When does environmental regulation facilitate entry-deterring practices

Abstract

This paper evaluates the welfare benefits of introducing environmental regulation in a market that is subject to the threat of entry. We consider complete and incomplete information settings, where potential entrants use the regulator's tax policy and the incumbent's output decisions in order to infer the incumbent's cost structure. When the regulator is absent, we show that firms' entry-deterring practices increase pollution relative to complete information. Hence, under certain conditions, environmental regulation becomes more beneficial in incomplete than in complete information contexts. Our results, therefore, identify under which cases an under- or over-estimation of the welfare benefits of environmental regulation arises from ignoring the information setting in which firms interact. We also examine how this estimation error increases as firms become more symmetric in their production costs.