Porter hypothesis vs. pollution haven hypothesis: can an environmental policy generate a win–win solution?

Abstract

This paper investigates the effects of environmental policy on firms’ location and green innovation for a two-country, two-firm model. To address this issue, a two-stage game is solved. At the first stage, firms can choose between three actions: to stay in the home country and invest in a green technology; to stay in the home country and produce with the business-as-usual technology; or to move to a pollution haven. At the second stage, the firms compete in quantities while serving the demand in the home country. Despite the model is symmetric, our findings indicate that all market configurations – both symmetric and asymmetric – can be a subgame perfect Nash equilibrium of the game. This includes a “win–win” solution where both firms choose to stay in the home country and invest in green technology confirming the “weak” version of the Porter Hypothesis. Remarkably, this outcome can occur even in seemingly adverse conditions with relatively low setup costs of relocating to a pollution haven. The model predicts that a stricter environmental policy plays in favor of the Porter Hypothesis because the “win–win” solution becomes more likely to arise as an equilibrium of the game. Our analysis examines two policy scenarios – an emission tax and an emission standard – finding that the emission tax can induce firms to stay and invest in green technology under circumstances for which the standard cannot, confirming in this way the “narrow” version of the Porter Hypothesis.