Environmental Policy, R&D and the Porter Hypothesis in a Model of Stochastic Invention and Differentiated Product Competition by Domestic and Foreign Firms

Abstract

We study a model of differentiated product competition by domestic and foreign firms that invest in environmental R&D in order to reduce costs of complying with government pollution standards. In this setting – and despite an absence of knowledge spillovers or other explicit sources of market failure in research – we find that optimal standards may often satisfy the "Porter Hypothesis" in two senses: (1) post-innovation (ex-post) environmental standards that maximize ex-post domestic welfare may be tighter than their globally optimal counterparts; and (2) in order to spur domestic R&D, government regulators may optimally commit to pollution abatement standards that exceed their ex-post optimal levels.