Revisiting the environmental subsidy in the presence of an eco-industry

This paper re-considers environmental subsidies in the context where polluting firms procure their abatement goods and services from a specialized oligopoly. To maximize social welfare, the regulator must then simultaneously alleviate two distortions: one that comes from pollution and the other that is due to the environment firms' market power. We find that combining an emission tax to a subsidy to polluters cannot lead to first-best, while the opposite conclusion holds if the subsidy is granted instead to environment firms. When public transfers are themselves subject to distortions, however, welfare may be higher if only an emission tax is used