Week 4 Discussions and
Required Resources
Assignment: This is a two-part assignment. Each part must be at least 200 words unless otherwise noted. Please read all attachments and follow ALL instructions.
To receive full credit you must include at least 2 citations of scholarly support to your answers for each discussion post (i.e. Discussion One – 2 citations, Discussion Two – 2 citations). Citations should be within your post and include (Author, year, page number) if you are using a quote, page number is not required if you are paraphrasing. Just listing references and not using them in your post does not count as a citation or support. You can use your textbook as scholarly support and remember to include a reference for the support cited.
Part 1: Emission Charges
European countries have relied to a much greater extent on emission charges than has the United States, which seems to be moving toward greater reliance on transferable emission permits. From an efficiency point of view, should the United States follow Europe’s lead and shift the emphasis toward emission charges? In your discussion, make sure to compare and contrast the use of transferable emission permits and emission charges.
Part 2: Fuel Economy
Air pollution is one critical issue that the United States economy has been struggling to deal with. A vehicle creates a lot of pollution that has negative externality effects in our economy. The Corporate Average Fuel Economy (CAFÉ) was designed to reduce American dependence on foreign oil by producing more fuel-efficient vehicles to help curb emissions. Should the government force car manufacturers to increase fuel efficiency standards, or should the government increase fuel taxes? When evaluating this question, discuss the different costs and benefits that are associated with the options listed and which one you think would be the most efficient way to reduce emissions.
Required Resources
Text
Tietenberg, T., & Lewis, L. (2012). Environmental and natural resource economics (9th ed.). Upper Saddle River, NJ: Pearson Addison-Wesley
· Chapter 14: Economics of Pollution Control: An Overview
· Chapter 15: Stationary-Source Local and Regional Air Pollution
· Chapter 17: Mobile-Source Air Pollution
· Chapter 18: Water Pollution
Recommended Resources
Website
AIRNow (
http://www.airnow.gov/index.cfm?action=topics.about_airnow
)
Week 4 Discussions and Required Resources
Assignment: This is a two-part assignment. Each part must be at least 200 words unless otherwise noted. Please read all attachments and follow ALL instructions.
To receive full credit you must include at least 2 citations of scholarly support to your answers for each discussion post (i.e. Discussion One – 2 citations, Discussion Two – 2 citations). Citations should be within your post and include (Author, year, page number) if you are using a quote, page number is not required if you are paraphrasing. Just listing references and not using them in your post does not count as a citation or support. You can use your textbook as scholarly support and remember to include a reference for the support cited.
Part 1: Emission Charges
European countries have relied to a much greater extent on emission charges than has the United States, which seems to be moving toward greater reliance on transferable emission permits. From an efficiency point of view, should the United States follow Europe’s lead and shift the emphasis toward emission charges? In your discussion, make sure to compare and contrast the use of transferable emission permits and emission charges.
Part 2: Fuel Economy
Air pollution is one critical issue that the United States economy has been struggling to deal with. A vehicle creates a lot of pollution that has negative externality effects in our economy. The Corporate Average Fuel Economy (CAFÉ) was designed to reduce American dependence on foreign oil by producing more fuel-efficient vehicles to help curb emissions. Should the government force car manufacturers to increase fuel efficiency standards, or should the government increase fuel taxes? When evaluating this question, discuss the different costs and benefits that are associated with the options listed and which one you think would be the most efficient way to reduce emissions.
Required Resources
Text
Tietenberg, T., & Lewis, L. (2012). Environmental and natural resource economics (9th ed.). Upper Saddle River, NJ: Pearson Addison-Wesley
· Chapter 14: Economics of Pollution Control: An Overview
· Chapter 15: Stationary-Source Local and Regional Air Pollution
· Chapter 17: Mobile-Source Air Pollution
· Chapter 18: Water Pollution
Recommended Resources
Website
AIRNow
(
http://www.airnow.gov/index.cfm?action=topics.about_airnow
)
Week Four Guidance
Congratulations, we have gotten past the half-way point of the class. I have enjoyed reading your posts and written assignments. Just a note on the use of old papers from past classes: Partial recycling of papers is allowed in this course however, all submissions in this course must demonstrate substantial new learning related to the course concepts and learning objectives. Under no circumstances are you allowed to submit an exact copy of a prior paper in an attempt to satisfy an assignment in this course.
Also just a reminder, to receive full credit for your initial discussion posts you must include at least two citations (Author, Year, pg. #) as support to your ideas and answers. Also your initial postings should be at least 200 words and have a scholarly voice or tone. On to our week four topics emission charges, fuel economy and economic incentives.
You will be reading chapters fourteen, fifteen, seventeen and eighteen. Your first discussion question involves emission charges and this topic will also be part of your weekly written assignment. You will compare how Europe is leaning towards emission charges versus the method of emission permits in the United States. Also decide if the United States should move towards emission charges similar to Europe. Tietenberg and Lewis (2012) state, “One approach, the choice of several countries including the United States, is to select specific legal levels of pollution based on some other criterion, such as providing adequate margins of safety for human or ecological health” (p. 368). The authors go further and explain what an emission charge is, “An emissions charge is a fee, collected by the government, levied on each unit of pollutant emitted into the air or water” (p. 371). The thought here is that companies would limit pollution due to the increased costs due to the emissions charge. The authors then go into emissions trading which will be the topic of your written assignment.
The second discussion question is on fuel economy and the government’s role in it. Should the government increase fuel taxes or should the government have the manufacturers increase fuel efficiency standards? Remember that fuel taxes would increase costs to the consumer but increasing fuel efficiency standards for the manufacturer could also increase costs to the consumers as the companies could pass these increased fuel efficiency costs to the consumers by increasing prices of these cars. Tietenberg and Lewis (2012) review CAFÉ standards and fuel taxes in the Debate 17.1 section and review the CAFÉ standards in chapter seventeen. The authors state, “Manufacturers have paid more than $590 million in CAFÉ fines since 1983” (p. 450). Make sure to review these topics in chapter seventeen when preparing your responses.
Your assignment is based on emissions trading or cap and trade as Tietenberg and Lewis (2012) describe as, “Under this system, all sources face a limit on their emissions and they are allocated (or sold) allowances to emit” (p. 373). Basically there is a “cap” set and allowances are traded as the authors state, “Firms emitting more than their holdings would buy additional allowances from firms who are emitting less than authorized” (p. 373). So a firm would make money being under the cap established by selling their extra allowances, giving firms incentive to be under the cap. But does creating a market seem ethical to help the environment? That is the main topic of your assignment. One ethical theory is Utilitarianism. This view of ethics is described by Beauchamp and Bowie (2004) as, “An action or practice is right if it leads to the best possible balance of good consequences over bad consequences for all the parties affected” (p. 17). Another theory is Kantian theory, that address how people need to respect one another to be ethical as Beauchamp and Bowie (2004) explain, “In Kantian theories respect for the human being is said to be necessary-not just as an option or at one’s discretion” (p. 23). Keep these ethical theories in mind while preparing your written assignment. Also make sure to review chapter fourteen to help with the assignment. Here is a link to an interesting article on this topic:
http://www.studentpulse.com/articles/656/3/the-challenges-of-climate-change-policy-explaining-the-failure-of-cap-and-trade-in-the-united-states-with-a-multiple-streams-framework
, and also attached is another article related to emissions trading and below a video on carbon credits.
Remember it is highly suggested that you use the parts of the question (a, b, c) as headings in your paper to enhance the focus and organization of your paper.
Your initial postings are due on Thursday 4/23, and to respond to your fellow student’s initial postings during the week. Your assignment is due on Monday 4/27. Please send me specific questions on the assignments if you have any issues completing them. Keep up the good work!
References
Beauchamp, T.L., & Bowie, N.E. (2004). Ethical theory and business. (7th Ed.). Upper Saddle River, NJ: Prentice Hall.
Tietenberg, T., & Lewis, L. (2012). Environmental and natural resource economics (9th ed.). Upper Saddle River, NJ: Pearson Addison-Wesley. ISBN: 9780131392595
Review of Industrial Organization 12: 751–765, 1997.
c
1997 Kluwer Academic Publishers. Printed in the Netherlands.
Raising Rivals’ Costs Strategies via Emission
Permits Markets
EFTICHIOS SOPHOCLES SARTZETAKIS
�
University College of the Cariboo, Department of Economics and Finance, 900 McGill Road, P.O.
Box 3010, Kamloops, B.C., Canada V2C 5N3
Abstract. In the present paper we examine the effect of emissions permit price manipulation within
an oligopolistic model. We examine the effect that positioning strategies in permits markets have on
the degree of competition in the product market as well as on social welfare. The analysis is based
on the concept of raising rivals’ cost strategies. We find that competition in the product market can
be lessened substantially. The welfare effect is ambiguous. If the leader expands its market share
at the expense of a less efficient rival, or if it excludes a less efficient entrant, overall efficiency
may increase despite the decrease in the industry’s output. When efficiency decreases, or when
consumers’ protection is a policy priority, the initial distribution of permits can be used to control
power in the permits market. Such interventions though, improve efficiency only when policy makers
have substantial information on the technological structure of the industry, and thus, should be used
with caution. Given the importance of information, sharing of information and coordination of actions
between policy makers is very important.
Key words: Tradeable emission permits, raising rivals’ costs strategies, antitrust policy.
I. Introduction
According to the theory of externalities, a proper policy should provide economic
agents with adequate incentives to undertake the right amount of the externality
creating activity. In the case of environmental externalities, this is accomplished
with the use of tradeable emission permits. Under ideal conditions, including perfect
competition, this policy instrument achieves efficiency. Many regulated industries
though, are not competitive, and the markets in which emission permits are traded
may not be competitive either. The literature recognizes that, in the presence of
product market distortions tradeable permits do not yield the optimum allocation
of resources. However, little is still known about the impact of emission permits
market distortions on product market structure, and on social welfare.
� I am grateful to Thomas Ross for his encouragement and support through all stages of this
research project. I would also like to thank an anonymous referee of this journal, Donald McFetridge,
Keith Acheson, Steven Ferris and Peter Tsigaris. Participants at the Sixth Annual Conference of the
European Association of Environmental and Natural Resource Economists (Umea, June 1995) have
also contributed with their comments. I gratefully acknowledge financial support from the Bureau of
Competition Policy, Industry Science and Technology Canada.
752 EFTICHIOS SOPHOCLES SARTZETAKIS
Even though permits markets imperfections might not be an important concern
when the number of regulated firms is large, it could be a serious problem in
more localized permits markets. For example, if the sulphur dioxide emissions of
electricity generating plants in Canada were controlled through emission permits
regulations at the provincial level, the small number of participants in the relevant
permits markets does not guarantee competitive behaviour. Similar concerns have
been raised by von der Fehr (1993) and Fershtman and de Zeeuw (1996) concerning
the U.K. electricity industry, and by Hanley and Moffat (1992) concerning Scotland.
In the present paper we examine whether power in the permits market can
be used to reduce the existing and potential level of competition in the product
market. Our analysis is based on the concept of raising rivals’ cost strategies.
1
From its conception, the theory generated a vigorous debate on both theoretical
and empirical level.2 Two main points of criticism are identified on the theoretical
level. The first, questions the applicability of raising rivals’ cost strategies by
arguing that such strategies are profitable only in limited cases. The second, argues
that raising rivals’ cost strategies have an ambiguous effect on overall efficiency,
and thus, do not necessarily require policy intervention.
Our objective is first, to contribute to the environmental policy literature by
examining the efficiency of tradeable emissions permits regulations in the presence
of market power. Second, to contribute to the theoretical evaluation of raising rivals’
cost strategies, by providing an example in which raising rivals’ cost strategies are
profitable, and examine the overall efficiency effects of these strategies.
We examine an oligopolistic industry whose emissions are controlled under a
tradeable emission permits regulation. Tradeable emission permits are considered
as an input with fixed, exogenously determined supply. Each firm can substitute
away from permits by engaging in abatement. Abatement depends on output and
thus, decisions in the product and permits markets are linked. We assume that
one of the firms, hereafter called the leader, has power in the permits market. The
leader can exercise power in aggressive (exclusionary strategies) or moderate ways
(positioning strategies). Although exclusionary strategies can be effective in forcing
rivals to exit the market, we do not examine them because they can be challenged
by existing antitrust policies.3 For the same reason we do not examine cases in
which permits are used to stabilize merger agreements by securing profits against
potential entry. We rather focus on moderate predatory (positioning) strategies and
assess their effect on social welfare.
We find that positioning strategies are profitable. The more stringent the regu-
lation and the more expensive the abatement is, the more profitable raising rivals’
1 See Salop and Scheffman (1981, 1983, 1987), and Krattenmaker and Salop (1985, 1986, 1987).
Subsequent extensions of the theory include, Hart and Tirole (1990), Ordover et al. (1990), Gaudet
and Long (1993).
2 For recent reviews of the debate see Ware (1994) and Coate and Kleit (1994).
3 For example, under Sections 77–79 of the Canadian Competition Act, these practices can be
clearly challenged for abuse of dominance position.
COSTS STRATEGIES VIA EMISSION PERMITS MARKETS 753
cost strategies are.4 The welfare effect of positioning strategies is ambiguous and
it depends on the technological efficiency of the leader relative to its existing and
potential rivals. 5 If the leader expands its market share at the expense of a less effi-
cient rival, or if it excludes a less efficient entrant, overall efficiency may increase
despite the decrease in the industry’s output. Thus, even when the market for per-
mits is not competitive, tradeable emission permits regulations can be an efficient
way to control pollution.
The literature on strategic behaviour in the permits market is limited. Misiolek
and Elder (1987) present the first analysis of the use of raising rivals’ costs strategies
in the permits markets within a dominant firm model. Von der Ferh (1993) analyses a
Cournot duopoly regulated through a tradeable emissions permits system. Although
our work bears some similarities in approach and results with von der Fehr (1993),
it defers in two respects. First, we model firms’ abatement costs separately from
all other production costs. Second, we focus on positioning strategies while von
der Ferh is more interested in exclusionary strategies. Requate (1993) analyses the
case of cooperation between firms. Fershtman and de Zeeuw (1996) examine the
bargain process of emissions trading between two Cournot players. They find that
once all possible sets of outputs have been identified, firms trade permits so as to
maximize joint profits and thus, aggregate output is reduced.
Although strategic manipulation of permits markets might not be an existing
problem,6 the potential application of permits systems to small numbers markets
justifies a closer look at possible anticompetitive behaviour. Our welfare results
support earlier views (Tietenberg, 1985, 1989) suggesting that the significance of
permit price manipulation is limited. However, there are situations, such as the case
of an inefficient leader, in which policy intervention is necessary. In such situations,
the distribution of emission permits can be used as an instrument to control power
in the permits market. Policy intervention can be welfare improving only if policy
makers have substantial information on the technological structure of the industry.
Given the importance of information, information sharing and coordination of
actions between policy makers (environmental and competition policy) is crucial.
The rest of the paper is organized as follows: Section II develops the benchmark
case of competitive permits market; Sections III and IV examine the cases in which
the leader in the permits market decreases its rivals’ shares in the product market,
and deters entry respectively. Section V contains the concluding remarks. All tables
referred to in the text appear at the end of the paper. Proofs of the results discussed
in the paper are available by the author upon request and they can also be found
4 Brown-Kruse et al. (1995) arrive at similar results conducting laboratory experiments in envi-
ronments that resemble very closely our theoretical framework.
5 Assuming that profits are distributed to consumers, the term welfare denotes the sum of consumer
and producer surplus.
6 Note however, that one of the explanations for the very low level of transactions in existing
permits trading programs is that firms fear that buyers of emission permits could later use them to
control the product market (see Hahn, 1989).
754 EFTICHIOS SOPHOCLES SARTZETAKIS
in Sartzetakis (1996a). In Appendix A we present the specifications of the model,
while in Appendix B we present the initial values we used for the simulations.
II. The Competitive Benchmark Case
Assume a homogeneous Cournot duopoly facing linear demand and increasing mar-
ginal cost of production. The production process generates emissions of a pollutant.
Firms can reduce emissions by either reducing output or controlling emissions. The
marginal cost of abatement is increasing both in output and abatement per unit of
output. Firms’ production and abatement technologies differ.
Policy makers aim at reducing emissions to a certain level, which is not optimally
decided.7 The regulatory intervention takes the form of tradeable emission permits.
Firms are required to own emission permits in order to emit. Each permit specifies
an amount of allowable emissions, assumed to be one unit, and is freely transferable.
The number of permits issued is the maximum allowable units of emissions.
Emissions permits can either be auctioned or distributed free of charge (grandfa-
thered) to the existing firms. Grandfathering of emission permits is based either on
firms’ historical level of emissions, or it is arbitrary, for example equiproportionate
allocation of permits. We assume that all permits are distributed to existing firms.
Thus, the supply of permits is perfectly inelastic, and potential entrants have to
buy all the permits they need from incumbent firms. This assumption simplifies
the exposition of our results without limiting their generality.8 After the initial
allocation of permits, trade is allowed.
Perfectly competitive markets for permits share the following two main proper-
ties. First, minimization of abatement costs is achieved but overall efficiency cannot
be achieved. If both firms act as price takers in the permits market, optimization
implies that each firm trades permits to the point that the permit price equals its mar-
ginal abatement cost. Equalization of marginal abatement cost across firms yields
the efficient distribution of abatement effort, but due to the oligopolistic product
market structure, it cannot achieve the efficient production allocation. Industry’s
output decreases from its pre-regulation level, while firms’ shares are unaffected
by the regulation. Thus, the more efficient firm reduces output relatively more than
the less efficient firm. Trading of permits does not necessarily yield the first-best
allocation of resources when product markets are imperfectly competitive.9
7 Emission ceilings are usually decided through a political process involving consultation with
various interest groups and may be influenced by international agreements.
8 If more than one industry’s emissions are regulated under a tradeable permits system, and all
firms participate in the allocation of permits, the supply of permits to one industry is elastic. To
examine the effects of power in the permits market, we have to examine the impact on all industries.
In the present paper we restrict our attention to one industry.
9 For extensive discussions of the efficiency of competitive permits markets when product markets
are oligopolistic, see Borenstein (1988), Malueg (1990), Hung and Sartzetakis (1994) and Sartzetakis
(1996b).
COSTS STRATEGIES VIA EMISSION PERMITS MARKETS 755
Second, the mode of permits distribution does not affect efficiency but only
profits’ distribution. The competitive permits price is independent of the initial
distribution of emission permits. This is not surprising since both firms are price
takers in the permits market and each firm’s permits endowment is exogenous. Thus,
firms’ optimal choices of output and abatement per unit of output are independent
of the mode of initial permits distribution.
III. Permits Price Manipulation
1. EFFICIENCY AND WELFARE RESULTS
Assume that one of the two Cournot players has price setting power in the permits
market. This case is modelled as a two stage game. In the first stage the leader
chooses the permit price. In the second stage, both firms make their output and
abatement decisions taking the permit price as given. To determine the subgame
perfect equilibrium, we begin by solving the second stage of the game first.
In the second stage, firm 2 is a permit price taker and thus, it trades permits up
to the point that its marginal abatement cost equals the marginal cost of permits,
i.e. the permit price. Although the leader, firm 1, does the same, its marginal cost
of permits is not equal to the permit price. This is because permits have an extra
value for the leader; by manipulating the price of permits, the leader can influence
its rival’s costs. Recognizing this, the leader trades a different than the competitive
number of permits, adjusting its output and abatement such that the permits market
clears at the permit price it has committed to in the first stage of the game. Thus,
its marginal cost of abatement is not equal to the permit price.
In the first stage, the leader chooses the permit price that maximizes its profits,
taking into account the Nash equilibrium of the second stage. The choice of a
higher than the competitive permit price has a twofold effect on the leader’s profits.
On the one hand, the rival’s costs increase and its output decreases resulting in an
increase in the leader’s revenue. On the other hand, the leader’s costs increase, first
because of the increase in the permit price, and second because the leader’s net
demand for permits increases in order to clear the market. The leader commits to a
higher than the competitive permit price if the benefits from raising its rival’s costs
dominate the increase of its own costs. In such a case, the leader overbuys permits
and thus, its marginal cost of abatement is lower than the permit price. Therefore,
compliance costs are not minimized in the case of permit price manipulation.
Another difference with the competitive case is that the permit price under
leadership is positively related to the leader’s endowment of permits. Thus, policy
makers could control the leader’s power by manipulating the initial distribution of
permits. Such an action though, requires full information and the willingness to base
756 EFTICHIOS SOPHOCLES SARTZETAKIS
Figure 1. Permits price determination.
the initial permits’ allocation on efficiency rather than distributional considerations.
Since both requirements are strong we do not pursue this policy option further.10
Figure 1 illustrates the effect of permits price manipulation on permits market.
Each firm’s demand for permits is given by its marginal abatement cost (MCAi).
The horizontal summation of the firms’ demands is the market demand for permits.
The supply of permits, �E, is perfectly inelastic. Under perfect competition, permits
price is P” and each firm holds E”1 permits at the equilibrium. When firm 1 is the
leader in the permits market, it sets a higher than the competitive permits price, Pm
and holds Em1 permits at the equilibrium, which are more relative to competition
(Em1 > E
”
1 ). The leader’s demand for permits does not coincide any more with
its marginal cost of abatement. The leader uses permits not only as a substitute to
abatement but also as a device of manipulating its rival’s costs. Thus, the value of
permits for the leader is higher and its demand for permits is higher accordingly.
Permits price manipulation also results in reshuffling of product market shares.
Because of the increase in permit price, both firms’ marginal costs increase and
10 Hahn (1984) derives the cost-minimizing allocations of permits in the case that one firm acts as
a monopolist/monopsonist in the permits market.
COSTS STRATEGIES VIA EMISSION PERMITS MARKETS 757
thus, industry’s output decreases. However, the increase in leader’s marginal cost
is smaller and thus, its product market share increases relative to competition.
Thus far we dealt with the effect of permits price manipulation on the alloca-
tion of abatement and production. We now move to examine the effect of permit
price manipulation on industry’s profits. We compare industry’s profits under price
manipulation to the competitive benchmark. Given that the allocation of produc-
tion under competition is not efficient, could leadership improve industry’s profits
despite the fact that industry’s abatement costs increase?
To illustrate the impact of leadership on industry’s profits we use simulations.
The values of the parameters used in the simulations are such that the cost of
abatement is a significant part of firms’ total costs. Table I presents the results
of these simulations. We find first, that leader’s profits increase regardless of the
technological structure of the industry (third column in Table I). Second, industry’s
profits decrease when firms have similar production and abatement technologies, or
the leader is less efficient that its rival (fourth column in Table I). Third, industry’s
profits increase when either the leader is more efficient in production or the price
taker in abatement (fourth column in Table I). Permit price manipulation implies
that the price taker is forced to engage in higher abatement and lower production
relative to competition, while the leader does exactly the opposite. Industry’s profits
therefore, depend on firms’ relative efficiency in production and abatement. On the
one extreme, if the leader is more efficient in production but less efficient in
abatement, permits price manipulation enhances efficiency by inducing firms to
exploit their respective advantages. On the other extreme, if the leader is less
efficient in production and more efficient in abatement, efficiency is decreased.
The ambiguity of the effect of permit price manipulation on industry’s profits
is carried over to social welfare. The model used for the simulations assumes that
permits price manipulation does not affect industry’s profits. Thus, the change in
industry’s profits equals the change in social welfare. Similar results are expected
in the case that output changes as a result of permits price manipulation. It is
more likely that output decreases (except if the leader is much more efficient than
its rival) and thus, welfare is more likely to decrease as a result of permits price
manipulation.
One clear case that calls for policy intervention emerges from the above discus-
sion. Namely, the case of a large, inefficient in production firm that can become a
leader in the permits market. Given that this is not an atypical situation in regulated
industries, such as electric utilities, policy makers should watch for overbuying of
permits.
2. FACTORS AFFECTING THE LEADER’S ABILITY TO EXERCISE MARKET POWER
We now turn to examine the factors influencing the ability of the leader to implement
raising rivals’ costs strategies. The leader’s choice of permit price depends on the
effects on both firms’ marginal costs. It can be shown that firms’ marginal costs
758 EFTICHIOS SOPHOCLES SARTZETAKIS
Table I. Effect of permits price manipulation on industry’s profits,
presented as a function of the leaders’ production and abatement
efficiency relative to the price taker
c1 (c2 = 200) d2 (d1 = 250)
(�
m
1 ��
”
1 )
�”
1
(
P
�m
i
�
P
�”
i
)P
�”
i
200 250 0.0364 �0.01013
150 250 0.02918 �0.0055
2
100 250 0.02385 �0.00162
100 200 0.02038 �0.00089
100 150 0.01715 �0.00028
100 100 0.01417 +0.00021
100 50 0.01145 +0.00060
100 0 0.00901 +0.00087
80 250 0.0221 �0.00024
75 250 0.02169 +0.00009
50 250 0.01979 +0.00164
0 250 0.01663 +0.00432
Where
P2
i=
1
�
j
i = �
j
1 + �
j
2 , i = 1, 2 and j = “, m, are the
industry’s profits. Superscripts ” and m denote equilibrium values
under competition and leadership respectively.
of production and abatement can both be expressed as functions of the difference
between the permit price under leadership and under competition. Thus, the permit
price difference is a good indicator of the strength of raising rivals’ costs strategies.
It can be shown that the permit price difference depends on the leader’s pre-
regulation product market share, its share of the emission permits in the initial
allocation, and its abatement efficiency relative to its rival. It is clear that the more
efficient the leader is in abatement the more it can raise its rival’s costs. The effect
of the leader’s share in the product market and in the initial permits allocation is
discussed in some detail.
First, the permit price difference is negatively related to the leader’s pre-
regulation market share. This result contrasts the predictions of the raising rivals’
costs theory.11 In the standard raising rivals’ costs model, it is assumed that the lead-
er buys exclusionary rights of the input, and that the cost of exclusion is independent
of the leader’s output. Thus, the higher the leader’s market share, the smaller is the
effect of the fixed exclusionary costs on its average cost. In our model, overbuying
strategies do not increase the leader’s fixed costs, they rather increase its marginal
cost. Thus, the larger the leader’s market share, the higher on its marginal cost it
operates, and thus, it is relatively more expensive to raise its market share further.
Table II illustrates this result with numerical examples. All changes are reported
11 For instance, see Salop and Scheffman (1987), and Coate and Kleit (1995, p. 80).
COSTS STRATEGIES VIA EMISSION PERMITS MARKETS 759
Table II. Profitability of raising rival’s cost strategies as a function of
the leader’s pre-regulation market share. Equiproportional distribution of
permits ( �E1 = �E=2)
�s1 P
m
� P”
�
@�m
1
@qm
1
�
@�”
1
@q”
1
�
@�”
1
=@q”
1
�
@�m
2
@qm
2
�
@�”
2
@q”
2
�
@�”
2
=@q”
2
(�
m
1 ��
”
1 )
�”
1
0.45647 65.7057 0.04145 0.13805 0.06189
0.47866 64.6653 0.04359 0.13427 0.04662
0.50 63.6249 0.04513 0.13058 0.0364
0.52053 62.5845 0.04621 0.12698 0.02918
0.54031 61.5441 0.04692 0.12345 0.02385
Where, �s1 is the leader’s pre-regulation market share; P
j, j = “, m is the
permit price; �j1 are the leader’s profits; and �
j
i = di�iqi + e�
2
1q
2
1 + P
j(�qi
� �iqi � �E), i = 1, 2 and j = “, m, is firm i’s total cost of compliance
with the environmental regulation. Superscripts ” and m denote equilibrium
values under competition and leadership respectively.
in percentage terms. Column two shows that, as the leader’s pre-regulation market
share, ŝ1 increases, the permits price difference P
m
� P” is decreasing. Columns
three and four demonstrate that as the leader’s market share increases, its marginal
cost of compliance is increasing, while that of the price taker is decreasing. As a
result, the increase of leader’s profits resulting from raising rivals’ costs strategies
decreases as its pre-regulation market share increases. This result is illustrated in
the fourth column of Table II.
Second, the larger the leader’s share in the initial permits distribution, the larger
is the permit price difference. The leader’s marginal cost of abatement is lower than
the permit price at the equilibrium. Thus, the leader’s compliance cost is lower the
higher is its endowment of permits. Comparison of the simulation results in Tables
II and III illustrates the impact of the mode of initial permits distribution on the
leader’s ability to raise its rival’s cost. In deriving Table II we assume that permits
are distributed equally among firms, while in Table III we assume that permits
are distributed according to the firms pre-regulation market share. Comparison of
each table’s column two reveals that, the higher the leader’s endowment of permits,
the higher the permit price difference.12 The mode of initial allocation of permits
affects the leader’s ability to raise its rival’s cost. When permits are auctioned, the
leader pays the higher price for all permits it uses, and thus, its ability to raise its
rival’s cost is reduced.
12 In contrast to the results in Table II, the permits price difference Pm � P” in Table III is larger
the larger is the leader’s pre-regulation market share. This indicates that, for range of values we use,
the impact of the endowment of permits on raising rival’s cost strategies is stronger than the impact
of the pre-regulation market share.
760 EFTICHIOS SOPHOCLES SARTZETAKIS
Table III. Profitability of raising rival’s cost strategies as a function of the
leader’s pre-regulation market share. Distribution of permits according to
pre-regulation market share: ( �E1 = ��q1)
�s1 P
m
� P”
�
@�m
1
@qm
1
�
@�”
1
@q”
1
�
@�”
1
=@q”
1
�
@�m
2
@qm
2
�
@�”
2
@q”
2
�
@�”
2
=@q”
2
(�
m
1 ��
”
1 )
�”
1
0.45647 61.0332 0.03529 0.12824 0.05704
0.47866 62.3291 0.04052 0.12942 0.04442
0.50 63.6249 0.04513 0.13058 0.0364
0.52053 64.9207 0.04924 0.13172 0.03087
0.54031 66.2166 0.05293 0.13282 0.02682
Where, �s1 is the leader’s pre-regulation market share; P
j, j = “, m is
the permit price; �j1 are the leader’s profits; and �
j
i = di�iqi + e�
2
1q
2
1 +
Pj(�qi � �iqi � �E), i = 1, 2 and j = “, m, is firm i’s total cost of com-
pliance with the environmental regulation. Superscripts ” and m denote
equilibrium values under competition and leadership respectively.
IV. Emission Permits as a Barrier to Entry
In this section we extend our discussion to cases in which raising rivals’ costs
strategies blockade entry. We assume that the two incumbent firms of the previous
section encounter a potential entrant who, in the absence of environmental regu-
lation, would enter into the industry. The potential entrant has zero endowment of
permits and thus, it has to buy all permits it needs. We assume that the potential
entrant is efficient enough to make positive profits when permits market is compet-
itive, but not as efficient as to rely solely on abatement. Thus, a permit price exists
above which the entrant is forced to engage in a level of abatement that renders
entry unprofitable. Under these assumptions, raising rivals’ costs strategies could
lead to entry deterrence, since in most cases Pm > P”. As we will show in what
follows, raising rivals’ costs strategies lead to entry deterrence only in a limited
number of cases.
In what follows we use simulations to examine: first, the effect of increased
rivalry on leader’s ability to raise the permits price; second, the effect of entry
deterrence on welfare; and third, the effect that the form of initial permits allocation
has on entry deterrence.
First, as the number of firms in the industry increases, their market share and
thus, their abatement decreases. All firms operate at a lower point on their abatement
cost schedules. As a result, the leader has to hold more permits and rely less on
abatement in order to increase the permit price and gain market share. Columns two
and three of Table IV illustrate these points. The leader’s cost of raising its rivals’
cost increases the more competitive the product market is. Thus, the leader chooses
a lower permit price the larger is the number of rivals i.e., Pm > P�, where the
superscript � denotes equilibrium values under leadership when three firms share
COSTS STRATEGIES VIA EMISSION PERMITS MARKETS 761
Table IV. Leader’s ability to raise rival’s costs as the number of firms in the industry
increases
d2 = d3 (d1 = 250) �A
m
1 � �A
�
1 �(NE
d
1 )
m
� �(NEd1 )
� Pm � P�
0 52.53590 �85.91165 59.1051
50 52.04524 �85.10928 53.8903
100 51.55458 �84.30690 48.6755
150 51.06392 �83.50453 43.4607
200 50.57326 �82.70215 38.2459
250 50.08260 �81.89978 33.0311
300 49.59194 �81.09740 27.8163
A
j
1 = �
j
1q
j
1 , j = “, m, �, � is the leader’s level of abatement, and �A
m
1 � �A
�
1 =
(Am1 �A
�
1) � (A
�
1 � A
�
1). Both parentheses are negative and thus, �A
m
1 � �A
�
1 >
0 implies that j�Am1 j > j�A
�
1 j. (NE
d
1 )
j, j = “, m, �, � is the leader’s net demand
for permits at the respective equilibrium and �(NEd1 )
m
� �(NEd1 )
� = [(NEd1 )
m
� (NEd1 )
“] � [(NEd1 )
�
� (NEd1 )
�].
The superscript � denotes equilibrium values under competition when three firms
share the market and the superscript � equilibrium values under leadership.
the market. Column three of Table IV shows that this result holds regardless of
firms’ abatement efficiency. Sartzetakis (1993) shows that as the product market
tends to competition, the leader’s power in the permits market vanishes completely.
Second, the welfare effect of deterring entry is positive in most cases. Table
V presents the simulations when permits are distributed equally between the two
incumbent firms. Column two presents the profits of the entrant under competition
��3. Firm 3 is assumed to be as efficient as firm 2, but firm 2’s profits are always
higher than firm 3’s because firm 2 has a positive endowment of permits. Column
three presents the profits of the entrant in the case of leadership, ��3 . Entry is
profitable only if the entrant is more efficient in abatement than the leader, i.e.
�
�
3 > 0 only if d3 < d1. Raising rivals’ costs strategies lead to entry deterrence in the cases that the potential entrant is equally or less efficient in abatement than the leader. Firm 1’s profits are higher when it acts as a leader, and the increase in leader’s profits is larger when leadership deters entry as shown in column three of Table V. Entry deterrence results in a decrease in output, since competition in the product market decreases. In contrast, industry’s profits increase, since entry is blockaded only when the potential entrant is less efficient than the leader. The increase in industry’s profits dominate the decrease in consumer surplus resulting in higher welfare, as illustrated in column five.13 Furthermore, entry deterrence yields an improvement in environmental quality because firms are engaging in higher levels of abatement in order to deter entry,14 as illustrated in the last column
13 This result is more general. Dixit and Stiglitz (1977) and Spence (1976) have shown that there
are cases in which there is too much entry and facilitating more does not improve economic welfare.
14 In the case of entry deterrence, the two incumbent firms make their decisions based on P�; the
equilibrium in this case is denoted with a superscript 2�. Total emissions are lower than the required
762 EFTICHIOS SOPHOCLES SARTZETAKIS
Table V. Effect of entry deterrence on social welfare. Grandfathering according to pre-
regulation market share: ( �Ei = �q̂i)
d2 = d3 (d1 = 250) �
�
3 �
�
3 �
�
1 � �
�
1 W
�
� W�
0 129,659.5 112,026.1 12,248.8 �8,001.5
50 106,456.1 87,033.4 13,841.2 �9,041.7
100 84,288.0 62,995.4 15,530.8 �10.145.5
150 63,155.1 39,912.4 17,317.7 �11,312.7
200 43,057.5 17,784.2 19.201.8 �12,543.6
�
2�
1 � �
�
1 W
2�
� W� E2� � �E
250 23,995.2 �3,389.1 183,913.7 46,790.6 �131.746
300 5,968.2 �23.607.6 179,009.1 63,288.2 �174.799
350 �11,023.5 �42.871.2
Where, Wj, j = �, �, 2�, mon is the social welfare at the respective equilibrium. Social welfare
is defined as the summation of consumer and producer surplus: Wj = uj(qj1 + q
j
2 ) �
P2
i=1
TC
j
i , where u
j is utility derived from the consumption of good q, and
P
Tc
j
i is aggregate
cost of producing Q. The superscript 2� denotes values of the variables in the case that entry
of firm 3 is deterred and the two incumbent firms are price takers at permit price P�.
of Table V. Raising rivals’ cost strategies may blockade the entry of even equally
efficient firms, but at the same time ameliorate social welfare and environmental
quality. Policy makers should take into consideration the welfare effects of raising
rivals’ cost strategies before intervening to facilitate entry.
Finally, since the initial permits distribution affects the leader’s ability to manip-
ulate the permit price, it also affects its ability to deter entry. Should policy makers
change the initial permit distribution in order to facilitate entry? To answer this
question, we compare the case that permits are equally distributed between the
two firms to the case of auctioning. The latter case, i.e. zero initial endowment of
permits for all firms, is presented in Table VI. Although incumbent firms have no
advantage over potential entrants, entry deterrence is still feasible, but only when
the leader is more efficient in abatement. Auctioning of permits reduces the leader’s
ability to raise the permit price. Thus, permits allocation is an efficient instrument
in controlling the leader’s power and facilitating entry. However, facilitating entry
does not necessarily increase social welfare. This point is clearly demonstrated
in the case that all three firms are equally efficient in abatement (bolded row in
Tables V and VI). When �E1 = �E2 = �E=2 entry of firm 3 is deterred, but social
welfare is larger relatively to the case that permits are auctioned, �E1 = �E2 = 0
and entry is facilitated. Changing the mode of permits allocation from grandfather-
ing to auctioning, increases competitiveness in the product market but decreases
social welfare. Although not shown in our simulations, permits distributions that
could increase both competitiveness and social welfare exist. However, the spec-
ceiling �E, because P� > Pm implies that aggregate abatement is higher than what is required by
the emissions ceiling.
COSTS STRATEGIES VIA EMISSION PERMITS MARKETS 763
Table VI. Effect of entry deterrence on social welfare. Auctioning of permits: ( �Ei = 0)
d2 = d3 (d1 = 250) �
�
3 , �
�
2 �
�
3 , �
�
2 �
�
1 � �
�
1 W
�
� W�
0 129,659.58 122,331.15 1,834.8 �12,822.1
50 106,456.17 97,647.42 2,480.9 �15,136.7
100 84,288.04 73,918.56 3,224.2 �17,514.7
150 63,155.17 51,144.56 4,064.9 �19,956.4
200 43,057.58 29,325.42 5,002.8 �22,461.5
250 23,995.27 8,461.15 6,037.9 �25,030.3
�
2�
1 � �
�
1 W
mon
� W�
300 5,968.23 �11,448.25 652,130.7 �11,009.1
350 �11,023.54 �30,402.79
Where, Wj, j = �, �, 2�, mon is the social welfare at the respective equilibrium.
Social welfare is defined as the summation of consumer and producer surplus: Wj =
uj(q
j
1 + q
j
2 ) �
P2
i=1
TC
j
i , where u
j is utility derived from the consumption of good
q, and
P
TC
j
i is aggregate cost of producing Q. The superscript mon denotes values
of the variables in the case that entry of the firm 3 is deterred, firm 2 exits the industry
and firm 1 monopolizes the product market.
ification of such distributions requires a vast amount of information on the part
of policy makers. Intervention in the case of incomplete information can be detri-
mental to both competition and welfare. An example is presented in row seven
(d2 = d3 = 300, d1 = 250) of Table VI. Firm 2 that has zero endowment of
permits makes negative profits under leadership and exits the market. The leader
buys all permits at price P�, and monopolizes the product market. The equilibrium
is denoted by a superscript mon. Both the level of competition and social welfare
decrease. Thus, informational requirements and the ambiguity of the welfare effect
render policy intervention problematic.
V. Conclusions
We examine cases in which emission permits markets are used as vehicles in
lessening competition in the product market. We focus our attention on moder-
ate cases of predatory behaviour in the form of raising rivals’ cost strategies.
In these cases, the leader in the permits market employs positioning rather than
exclusionary strategies; i.e does not attempt to exclude existing rivals. Positioning
strategies though, can lead to entry deterrence under certain conditions. We find
that although in many instances competition is lessened substantially, overall effi-
ciency may increase when the market share of the more efficient firms increase.
However, there are situations that should be examined closely by policy makers.
For example, the case of a large entrenched inefficient firm that overbuys permits
calls for policy intervention. According to our analysis this is a case of an inefficient
leader and can lead to large decreases in social welfare. In such cases as well as
764 EFTICHIOS SOPHOCLES SARTZETAKIS
when consumers’ protection is a policy priority, policy makers can use the initial
distribution of permits to control power in the permits market. Such interventions
though can succeed only when policy makers have substantial information on the
technological structure of the industry, and thus, should be used with caution. Given
the importance of information, sharing of information and coordination of actions
between policy makers (environmental and competition policy agencies, or any
other type of regulators involved) is very important.
Appendix A. Notation of the Model Used in the Simulations
Inverse demand: p = a � b(q1 + q2), where qi, i = 1, 2, is firm i’s output.
Cost of production: CPi = qi +�q
2
i
, where c, � � 0 are technological parame-
ters and k = k1 = k2.
Emissions generation: ei = �iqi, where � is the rate of emission per unit of
output, with �1 = �2.
Cost of abatement: CAi = d1�iqi + e�
2
i
q2
i
, where � is the abatement per unit
of output, and d, e � 0 represent technological parameters, with e1 = e2 = e.
Supply of emission permits: �E = �Q̂, where Q = q̂1 + q̂, is industry’s pre-
regulation level of output, and � 1.
Methods of permits distribution examined: (1) according to firms’ pre-regulation
level of emissions: �Ei = �qi; (2) equiproportional: �Ei = �E=2; (3) auctioning:
�Ei = 0; where �Ei is firm i’s endowment of permits.
Appendix B. Initial Values of the Parameters Used in the Simulations
a = 1,500; b = 0.20; k = 0.07; e = 0.30; � = 0.60; = 0.40; d1 = d2 = 250;
c1 = c2 = 200; and F1 = F2 = 333:000. We start with the assumption that both
the leader and the price taker have identical production and abatement technologies,
in order to demonstrate that leadership in the permits market translates into raising
rivals’ cost strategies without requiring technological asymmetries. We then allow
the technological parameters to vary. Technological parameters and the required
percentage reduction in emissions are chosen such that the cost of compliance is a
significant part of firms’ total cost.
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