Voluntary agreements with an industry: An equilibrium analysis

Since the early 1990s, there has been a worldwide increase in the use of voluntary approaches as an alternative to the costly command and control regulations for environmental protection. Many voluntary agreements (VAs) are concluded between government and industry or trade associations. ^ A potential problem arises when an industry signs a VA with the government, namely, the incentive for individual firms to free-ride. An important policy question is whether this free-riding incentive undermines the viability of a VA to achieve an environmental quality target. In the existing literature, only a few studies address VAs with an industry. Several recent studies examining the free-riding problem in the context of VAs with an industry fail to explain the observed partial cooperation in the on-going VAs with an industry. This study differs from the previous studies in this respect. ^ In this dissertation, I develop a multiple-firm model of an industry\u27s voluntary adoption of environmental protection measures to achieve a predetermined industry-wide emissions reduction target under an explicit threat of alternative policies. I examine the free-riding incentive of individual firms and its impact on the viability of a VA. ^ I find that, in order to take advantage of the potential cost savings under the VA, there is an incentive for a sub-group of firms in an industry to participate in a VA despite the free-riding problem. At equilibrium, participating firms enjoy no surplus, and non-participating firms are strictly better off than under alternative policies. When firms differ by abatement cost, firms with higher willingness-to-abate are more likely to participate. I prove that there always exists an equilibrium VA with at least one firm participating (except when the fixed cost under VA is very high). When extending the analysis to the long run where firms\u27 entry and exit decisions are explicitly taken into account, the short run equilibrium is still sustainable. Under perfectly competitive market, the only long run equilibrium is one with full participation. In an oligopoly market with sunk entry cost, the degree of free-riding is reduced, but not completely eliminated as in the perfectly competitive market.