Firms’ Behavior

What kind of actions should firms adopt while facing government policies? First of all, we analyze the idea presented by some past scholars about firms’ behavior under different environmental policies, like uncertain environmental policy, cost

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uncertainties and so on. And they will be discussed in order as below. In the aspect of uncertain environmental policies, Farzin and Kort (2000) investigated the situation when firms face uncertain environmental policies of stringency and enactment date of an environmental regulation. The authors showed that the magnitude of uncertainty discourages abatement investment, but at the time of the actual tax increase the abatement investment path may shift either upward or downward. In the aspect of cost uncertainties, Zhao (2003) found that firms’ investment incentive diminishes in cost uncertainties, but the reduction is more under emissions charges than under permits. Therefore, tradable permits may be helpful to maintain firms’ investment incentive under uncertainty. Between the firm and regulatory, Magali and Alfred (2004) extended transaction costs economics to analyze relationships between firms and regulatory agencies. The authors analyzed the transaction costs of three ideal type governance structures including command and control regulation, market based mechanisms, and negotiated agreements. They compared the economic efficiency of firm-agency governance structures for dealing with pollution reduction. The authors’

contribution to transaction cost theory is that we have mentioned a situation where minimization of ex-ante negotiation costs might cause higher opportunity costs. In fact, negotiation costs and opportunity costs in our framework have inverse relation.

Under environmental policy, firms have to select whether following the regulation or not and have the correct attitude toward it. Glazer and Janeba (2004) found that the stringency of government’s regulation choice depends on the regulated firms’ previous investments. In order to decrease their payment of emissions taxes, the regulated firms may reduce emissions below their socially optimal level. Cohen (1998) studied the issues of environmental monitoring and enforcement generally lack of attention which can be disastrous for environmental quality and for social welfare. From the economic prospective for compliance, every firm will react to both

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positive and negative incentives. If the firms aware that expected penalties are sufficiently high, the threat of being punished for noncompliance should be an adequate reason. Stranlund (2008) concluded that a firm’s decision to be compliant with environmental regulations or not is independent of its manager’s risk preference.

However, non-compliant firms with risk-averse managers will have lower violations than otherwise identical firms with risk-neutral managers. The violations of non-compliant firms are independent of differences in their profit functions and their initial allocations of permits with risk-averse managers, when only if the utility functions of their managers’ exhibit a constant absolute risk aversion. Kydland and Prescott (1977) found that discretion is not first best because of the strategic foundation of the game. The firm will distort its investment decision for influencing regulation. With relatively small uncertainty about damages, rules are preferred to discretion for the sake of avoiding distortion of investment incentives is more important than adjusting policy in light of new information. On the other hand, discretion is preferred to rules while uncertainty about damages is relatively large.

How should firms select a proper behavior and equipment to reduce the amount of pollution emission? Adopting R&D maybe one of the ways to make it. Biglaiser and Horowitz (1995) focused on R&D incentives and considered the adoption of new pollution abatement technology under environmental taxes if firms engage in R&D and sell their new technology to unsuccessful research firms or non-research firms.

Poyago-Theotoky (2007) investigated in environmental R&D or abatement activities where firms undertake R&D in order to develop new processes to reduce toxic emissions. R&D affects the emissions of a firm in the sense that by undertaking R&D a firm can reduce its polluting emissions. If the environmental policy is inactive, that means emission tax is fixed and beyond the control of the regulator, R&D subsidization and the promotion of R&D cooperation are adopted. (Petrakis and

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Poyago-Theotoky, 2002). When firms invest in R&D and equipment, the change of policy should be considers as a vital element. Therefore, Tarui and Polasky (2005) proposed that firms should anticipate as to how the investment in their R&D or new plant and equipment will affect not only the cost given regulations, but also as to how investment might have its influence on its future regulation. In general, under either rules or discretion the first best solution cannot be achieved when investment occurs prior to the learning about the damage function. Rules are not first best since regulation may not reflect actual benefits or costs of abatement after investment and uncertainty about damages is resolved.

When firms choose emissions abatement, their objectives are to minimize the sum of abatement costs, tax payments on actual emissions, and the cost of purchasing emissions permits. Fischer, Parry, and Pizer (1998) concluded that firstly, after innovation the amount of emissions abatement under emission tax is greater than when its under emission permits. Innovation make the lower (marginal) cost of emissions abatement, which induces more emissions abatement under a tax, while under permits the industry-level amount of emissions remains the same. Since firms reduce emissions by a larger amount under the tax, they are willing to pay more for innovations that can help to reduce the costs of abatement.

When the change of environmental policy occurs, what should the firm do?

Knowing that regulations are going to be changed to reflect future conditions, regulated firms can invest strategically to change future regulation. With adjusting standards, the firm has a strategic incentive to reduce investment since investment can lower the abatement cost function resulting in tighter emissions standards. With adjusting taxes, the firm has a strategic incentive to increase investment since a lower abatement cost function causes the regulator to set a lower tax rate (Biglaiser,

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Horowitz and Quiggin, 1995; Kennedy, Laplante, 1999; Moledina, Coggins, Polasky and Costello, 2003).

In past literatures, scholars have discussed issues related to over compliance and violation of environmental regulation. First, environmental over compliance has puzzled economists for a long time because it appears to defy conventional wisdom in the environmental literatures that can be explained with the help of green consumer theory and strategic behavior theory.

Under the green consumer theory, firms over-comply to appeal to environmentally conscious consumers, who are willing to pay more for green products or prefer environmentally friendly firms. Whereas, strategic behavior theory contends that in future firms should over-comply to preempt stricter environmental regulation, gain competitive advantage, or induce government to choose for them a favorable form of regulation (Arora and Gangopadhyay, 1995). From the opinion of Wu (2009), competitive pressure can produce differentiated products, reduce costs, attract and retain quality employees, and create product and process innovations is a vital factor deterring environmental violations and a likely factor contributing to environmental over compliance.

Second, violations of environmental regulation by firms are discussed. Under costs and risks related with the adoption of environmentally friendly practices and technologies, either real or perceived, were found to have a growing trend on the probability of environmental violations. Furthermore, standard economic theory can explain environmental violations from two different aspects: a firm will select to violate an environmental standard if the expected penalty for the violation is smaller than the expected cost of compliance (Wu, 2009). Helland (1998) provided empirical evidence on the role of targeting firms for inspecting regulatory compliance. He

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found that there is a one-quarter penalty period following a violation and targeting opens the door to interest-group influence.

We then discuss how does the government use regulation to punish illegal firms.

(Wu, 2009) Previous empirical studies suggest that punishments and inspections are really strong factors for environmental violations. For example, Karpoff et al. (2005) proved that legal penalties, not reputation loss, are most important in deterring environmental violations. Stafford (2007) examined that in association with the violations of hazardous waste regulation on firm compliance, the effect of EPA’s dramatic 1991 increase in penalties, it has been found that violations has decreased after the penalty is change. Consequently, punishing illegal firms or rewarding legal firms, which one can help government to achieve the purpose of making polluters obey rules and reducing the level of pollution. In this paper, The firm’s behavior under government polices is the main topic that we are going to explored.

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