Green Premium, Ecolabel, and Environmental Damage

In markets where differences in environmental performance of competing firms arise due to differences in technology and other attributes that cannot be altered in the short run and firms have private information about these attributes, an ecolabel may allow firms to credibly communicate their private information to environmentally conscious uninformed consumers. This may ameliorate the distortion in pricing and consumption patterns in the market outcomes, when there is no credible direct disclosure mechanism and pricing is the only channel of signaling private information. In an incomplete information duopoly market with price competition, I show that even if a credible ecolabel is available freely, clean firms may not always find it individually advantageous to adopt the ecolabel. The adoption of the ecolabel by the clean firms removes price and welfare distortions (caused by price signaling); in this case, the availability of the ecolabel makes competition more intense, reduces market power, increases market shares of the clean firms, and lowers the expected environmental damage. The effect of the ecolabel on the incentives to invest in the development of a clean technology is more complex; the presence of an ecolabel may reduce the level of aggregate investment.