Environmental policy and strategic abatement under scale economies

This paper analyzes strategic interactions among polluting firms in a monopolistically competitive market with scale economies and explores the design of optimal environmental regulation. Extending the Dixit-Stiglitz-Krugman model, we introduce two key features. First, firms generate pollution through production and can invest in abatement. Second, firms act strategically, as each firm’s choices influence the decisions and profits of others. Our model obtains theoretical predictions that better align with empirical evidence: (i) markups decline with intensified competition, (ii) the relationship between fixed costs and firm-level pollution is hump-shaped, and (iii) while emissions taxes stimulate firm entry, intensity standards have no impact on entry or exit. Our simulations show that abatement is socially desirable under empirically plausible configurations, yet neither policy instrument can reach the first best outcome. Contrary to the traditional view, the second-best standard provides greater welfare and environmental benefits than the second-best tax, revealing its superiority in the presence of strategic firm behavior and scale economies.