Fig. 1. Multiple equilibria for competing firms with different levels of pollution abatement.
ence or taste amongst the managers and owners of the relatively x-inefficient polluting firms in the
absence of environmental regulation. Clearly, be- coming greener is not a free ride even when the
increased costs of pollution reduction do not in- crease average production costs. Unlike in the
Porter hypothesis, it is not stipulated here that adopting an environmentally friendly system of
production is profitable in the sense of yielding increased profits or lower unit production costs.
Failing to become greener, therefore, does not imply that owners and managers are somehow
systematically ignoring economic opportunities for gain in a market economy. The latter is the
fundamental dilemma posed by the Porter hy- pothesis to the conventional neoclassical world-
view. In a world of x-inefficiency this dilemma would not exist and environmental regulations are
afforded the opportunity to push the decision- makers of firms into adopting greener production
processes that in the long run need not generate higher costs or lower profits.
4. Induced technical change and environmental regulation
The Porter Hypothesis maintains that firms can go well beyond adjusting the production process
within the constraints of the prevailing technology so as to become greener without generating higher
costs or lower profits. Applying a simple behav- ioral model of induced technical change, it can be
shown that the Porter hypothesis may hold true without posing the dilemma to the conventional
economic wisdom of producing profit opportuni- ties that are systematically bypassed by the deci-
sion makers of the firm. Following in the tradition established by Hicks 1932 see also Habbakkuk,
1962; Hayami and Ruttan, 1971; Binswanger,
Fig. 2. Technological change and pollution abatement.
1978; Altman, 1996; Ruttan, 1997, I assume that changes in factor prices and in relative factor
prices affect the pace and the path of technologi- cal change. Moreover, in the tradition of this
literature increasing unit costs of production, irre- spective of changes in relative factor prices, also
serve to induce technical change. In the tradition of Leibenstein 1973 it is assumed that the pace
of technological change is affected to the extent to which x-inefficiency exists and can be expected to
exist in the firm. As before, it is assumed that firms are profit maximizers and that perfect com-
petition in the product market exists.
6
In Fig. 2, capital and labor are the two factor inputs that comprise both OI and EI. The latter
are required to reduce pollutants. Capital and labor are mapped out along the vertical and hori-
zontal axes, respectively. The initial equilibrium for marketed output is given by point A along
isoquant Q
1
. For pollution abatement to take place more EI are required, and therefore, more
capital and labor are required to produce a given level of marketed output. This is illustrated by a
shift outward of the budget or isocost line from BC to BC and of the isoquant from Q
1
to Q ,
where the level of output at Q
1
and Q is equal.
The new equilibrium is given by point E along Q .
In other words, pollution abatement increases the average cost of marketed output, given by Q
, as
6
This discussion follows the argument developed in Altman 1996, Chs. 2 and 4.
more expenditure is required to produce a given level of marketed output. For average cost to
remain unchanged with pollution abatement re- quires technical change or a reduction in the level
of x-inefficiency such that the isoquant shifts from Q
to Q
1
, where the level of output produced at Q
1
and Q is equal. In this case, unit costs need
not increase if pollution abatement induces a sufficient amount of technical change or increases
in the level of x-efficiency to neutralize the cost of pollution abatement. However, such improve-
ments in productivity also typically require and go hand and hand with improving the conditions of
labor, resulting in increasing the relative price of labor, which is illustrated by increasing the slope
of the isocost line from BC to BC. Without further technological change and or further reduc-
tions in the level of x-inefficiency, the profit maxi- mizing firm will adjust its input combination
along ray 2, at A of isoquant Q
2
, so as to minimize unit cost. To produce the initial level of
output given by isoquant Q
1
translates into pro- ducing marketed output, now with less pollution,
at a higher unit cost — the isocost curve shifts outward along ray 2 to isoquant Q
1
. However, this expected or realized increased cost of pollu-
tion abatement might induce further technological change, shifting the isoquant from Q
1
to Q
2
, where the level of output at Q
1
to Q
2
is equal. The firm could then produce the original level of
output at the original unit cost since isocost curves BC and BC represent the identical level
of expenditure. The technological changes and reductions in the level of x-inefficiency are dis-
cussed here sequentially for illustrative purposes only and can be expected to take place simulta-
neously in response to the cost increases flowing from pollution abatement.
7
In this scenario, the relatively pollution inten- sive firm produces its marketed output at the
same unit costs as the relatively green firm once technological change is introduced into the equa-
tion. From this perspective, the pollution inten- sive firm has no incentive to adopt the new
technology if the new technology yields no unit cost advantage to the firm. Moreover, the old and
new technologies are linked to specific and differ- ential costs reflected in isocost curves BC and
BC. In other words, pollution abatement tech- nology requires an investment in time, effort, and
capital. In addition, if firms are required to be- come more x-efficient for the new technology to
become cost competitive, it becomes even more costly for firms to adopt the greener technologies.
For this reason, there would be no economic imperative, in the absence of regulation, for pol-
luting firms to become greener, unless the prefer- ences of the firms’ decision makers drove them in
this direction. In effect, environmental regulations serve to induce environmentally related techno-
logical change. Only if the relatively green firms developed even more advanced technology, given
by a shift in the isoquant from Q
2
to Q
3
, where the quantity of output at Q
2
equals that at Q
3
and where the isocost curve shifts inward from BC to
BC, would the unit cost of the greener firm drop below that of the more pollution intensive
firm. In this case, market forces induce the pollu- tion intensive firms to become greener.
At a more general level, Rosenberg 1982, p. 27, argues with respect to the process of techno-
logical change that, ‘…there is a threshold level at which the costs of the new technology become
competitive with those of the old.’ For this rea- son, there need not be a widespread adoption of
the new technology unless the production costs generated when using the new technology fall
below those associated with the old. If the threshold level is not passed, only environmental
regulation will result in the widespread adoption of the greener technologies. Moreover, if the
threshold is not passed, the relatively pollution intensive firms would not be foresaking economic
gain by avoiding greener technologies. Induced technological change adds another degree of free-
dom to the capacity of firms to become greener without causing unit production costs to rise or
profit rates to fall. However, it bears repeating that even if greener technologies are cost competi-
tive and do not cause average costs to increase, this in no way implies that the free market will
force their adoption by polluting firms as long as
7
The notion that environmental regulations might induce technological change has been explored by Faucheux and
Nicholaı¨ 1998.
these firms, themselves, remain cost competitive and profitable. If the new technology is known to
all firms and is not adopted by the pollution intensive firms, this represents a type of x-ineffi-
ciency in so far that the new technology yields a higher level of output than is possible with the
old.
Although the existence of x-inefficiency and induced technological change provides the possi-
bility of pollution abatement at no increased unit cost, this possibility is contingent upon the elastic-
ity of productivity increases to increases in pollu- tion abatement. The latter is, of course, an
empirical question. However, the extent to which productivity must increase to prevent, for exam-
ple, unit costs from increasing, depends not only on the percentage increase in pollution abatement
costs, but also on the relative importance of these costs to the firm’s total costs. In reality, abate-
ment costs represent only one component of total costs such that introducing or increasing the strin-
gency of environmental regulation need not in- crease unit production cost by much, even in the
absence of cost offsets. In the absence of these offsets, the increase in average cost is given by the
share of abatement or environmental costs to total costs multiplied by the percentage change in
abatement costs. This is given by:
DAC AC
= EC
EC + OC DEC
EC 4
where AC is average cost, EC are the abatement or environmental costs and OC are the other
costs. At one extreme, if abatement costs repre- sent 100 of total costs, the doubling of such
costs would increase average cost by 100 and output would have to increase by the same per-
centage to keep average cost from rising. If the environmental costs constituted 50 of total
costs, the doubling of such costs would increase average cost by only a 50 unless output in-
creased by the same percentage. If environmental costs share in the total falls to 3 — which is
much closer to the stylized facts — the doubling of such costs results in a 3 increase in average
cost and requires only a 3 increase in productiv- ity as a cost offset. If the environmental costs
increased by only 50, average cost would in- crease by 1.5, necessitating only a 1.5 increase
in output as a cost offset. In effect, it is easier for firms to manage environmental regulations when
these costs represent only a small percentage of total costs. Needless to say, introducing or tight-
ening such regulations does not imply high or higher production costs, as long as labour produc-
tivity can be sufficiently increased. The probabil- ity of this occurring through reductions in the
level of x-inefficiency and through induced tech- nological change increases as the share of environ-
mental costs in the total diminishes. And, the literature has documented that the share of these
costs in the total is relatively small Cropper and Oates, 1992; Jaffe et al., 1995.
5. Conclusion
