Working Paper No. 08-13

The Effect of Environmental Enforcement on Product Choice and Competition: Theory and evidence from India
Molly Lipscomb
November 2008

ABSTRACT

Sustainable development requires attaining a balance between maintaining environmental quality and controlling the impact of environmental regulations on productivity and competitiveness. This paper examines a margin of adjustment not commonly addressed in evaluating environmental regulation; the response by multi-product firms at the intensive (quantity per variety) and extensive (number of varieties) margins of their product portfolios. It parses the effect of changes in enforcement across the distribution of low to high productivity firms. I find (a) that firms react to changes in enforcement by increasing the share of their product portfolios allocated to clean products, (b) that consistent with theory the magnitude of this effect varies across the productivity distribution, and (c) that this in turn affects competition and quantities supplied in these markets.

I develop a product selection model for heterogeneous multi-product firms and apply it to a setting in which large firms face changes in the enforcement of environmental regulations. The model shows that firms respond to changes in the fixed cost of producing the pollution intensive product by either shifting their portfolios toward the clean product or focusing their operations on a high margin pollution intensive product. The overall response depends on the profit margins and fixed costs of clean and dirty products and on the firm’s intrinsic productivity. Portfolio reallocations by competitors allow highly productive firms specializing in the pollution intensive industry to gain market share.

I test the predictions of the model using a firm and product-level data set for over 2300 large firms across all manufacturing industries in India for the period 1997-2005. This data is overlaid with state-level environmental enforcement data. High productivity firms in the pollution intensive industry invest in new, generally cleaner capital and gain in both sales and profitability following an increase in enforcement. Low productivity firms in both industries have reduced sales. The market consolidation toward cleaner high productivity firms in response to environmental regulation shows that the costs of regulation are not evenly distributed. Portfolio reallocations in response to changes in environmental regulations cause compositional changes in local manufacturing which increase the impact of the change in environmental enforcement beyond the benefits associated with the required abatement technologies.

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