Marketable permits in a stochastic dynamic model of the firm

This contribution attempts to determine the effects of environmental regulation on the growth of an individual firm. Here, it is assumed that the firm revenue is stochastic. The government tries to reduce pollution by creating a market on which the firm has to buy permits in order to be allowed to pollute the environment.Pollution is an inevitable byproduct of the firm production process, and in our model the firm is offered two ways to deal with it. The first is to buy marketable permits, and the second is to clean up pollution which can be achieved through investing in abatement capital stock.It turns out that the firm optimal trajectory consists of at most seven different policies. They can be depicted in a feedback diagram from which we can conclude that, provided that the firm never faces a shortage of cash, productive and abatement capital stocks ultimately reach their equilibrium levels where marginal revenue equals marginal costs.This paper was presented at EURO XIII, July 19–22, 1994 in Glasgow, Scotland. The research of the second author has been made possible by a fellowship of the Royal Netherlands Academy of Arts and Sciences. Thanks are due to M. Stimming for valuable comments and suggestions and to A. Van Den Elzen for his corrections.