Market distortions and optimal environmental policy instruments

In practice, a market does not comprise only one type of firm, resulting in two distortions: negative externalities caused by pollution damage and pricing power enjoyed by dominant firms. This paper examines choice of environmental policy instruments (tax-centered, quota-centered, and mixed policy) in markets where multiple dominant firms are price makers and multiple fringe firms are price takers. Environmental policy is not necessarily applied to all firms or facilities. This study focuses on the situation where only dominant firms are objects of environmental policy because this situation best reflects actual policy instruments. Understanding whether abatement costs exceed the environmental damage is essential to determining the best policy. The major finding of the study is that deadweight loss is reduced if dominant firms adopt eco-friendly technology and the regulator increases the ratio of taxed dominant firms to all dominant firms. Additionally, mixed policy is efficient when market distortion as a result of pricing power decreases.