be that pro�table.Two extreme cases: Prohibitive regulation (regulation too high) andNo regulation =) zero investment.
Aditi Sengupta (SMU) Environmental Regulation and Industry Dynamics 30th January, 2010 20 / 24
Comparative dynamics
Su¢ cient conditions under which on the equilibrium path with morestringent regulation active �rms invest more i.e., have lower cost ofcompliance.
Why would a �rm not invest more on the higher regulation path?
With high regulation the compliance cost is high, and thus �rms wantto invest more to reduce that cost.But there is a disincentive e¤ect: If regulation is quite high then thereturn from investment may not be that pro�table.Two extreme cases: Prohibitive regulation (regulation too high) andNo regulation =) zero investment.
Aditi Sengupta (SMU) Environmental Regulation and Industry Dynamics 30th January, 2010 20 / 24
Comparative dynamics
Su¢ cient conditions under which on the equilibrium path with morestringent regulation active �rms invest more i.e., have lower cost ofcompliance.
Why would a �rm not invest more on the higher regulation path?
With high regulation the compliance cost is high, and thus �rms wantto invest more to reduce that cost.
But there is a disincentive e¤ect: If regulation is quite high then thereturn from investment may not be that pro�table.Two extreme cases: Prohibitive regulation (regulation too high) andNo regulation =) zero investment.
Aditi Sengupta (SMU) Environmental Regulation and Industry Dynamics 30th January, 2010 20 / 24
Comparative dynamics
Su¢ cient conditions under which on the equilibrium path with morestringent regulation active �rms invest more i.e., have lower cost ofcompliance.
Why would a �rm not invest more on the higher regulation path?
With high regulation the compliance cost is high, and thus �rms wantto invest more to reduce that cost.But there is a disincentive e¤ect: If regulation is quite high then thereturn from investment may not be that pro�table.
Two extreme cases: Prohibitive regulation (regulation too high) andNo regulation =) zero investment.
Aditi Sengupta (SMU) Environmental Regulation and Industry Dynamics 30th January, 2010 20 / 24
Comparative dynamics
Su¢ cient conditions under which on the equilibrium path with morestringent regulation active �rms invest more i.e., have lower cost ofcompliance.
Why would a �rm not invest more on the higher regulation path?
With high regulation the compliance cost is high, and thus �rms wantto invest more to reduce that cost.But there is a disincentive e¤ect: If regulation is quite high then thereturn from investment may not be that pro�table.Two extreme cases: Prohibitive regulation (regulation too high) andNo regulation =) zero investment.
Aditi Sengupta (SMU) Environmental Regulation and Industry Dynamics 30th January, 2010 20 / 24
Comparative dynamics
Su¢ cient conditions under which the industry experiences highershake-out.
Conditions under which on a dynamic path with higher regulation thenumber of �rms is higher in period 1 and lower in period 2.
Aditi Sengupta (SMU) Environmental Regulation and Industry Dynamics 30th January, 2010 21 / 24
Comparative dynamics
Su¢ cient conditions under which the industry experiences highershake-out.Conditions under which on a dynamic path with higher regulation thenumber of �rms is higher in period 1 and lower in period 2.
Aditi Sengupta (SMU) Environmental Regulation and Industry Dynamics 30th January, 2010 21 / 24
Average cost under
weak regulation
Marginal cost under
weak regulation
Marginal cost under
stringent regulation
Average cost under
stringent regulation
Demand curve
Higher number of firms in period 1 under stringent regulation
Price under
stringent
regulation
Price under weak
regulation
price
q, Q
Number of firms = Total industry output (Q) /
minimum efficient scale (q)
q1 Q1q2 Q2
Q1/q1 > Q2/q2
Comparative dynamicsHigher number of �rms in period 1
The price in period 1 is exactly equal to minimum average cost of anew entrant.
Each �rm produces at its minimum e¢ cient scale earning exactly zerocurrent pro�t (gross of investment).
Therefore, the number of �rms in period 1 is higher on the morestringent regulation path i¤ the minimum e¢ cient scale is moresensitive to regulation than the total industry demand (possible whenthe demand curve is su¢ ciently inelastic).
Aditi Sengupta (SMU) Environmental Regulation and Industry Dynamics 30th January, 2010 22 / 24
Comparative dynamicsThree e¤ects of higher regulation on the number of �rms
E¤ect 1: (Given investment) higher level of regulation =) " costof the industry =) " the equilibrium price and # total industryoutput sold =) # the number of �rms in period 2. (Direct e¤ect)
E¤ect 2: (Given investment) higher level of regulation =) " theaverage cost and the e¤ective marginal cost =) alter the optimalscale =) a¤ect the number of �rms depending on the direction andextent of changes in optimal scale. (Direct e¤ect)E¤ect 3: " in regulation may " investment =) " in the optimalscale =) # the number of �rms. (Indirect e¤ect)
Aditi Sengupta (SMU) Environmental Regulation and Industry Dynamics 30th January, 2010 23 / 24
Comparative dynamicsThree e¤ects of higher regulation on the number of �rms
E¤ect 1: (Given investment) higher level of regulation =) " costof the industry =) " the equilibrium price and # total industryoutput sold =) # the number of �rms in period 2. (Direct e¤ect)E¤ect 2: (Given investment) higher level of regulation =) " theaverage cost and the e¤ective marginal cost =) alter the optimalscale =) a¤ect the number of �rms depending on the direction andextent of changes in optimal scale. (Direct e¤ect)
E¤ect 3: " in regulation may " investment =) " in the optimalscale =) # the number of �rms. (Indirect e¤ect)
Aditi Sengupta (SMU) Environmental Regulation and Industry Dynamics 30th January, 2010 23 / 24
Comparative dynamicsThree e¤ects of higher regulation on the number of �rms
E¤ect 1: (Given investment) higher level of regulation =) " costof the industry =) " the equilibrium price and # total industryoutput sold =) # the number of �rms in period 2. (Direct e¤ect)E¤ect 2: (Given investment) higher level of regulation =) " theaverage cost and the e¤ective marginal cost =) alter the optimalscale =) a¤ect the number of �rms depending on the direction andextent of changes in optimal scale. (Direct e¤ect)E¤ect 3: " in regulation may " investment =) " in the optimalscale =) # the number of �rms. (Indirect e¤ect)
Aditi Sengupta (SMU) Environmental Regulation and Industry Dynamics 30th January, 2010 23 / 24
Conclusion
Establishes a relation between environmental regulation and industrydynamics via investment in compliance technology.
The e¤ect of the increasing stringency of environmental regulation onindustry dynamics i.e., size distribution, investment behavior,heterogeneity and shake-out of �rms.
Finds su¢ cient conditions under which on the equilibrium path withmore stringent regulation:
the industry experiences higher shake-out (; anti-competitive role)the active �rms invest more to reduce future stream of compliance cost.
Explains the empirical regularities of industry dynamics. and the(mixed) empirical evidence on the e¤ect of environmental regulationon shake-out.
Aditi Sengupta (SMU) Environmental Regulation and Industry Dynamics 30th January, 2010 24 / 24
Conclusion
Establishes a relation between environmental regulation and industrydynamics via investment in compliance technology.
The e¤ect of the increasing stringency of environmental regulation onindustry dynamics i.e., size distribution, investment behavior,heterogeneity and shake-out of �rms.
Finds su¢ cient conditions under which on the equilibrium path withmore stringent regulation:
the industry experiences higher shake-out (; anti-competitive role)the active �rms invest more to reduce future stream of compliance cost.
Explains the empirical regularities of industry dynamics. and the(mixed) empirical evidence on the e¤ect of environmental regulationon shake-out.
Aditi Sengupta (SMU) Environmental Regulation and Industry Dynamics 30th January, 2010 24 / 24
Conclusion
Establishes a relation between environmental regulation and industrydynamics via investment in compliance technology.
The e¤ect of the increasing stringency of environmental regulation onindustry dynamics i.e., size distribution, investment behavior,heterogeneity and shake-out of �rms.
Finds su¢ cient conditions under which on the equilibrium path withmore stringent regulation:
the industry experiences higher shake-out (; anti-competitive role)the active �rms invest more to reduce future stream of compliance cost.
Explains the empirical regularities of industry dynamics. and the(mixed) empirical evidence on the e¤ect of environmental regulationon shake-out.
Aditi Sengupta (SMU) Environmental Regulation and Industry Dynamics 30th January, 2010 24 / 24
Conclusion
Establishes a relation between environmental regulation and industrydynamics via investment in compliance technology.
The e¤ect of the increasing stringency of environmental regulation onindustry dynamics i.e., size distribution, investment behavior,heterogeneity and shake-out of �rms.
Finds su¢ cient conditions under which on the equilibrium path withmore stringent regulation:
the industry experiences higher shake-out (; anti-competitive role)
the active �rms invest more to reduce future stream of compliance cost.
Explains the empirical regularities of industry dynamics. and the(mixed) empirical evidence on the e¤ect of environmental regulationon shake-out.
Aditi Sengupta (SMU) Environmental Regulation and Industry Dynamics 30th January, 2010 24 / 24
Conclusion
Establishes a relation between environmental regulation and industrydynamics via investment in compliance technology.
The e¤ect of the increasing stringency of environmental regulation onindustry dynamics i.e., size distribution, investment behavior,heterogeneity and shake-out of �rms.
Finds su¢ cient conditions under which on the equilibrium path withmore stringent regulation:
the industry experiences higher shake-out (; anti-competitive role)the active �rms invest more to reduce future stream of compliance cost.
Explains the empirical regularities of industry dynamics. and the(mixed) empirical evidence on the e¤ect of environmental regulationon shake-out.
Aditi Sengupta (SMU) Environmental Regulation and Industry Dynamics 30th January, 2010 24 / 24
Conclusion
Establishes a relation between environmental regulation and industrydynamics via investment in compliance technology.
The e¤ect of the increasing stringency of environmental regulation onindustry dynamics i.e., size distribution, investment behavior,heterogeneity and shake-out of �rms.
Finds su¢ cient conditions under which on the equilibrium path withmore stringent regulation:
the industry experiences higher shake-out (; anti-competitive role)the active �rms invest more to reduce future stream of compliance cost.
Explains the empirical regularities of industry dynamics. and the(mixed) empirical evidence on the e¤ect of environmental regulationon shake-out.
Aditi Sengupta (SMU) Environmental Regulation and Industry Dynamics 30th January, 2010 24 / 24