The strategic use of innovation to influence regulatory standardsIntroductionModel of innovation under endogenous regulationStage gameNotationChoice of regulatory standardIndustry innovationExamples of equilibrium outcomesSpecial case of general modelValue of regulatory commitment: monopoly vs. oligopolyEffect of compliance cost asymmetries on innovationDiscussion: regulatory examples of raising rivals costsReformulated gasoline and UnocalThe Montreal Protocol and DuPontExtensions to other policy instrumentsEmissions taxTradable pollution permitsConclusionsAcknowledgmentsAppendixReferencesJournal of Environmental Economics and Management 52 (2006) 690–706The strategic use of innovation to influence regulatory standardsSteven L. PullerDepartment of Economics, Texas A&M University, 3046 Allen, College Station, TX 77843, USAReceived 19 July 2005AbstractThis paper investigates the welfare consequences of strategic behavior by firms to affect the amount of environmentalregulation they face. Environmental regulation often attempts to force an industry to develop cleaner technology, but theregulator may have no means to commit to a specific standard. This lack of regulatory commitment induces firms tochoose innovation strategically. It is well-known that firms have incentives to suppress innovation to induce the regulatorto ratchet down the standard, and this strategic behavior lowers welfare. This paper explores a countervailing incentive. Inoligopoly settings, firms have heightened incentives to innovate so as to increase regulation and raise rivals costs. Inequilibrium, the incentive to raise rivals cost can mitigate the welfare loss arising from no regulatory commitment. Also, aregulator who is unable to commit ex ante to the stringency of a regulatory standard can induce more clean technologythan a regulator with a commitment mechanism.r 2006 Elsevier Inc. All rights reserved.Keywords: Environmental regulation; Innovation; Rules versus discretion1. IntroductionGovernment regulation is the impetus for many innovations in environmentally cleaner technology. In acommon regulatory scenario, the regulator imposes a standard because clean technology has yet to bedeveloped and the regulator seeks to spur innovation. However, because no cost-effective technology isinitially available to meet the standard, the regulator must rely on the industry’s innovation to make theregulation welfare-improving. If for some reason the industry does not innovate, the regulator would have anincentive to ratchet down the regulation to avoid imposing an expensive policy on society. This will createincentives for the firms in the industry to behave strategically with the regulator when choosing innovation.This paper analyzes incentives to innovate in cleaner technology when firms are not ‘‘regulation-takers’’.In oligopoly settings, firms face countervailing incentives to innovate relative to exogenous regulation. If theregulator cannot commit to a standard, firms have lower incentives to innovate because the regulator has an expost incentive to ratche t up regulation and expropriate gains from cost-reducing innovation. In anticipation ofexpropriation, firms face dampened incentives to innovate. However, oligopoly firms face another incentive aswell. A firm may innovate and encourage regulation if the firm has a cost advantage over competitors inARTICLE IN PRESSwww.elsevier.com/locate/jeem0095-0696/$ - see front matter r 2006 Elsevier Inc. All rights reserved.doi:10.1016/j.jeem.2006.07.002Fax: +979 847 8757.E-mail address: [email protected] with the regulation. Therefore, the incentive to influence the regulatory standard depends on therelative sizes of the ‘‘ratchet’’ and ‘‘raise rivals cost’’ effects. I model the incentives to innovate and addresswhether the incentive to raise rivals cost induces welfare improving innovation. This paper analyzes whether‘‘rules are better than discretion’’ in regula tion of oligopoly firms.Many examples of environmental , health, safety and product quality regulation involve strategic incentivesfor firms to use innovation to influence the regulatory standard. In some cases, the impetus is to ratchet downsubsequent regulation. Analysts have claimed that auto emission standards were held up for several years inthe 1970s due to auto manufacturers footdragging in innovation to holdup the Environmental ProtectionAgency.1In 1990, California adopted zero emission vehicle requirements, but the schedule was rolled backseveral times because few vehicles meeting the standard were commercially feasible. Finally, advocates ofelectric vehicle regulation have contended that auto manufacturers suppressed fuel cell technology in order todiscourage regulation.In other cases, the raise rivals cost effect appears to dominate. In the case of energy efficie ncy regulation ofhousehold appliances, Whirlpool Corporation invested heavily in designing more efficient refrigerators andthen lobbied for stronger regulation to gain a competitive advantage over less innovating rivals. To quote acompetitor, ‘‘They (Whirlpool) believe government regulations can be used to their competitive advantage’’.2In regulations to impose fuel economy standards (CAFE) in the 1980s, U.S. automakers had differentpositions on increasing the standard . GM and Ford generally opposed the 27.5 mpg standard while Chryslerfavored a higher standard because it had eliminated much of its large car segment in the early 1980s [27].However, the 27.5 mpg standard has been maintained, despite fuel-savi ng technologies that appear to havebeen utilized to increase performance rather than boost fuel economy [3]. In international regulation to reducedestruction of the ozone layer, DuPont, a leading developer of CFC alternatives, plan ned to phase-out CFCproduction ahead of schedule in what some analysts claim was the hope of accelerating regulation and hurtingrivals who did not possess viable CFC alternatives.3Even regulation less in the public spotlight such as powertool regulation boasts stories of some firms in the industry innovating and encouraging regulation, while otherfirms do not innovate and press regulators for less stringent standards.4Most recently, this effect is present inUnocal’s research into reformulated gasoline and its efforts to influence the California Air Resources Board’s(CARB) cleaner-burning gasoline standards. In the