Effects of environmental regulation on firm entry and exit and China’s industrial productivity: a new perspective on the Porter Hypothesis

This paper dissects the effects of environmental regulation on the productivity of pollution-intensive industries and by doing so offers a new perspective on the Porter Hypothesis. A theoretical model that incorporates firm’s productivity heterogeneity shows that tighter environmental regulations impose two opposite effects on aggregate industry productivity: a negative productivity erosion effect on all the firms, and a positive productivity selection effect through impacts on firms’ entry and exit. Thus, the final effect of environmental regulation on industry productivity depends on the magnitude of the two individual effects. An empirical study supports the theoretical model. Data from 184,186 firms from 15 Chinese pollution-intensive industries during 1998–2007 shows that environmental regulation has imposed a significant negative effect on firm-level productivity but at the same time has affected the probability of entry and exit of low productivity firms. Stricter environmental regulation increases the probability of exit for the lower productivity firms and reduces the probability of entry for potential pollution-intense entrants, leading to significant resource reallocation within the industries. These two effects result in an inverted U-shaped relationship between environmental regulation stringency and aggregate industry productivity; aggregate industry productivity increases when the stringency of environmental regulation is neither too high nor too low.