Basic Mechanism of Sustainable Development

In this chapter, the variety expansion model is extended to include pollution emitted from the production of goods. To internalise this negative externality, the government introduces environmental tax and emissions trading for goods firms. The environmental tax is passed on to the price, hence, demand for goods decreases. Goods firms reduce production, therefore, pollution is reduced. Labour moves from goods to the R&D sector, hence, varieties are developed and the economy grows. While consumption reduction caused by production contraction worsens welfare, consumption expansion and pollution reduction caused by economic growth improves welfare. Therefore, environmental taxes have a U-shaped welfare effect. The reduction in emission quotas leads to economic growth due to labour transfer from goods to the R&D sector, as emission allowances are passed on to prices. Furthermore, since the emission allowances allocated for free are potential rents, profit increases from rents stimulate incentives for developing variety, leading to economic growth. This is the distribution effect. Since the emission allowances cap production, the economic growth rate depends on population, fixed costs, pollution removal productivity and emission allowances. The emission allowances have an inverted U-shaped welfare effect. Hence, the effects of environmental taxes and emission allowances on pollution and growth are equivalent.