The perverse effect of environmental regulation on emissions: The role of product‐mix changes

We study the effect of environmental regulation (taxation) on emissions when the only available abatement method consists of product‐mix changes. Firms choose to produce one or both varieties of a product—a pollution‐intensive (dirty) and a non‐pollution‐intensive (green)—and compete in a differentiated Cournot duopoly. We characterize the equilibrium market structure as a function of the tax rate and show that increases in the tax can promote product‐mix changes that lead to a jump in emissions for some tax range, an effect we call the perverse effect of taxation. Our work emphasizes the key role horizontal product differentiation in this process and shows that the perverse effect does not require the presence of vertical product differentiation. Further, the perverse effect of taxation is especially strong in the presence of incomplete regulation, that is, when only one of the markets is subject to taxation.