Tax and pollution in a vertically differentiated duopoly: When consumers matter

Inspired by the so‐called polluter pays principle, environmental taxes can drive a more sustainable European market. However, unilateral mitigation measures can reduce the competitiveness of carbon‐intensive industries, thereby inducing relocation. In this paper, we wonder whether a tax can effectively curb emissions without hurting firms. Our analysis's entry point is that the level of emissions in a region is jointly determined by (i) the number of consumers buying dirty goods and (ii) the environmental quality of these products. Thus, to curb emissions, on the one hand, firms have to reduce their goods' emissions intensity. On the other hand, consumers have to reduce the consumption of dirtier goods. This leads to defining a tax depending on the number of consumers buying the brown products and the relative quality of these products. We show that under this tax, lower emissions do not come at the expense of lower profits.