Review of Industrial Organization 12 751–765, 1997.c 1997 .docx

Review of Industrial Organization 12: 751–765, 1997.
c
1997 Kluwer Academic Publishers. Printed in the Netherlands.
Raising Rivals’ Costs Strategies via Emission
Permits Markets
EFTICHIOS SOPHOCLES SARTZETAKIS�
University College of the Cariboo, Department of Economics
and Finance, 900 McGill Road, P.O.
Box 3010, Kamloops, B.C., Canada V2C 5N3
Abstract. In the present paper we examine the effect of
emissions permit price manipulation within
an oligopolistic model. We examine the effect that positioning
strategies in permits markets have on
the degree of competition in the product market as well as on
social welfare. The analysis is based
on the concept of raising rivals’ cost strategies. We find that
competition in the product market can
be lessened substantially. The welfare effect is ambiguous. If
the leader expands its market share
at the expense of a less efficient rival, or if it excludes a less
efficient entrant, overall efficiency
may increase despite the decrease in the industry’s output.
When efficiency decreases, or when
consumers’ protection is a policy priority, the initial
distribution of permits can be used to control
power in the permits market. Such interventions though,
improve efficiency only when policy makers
have substantial information on the technological structure of
the industry, and thus, should be used

with caution. Given the importance of information, sharing of
information and coordination of actions
between policy makers is very important.
Key words: Tradeable emission permits, raising rivals’ costs
strategies, antitrust policy.
I. Introduction
According to the theory of externalities, a proper policy should
provide economic
agents with adequate incentives to undertake the right amount
of the externality
creating activity. In the case of environmental externalities, this
is accomplished
with the use of tradeable emission permits. Under ideal
conditions, including perfect
competition, this policy instrument achieves efficiency. Many
regulated industries
though, are not competitive, and the markets in which emission
permits are traded
may not be competitive either. The literature recognizes that, in
the presence of
product market distortions tradeable permits do not yield the
optimum allocation
of resources. However, little is still known about the impact of
emission permits
market distortions on product market structure, and on social
welfare.
� I am grateful to Thomas Ross for his encouragement and
support through all stages of this
research project. I would also like to thank an anonymous
referee of this journal, Donald McFetridge,
Keith Acheson, Steven Ferris and Peter Tsigaris. Participants at
the Sixth Annual Conference of the

European Association of Environmental and Natural Resource
Economists (Umea, June 1995) have
also contributed with their comments. I gratefully acknowledge
financial support from the Bureau of
Competition Policy, Industry Science and Technology Canada.
752 EFTICHIOS SOPHOCLES SARTZETAKIS
Even though permits markets imperfections might not be an
important concern
when the number of regulated firms is large, it could be a
serious problem in
more localized permits markets. For example, if the sulphur
dioxide emissions of
electricity generating plants in Canada were controlled through
emission permits
regulations at the provincial level, the small number of
participants in the relevant
permits markets does not guarantee competitive behaviour.
Similar concerns have
been raised by von der Fehr (1993) and Fershtman and de
Zeeuw (1996) concerning
the U.K. electricity industry, and by Hanley and Moffat (1992)
concerning Scotland.
In the present paper we examine whether power in the permits
market can
be used to reduce the existing and potential level of competition
in the product
market. Our analysis is based on the concept of raising rivals’
cost strategies.1
From its conception, the theory generated a vigorous debate on
both theoretical

and empirical level.2 Two main points of criticism are
identified on the theoretical
level. The first, questions the applicability of raising rivals’
cost strategies by
arguing that such strategies are profitable only in limited cases.
The second, argues
that raising rivals’ cost strategies have an ambiguous effect on
overall efficiency,
and thus, do not necessarily require policy intervention.
Our objective is first, to contribute to the environmental policy
literature by
examining the efficiency of tradeable emissions permits
regulations in the presence
of market power. Second, to contribute to the theoretical
evaluation of raising rivals’
cost strategies, by providing an example in which raising rivals’
cost strategies are
profitable, and examine the overall efficiency effects of these
strategies.
We examine an oligopolistic industry whose emissions are
controlled under a
tradeable emission permits regulation. Tradeable emission
permits are considered
as an input with fixed, exogenously determined supply. Each
firm can substitute
away from permits by engaging in abatement. Abatement
depends on output and
thus, decisions in the product and permits markets are linked.
We assume that
one of the firms, hereafter called the leader, has power in the
permits market. The
leader can exercise power in aggressive (exclusionary
strategies) or moderate ways
(positioning strategies). Although exclusionary strategies can be

effective in forcing
rivals to exit the market, we do not examine them because they
can be challenged
by existing antitrust policies.3 For the same reason we do not
examine cases in
which permits are used to stabilize merger agreements by
securing profits against
potential entry. We rather focus on moderate predatory
(positioning) strategies and
assess their effect on social welfare.
We find that positioning strategies are profitable. The more
stringent the regu-
lation and the more expensive the abatement is, the more
profitable raising rivals’
1 See Salop and Scheffman (1981, 1983, 1987), and
Krattenmaker and Salop (1985, 1986, 1987).
Subsequent extensions of the theory include, Hart and Tirole
(1990), Ordover et al. (1990), Gaudet
and Long (1993).
2 For recent reviews of the debate see Ware (1994) and Coate
and Kleit (1994).
3 For example, under Sections 77–79 of the Canadian
Competition Act, these practices can be
clearly challenged for abuse of dominance position.
COSTS STRATEGIES VIA EMISSION PERMITS MARKETS
753
cost strategies are.4 The welfare effect of positioning strategies
is ambiguous and

it depends on the technological efficiency of the leader relative
to its existing and
potential rivals. 5 If the leader expands its market share at the
expense of a less effi-
cient rival, or if it excludes a less efficient entrant, overall
efficiency may increase
despite the decrease in the industry’s output. Thus, even when
the market for per-
mits is not competitive, tradeable emission permits regulations
can be an efficient
way to control pollution.
The literature on strategic behaviour in the permits market is
limited. Misiolek
and Elder (1987) present the first analysis of the use of raising
rivals’ costs strategies
in the permits markets within a dominant firm model. Von der
Ferh (1993) analyses a
Cournot duopoly regulated through a tradeable emissions
permits system. Although
our work bears some similarities in approach and results with
von der Fehr (1993),
it defers in two respects. First, we model firms’ abatement costs
separately from
all other production costs. Second, we focus on positioning
strategies while von
der Ferh is more interested in exclusionary strategies. Requate
(1993) analyses the
case of cooperation between firms. Fershtman and de Zeeuw
(1996) examine the
bargain process of emissions trading between two Cournot
players. They find that
once all possible sets of outputs have been identified, firms
trade permits so as to
maximize joint profits and thus, aggregate output is reduced.

Although strategic manipulation of permits markets might not
be an existing
problem,6 the potential application of permits systems to small
numbers markets
justifies a closer look at possible anticompetitive behaviour.
Our welfare results
support earlier views (Tietenberg, 1985, 1989) suggesting that
the significance of
permit price manipulation is limited. However, there are
situations, such as the case
of an inefficient leader, in which policy intervention is
necessary. In such situations,
the distribution of emission permits can be used as an
instrument to control power
in the permits market. Policy intervention can be welfare
improving only if policy
makers have substantial information on the technological
structure of the industry.
Given the importance of information, information sharing and
coordination of
actions between policy makers (environmental and competition
policy) is crucial.
The rest of the paper is organized as follows: Section II
develops the benchmark
case of competitive permits market; Sections III and IV examine
the cases in which
the leader in the permits market decreases its rivals’ shares in
the product market,
and deters entry respectively. Section V contains the concluding
remarks. All tables
referred to in the text appear at the end of the paper. Proofs of
the results discussed
in the paper are available by the author upon request and they
can also be found

4 Brown-Kruse et al. (1995) arrive at similar results conducting
laboratory experiments in envi-
ronments that resemble very closely our theoretical framework.
5 Assuming that profits are distributed to consumers, the term
welfare denotes the sum of consumer
and producer surplus.
6 Note however, that one of the explanations for the very low
level of transactions in existing
permits trading programs is that firms fear that buyers of
emission permits could later use them to
control the product market (see Hahn, 1989).
in Sartzetakis (1996a). In Appendix A we present the
specifications of the model,
while in Appendix B we present the initial values we used for
the simulations.
II. The Competitive Benchmark Case
Assume a homogeneous Cournot duopoly facing linear demand
and increasing mar-
ginal cost of production. The production process generates
emissions of a pollutant.
Firms can reduce emissions by either reducing output or
controlling emissions. The
marginal cost of abatement is increasing both in output and
abatement per unit of
output. Firms’ production and abatement technologies differ.
Policy makers aim at reducing emissions to a certain level,

which is not optimally
decided.7 The regulatory intervention takes the form of
tradeable emission permits.
Firms are required to own emission permits in order to emit.
Each permit specifies
an amount of allowable emissions, assumed to be one unit, and
is freely transferable.
The number of permits issued is the maximum allowable units
of emissions.
Emissions permits can either be auctioned or distributed free of
charge (grandfa-
thered) to the existing firms. Grandfathering of emission
permits is based either on
firms’ historical level of emissions, or it is arbitrary, for
example equiproportionate
allocation of permits. We assume that all permits are distributed
to existing firms.
Thus, the supply of permits is perfectly inelastic, and potential
entrants have to
buy all the permits they need from incumbent firms. This
assumption simplifies
the exposition of our results without limiting their generality.8
After the initial
allocation of permits, trade is allowed.
Perfectly competitive markets for permits share the following
two main proper-
ties. First, minimization of abatement costs is achieved but
overall efficiency cannot
be achieved. If both firms act as price takers in the permits
market, optimization
implies that each firm trades permits to the point that the permit
price equals its mar-
ginal abatement cost. Equalization of marginal abatement cost
across firms yields

the efficient distribution of abatement effort, but due to the
oligopolistic product
market structure, it cannot achieve the efficient production
allocation. Industry’s
output decreases from its pre-regulation level, while firms’
shares are unaffected
by the regulation. Thus, the more efficient firm reduces output
relatively more than
the less efficient firm. Trading of permits does not necessarily
yield the first-best
allocation of resources when product markets are imperfectly
competitive.9
7 Emission ceilings are usually decided through a political
process involving consultation with
various interest groups and may be influenced by international
agreements.
8 If more than one industry’s emissions are regulated under a
tradeable permits system, and all
firms participate in the allocation of permits, the supply of
permits to one industry is elastic. To
examine the effects of power in the permits market, we have to
examine the impact on all industries.
In the present paper we restrict our attention to one industry.
9 For extensive discussions of the efficiency of competitive
permits markets when product markets
are oligopolistic, see Borenstein (1988), Malueg (1990), Hung
and Sartzetakis (1994) and Sartzetakis
(1996b).
755

Second, the mode of permits distribution does not affect
efficiency but only
profits’ distribution. The competitive permits price is
independent of the initial
distribution of emission permits. This is not surprising since
both firms are price
takers in the permits market and each firm’s permits endowment
is exogenous. Thus,
firms’ optimal choices of output and abatement per unit of
output are independent
of the mode of initial permits distribution.
III. Permits Price Manipulation
1. EFFICIENCY AND WELFARE RESULTS
Assume that one of the two Cournot players has price setting
power in the permits
market. This case is modelled as a two stage game. In the first
stage the leader
chooses the permit price. In the second stage, both firms make
their output and
abatement decisions taking the permit price as given. To
determine the subgame
perfect equilibrium, we begin by solving the second stage of the
game first.
In the second stage, firm 2 is a permit price taker and thus, it
trades permits up
to the point that its marginal abatement cost equals the marginal
cost of permits,
i.e. the permit price. Although the leader, firm 1, does the same,
its marginal cost
of permits is not equal to the permit price. This is because
permits have an extra

value for the leader; by manipulating the price of permits, the
leader can influence
its rival’s costs. Recognizing this, the leader trades a different
than the competitive
number of permits, adjusting its output and abatement such that
the permits market
clears at the permit price it has committed to in the first stage
of the game. Thus,
its marginal cost of abatement is not equal to the permit price.
In the first stage, the leader chooses the permit price that
maximizes its profits,
taking into account the Nash equilibrium of the second stage.
The choice of a
higher than the competitive permit price has a twofold effect on
the leader’s profits.
On the one hand, the rival’s costs increase and its output
decreases resulting in an
increase in the leader’s revenue. On the other hand, the leader’s
costs increase, first
because of the increase in the permit price, and second because
the leader’s net
demand for permits increases in order to clear the market. The
leader commits to a
higher than the competitive permit price if the benefits from
raising its rival’s costs
dominate the increase of its own costs. In such a case, the
leader overbuys permits
and thus, its marginal cost of abatement is lower than the permit
price. Therefore,
compliance costs are not minimized in the case of permit price
manipulation.
Another difference with the competitive case is that the permit
price under
leadership is positively related to the leader’s endowment of

permits. Thus, policy
makers could control the leader’s power by manipulating the
initial distribution of
permits. Such an action though, requires full information and
the willingness to base
Figure 1. Permits price determination.
the initial permits’ allocation on efficiency rather than
distributional considerations.
Since both requirements are strong we do not pursue this policy
option further.10
Figure 1 illustrates the effect of permits price manipulation on
permits market.
Each firm’s demand for permits is given by its marginal
abatement cost (MCAi).
The horizontal summation of the firms’ demands is the market
demand for permits.
The supply of permits, �E, is perfectly inelastic. Under perfect
competition, permits
price is P" and each firm holds E"1 permits at the equilibrium.
When firm 1 is the
leader in the permits market, it sets a higher than the
competitive permits price, Pm
and holds Em1 permits at the equilibrium, which are more
relative to competition
(Em1 > E
"

1 ). The leader’s demand for permits does not coincide any more
with
its marginal cost of abatement. The leader uses permits not only
as a substitute to
abatement but also as a device of manipulating its rival’s costs.
Thus, the value of
permits for the leader is higher and its demand for permits is
higher accordingly.
Permits price manipulation also results in reshuffling of product
market shares.
Because of the increase in permit price, both firms’ marginal
costs increase and
10 Hahn (1984) derives the cost-minimizing allocations of
permits in the case that one firm acts as
a monopolist/monopsonist in the permits market.
757
thus, industry’s output decreases. However, the increase in
leader’s marginal cost
is smaller and thus, its product market share increases relative
to competition.
Thus far we dealt with the effect of permits price manipulation
on the alloca-
tion of abatement and production. We now move to examine the
effect of permit
price manipulation on industry’s profits. We compare industry’s
profits under price
manipulation to the competitive benchmark. Given that the
allocation of produc-

tion under competition is not efficient, could leadership
improve industry’s profits
despite the fact that industry’s abatement costs increase?
To illustrate the impact of leadership on industry’s profits we
use simulations.
The values of the parameters used in the simulations are such
that the cost of
abatement is a significant part of firms’ total costs. Table I
presents the results
of these simulations. We find first, that leader’s profits increase
regardless of the
technological structure of the industry (third column in Table I).
Second, industry’s
profits decrease when firms have similar production and
abatement technologies, or
the leader is less efficient that its rival (fourth column in Table
I). Third, industry’s
profits increase when either the leader is more efficient in
production or the price
taker in abatement (fourth column in Table I). Permit price
manipulation implies
that the price taker is forced to engage in higher abatement and
lower production
relative to competition, while the leader does exactly the
opposite. Industry’s profits
therefore, depend on firms’ relative efficiency in production and
abatement. On the
one extreme, if the leader is more efficient in production but
less efficient in
abatement, permits price manipulation enhances efficiency by
inducing firms to
exploit their respective advantages. On the other extreme, if the
leader is less
efficient in production and more efficient in abatement,
efficiency is decreased.

The ambiguity of the effect of permit price manipulation on
industry’s profits
is carried over to social welfare. The model used for the
simulations assumes that
permits price manipulation does not affect industry’s profits.
Thus, the change in
industry’s profits equals the change in social welfare. Similar
results are expected
in the case that output changes as a result of permits price
manipulation. It is
more likely that output decreases (except if the leader is much
more efficient than
its rival) and thus, welfare is more likely to decrease as a result
of permits price
manipulation.
One clear case that calls for policy intervention emerges from
the above discus-
sion. Namely, the case of a large, inefficient in production firm
that can become a
leader in the permits market. Given that this is not an atypical
situation in regulated
industries, such as electric utilities, policy makers should watch
for overbuying of
permits.
2. FACTORS AFFECTING THE LEADER’S ABILITY TO
EXERCISE MARKET POWER
We now turn to examine the factors influencing the ability of
the leader to implement
raising rivals’ costs strategies. The leader’s choice of permit
price depends on the
effects on both firms’ marginal costs. It can be shown that
firms’ marginal costs

Table I. Effect of permits price manipulation on industry’s
profits,
presented as a function of the leaders’ production and abatement
efficiency relative to the price taker
c1 (c2 = 200) d2 (d1 = 250)
(�
m
1 ��
"
1 )
�"
1
(
P
�m
i
�
P
�"
i
)P
�"
i

200 250 0.0364 �0.01013
150 250 0.02918 �0.00552
100 250 0.02385 �0.00162
100 200 0.02038 �0.00089
100 150 0.01715 �0.00028
100 100 0.01417 +0.00021
100 50 0.01145 +0.00060
100 0 0.00901 +0.00087
80 250 0.0221 �0.00024
75 250 0.02169 +0.00009
50 250 0.01979 +0.00164
0 250 0.01663 +0.00432
Where
P2
i=1
�
j
i = �
j
1 + �
j
2 , i = 1, 2 and j = ", m, are the
industry’s profits. Superscripts " and m denote equilibrium
values
under competition and leadership respectively.
of production and abatement can both be expressed as functions
of the difference

between the permit price under leadership and under
competition. Thus, the permit
price difference is a good indicator of the strength of raising
rivals’ costs strategies.
It can be shown that the permit price difference depends on the
leader’s pre-
regulation product market share, its share of the emission
permits in the initial
allocation, and its abatement efficiency relative to its rival. It is
clear that the more
efficient the leader is in abatement the more it can raise its
rival’s costs. The effect
of the leader’s share in the product market and in the initial
permits allocation is
discussed in some detail.
First, the permit price difference is negatively related to the
leader’s pre-
regulation market share. This result contrasts the predictions of
the raising rivals’
costs theory.11 In the standard raising rivals’ costs model, it is
assumed that the lead-
er buys exclusionary rights of the input, and that the cost of
exclusion is independent
of the leader’s output. Thus, the higher the leader’s market
share, the smaller is the
effect of the fixed exclusionary costs on its average cost. In our
model, overbuying
strategies do not increase the leader’s fixed costs, they rather
increase its marginal
cost. Thus, the larger the leader’s market share, the higher on
its marginal cost it
operates, and thus, it is relatively more expensive to raise its
market share further.
Table II illustrates this result with numerical examples. All
changes are reported

11 For instance, see Salop and Scheffman (1987), and Coate and
Kleit (1995, p. 80).
759
Table II. Profitability of raising rival’s cost strategies as a
function of
the leader’s pre-regulation market share. Equiproportional
distribution of
permits ( �E1 = �E=2)
�s1 P
m
� P"
�
@�m
1
@qm
1
�
@�"
1
@q"
1
�

@�"
1
[email protected]"
1
�
@�m
2
@qm
2
�
@�"
2
@q"
2
�
@�"
2
[email protected]"
2
(�
m
1 ��
"
1 )

�"
1
0.45647 65.7057 0.04145 0.13805 0.06189
0.47866 64.6653 0.04359 0.13427 0.04662
0.50 63.6249 0.04513 0.13058 0.0364
0.52053 62.5845 0.04621 0.12698 0.02918
0.54031 61.5441 0.04692 0.12345 0.02385
Where, �s1 is the leader’s pre-regulation market share; P
j, j = ", m is the
permit price; �j1 are the leader’s profits; and �
j
i = di�iqi + e�
2
1q
2
1 + P
j(�qi
� �iqi � �E), i = 1, 2 and j = ", m, is firm i’s total cost of
compliance
with the environmental regulation. Superscripts " and m denote
equilibrium
values under competition and leadership respectively.
in percentage terms. Column two shows that, as the leader’s
pre-regulation market
share, ŝ1 increases, the permits price difference P
m
� P" is decreasing. Columns

three and four demonstrate that as the leader’s market share
increases, its marginal
cost of compliance is increasing, while that of the price taker is
decreasing. As a
result, the increase of leader’s profits resulting from raising
rivals’ costs strategies
decreases as its pre-regulation market share increases. This
result is illustrated in
the fourth column of Table II.
Second, the larger the leader’s share in the initial permits
distribution, the larger
is the permit price difference. The leader’s marginal cost of
abatement is lower than
the permit price at the equilibrium. Thus, the leader’s
compliance cost is lower the
higher is its endowment of permits. Comparison of the
simulation results in Tables
II and III illustrates the impact of the mode of initial permits
distribution on the
leader’s ability to raise its rival’s cost. In deriving Table II we
assume that permits
are distributed equally among firms, while in Table III we
assume that permits
are distributed according to the firms pre-regulation market
share. Comparison of
each table’s column two reveals that, the higher the leader’s
endowment of permits,
the higher the permit price difference.12 The mode of initial
allocation of permits
affects the leader’s ability to raise its rival’s cost. When permits
are auctioned, the
leader pays the higher price for all permits it uses, and thus, its
ability to raise its
rival’s cost is reduced.

12 In contrast to the results in Table II, the permits price
difference Pm � P" in Table III is larger
the larger is the leader’s pre-regulation market share. This
indicates that, for range of values we use,
the impact of the endowment of permits on raising rival’s cost
strategies is stronger than the impact
of the pre-regulation market share.
Table III. Profitability of raising rival’s cost strategies as a
function of the
leader’s pre-regulation market share. Distribution of permits
according to
pre-regulation market share: ( �E1 = ��q1)
�s1 P
m
� P"
�
@�m
1
@qm
1
�
@�"
1
@q"
1

�
@�"
1
[email protected]"
1
�
@�m
2
@qm
2
�
@�"
2
@q"
2
�
@�"
2
[email protected]"
2
(�
m
1 ��

"
1 )
�"
1
0.45647 61.0332 0.03529 0.12824 0.05704
0.47866 62.3291 0.04052 0.12942 0.04442
0.50 63.6249 0.04513 0.13058 0.0364
0.52053 64.9207 0.04924 0.13172 0.03087
0.54031 66.2166 0.05293 0.13282 0.02682
Where, �s1 is the leader’s pre-regulation market share; P
j, j = ", m is
the permit price; �j1 are the leader’s profits; and �
j
i = di�iqi + e�
2
1q
2
1 +
Pj(�qi � �iqi � �E), i = 1, 2 and j = ", m, is firm i’s total cost
of com-
pliance with the environmental regulation. Superscripts " and m
denote
equilibrium values under competition and leadership
respectively.
IV. Emission Permits as a Barrier to Entry
In this section we extend our discussion to cases in which
raising rivals’ costs

strategies blockade entry. We assume that the two incumbent
firms of the previous
section encounter a potential entrant who, in the absence of
environmental regu-
lation, would enter into the industry. The potential entrant has
zero endowment of
permits and thus, it has to buy all permits it needs. We assume
that the potential
entrant is efficient enough to make positive profits when
permits market is compet-
itive, but not as efficient as to rely solely on abatement. Thus, a
permit price exists
above which the entrant is forced to engage in a level of
abatement that renders
entry unprofitable. Under these assumptions, raising rivals’
costs strategies could
lead to entry deterrence, since in most cases Pm > P". As we
will show in what
follows, raising rivals’ costs strategies lead to entry deterrence
only in a limited
number of cases.
In what follows we use simulations to examine: first, the effect
of increased
rivalry on leader’s ability to raise the permits price; second, the
effect of entry
deterrence on welfare; and third, the effect that the form of
initial permits allocation
has on entry deterrence.
First, as the number of firms in the industry increases, their
market share and
thus, their abatement decreases. All firms operate at a lower
point on their abatement
cost schedules. As a result, the leader has to hold more permits
and rely less on

abatement in order to increase the permit price and gain market
share. Columns two
and three of Table IV illustrate these points. The leader’s cost
of raising its rivals’
cost increases the more competitive the product market is. Thus,
the leader chooses
a lower permit price the larger is the number of rivals i.e., Pm >
P�, where the
superscript � denotes equilibrium values under leadership when
three firms share
761
Table IV. Leader’s ability to raise rival’s costs as the number of
firms in the industry
increases
d2 = d3 (d1 = 250) �A
m
1 � �A
�
1 �(NE
d
1 )
m
� �(NEd1 )
� Pm � P�
0 52.53590 �85.91165 59.1051

50 52.04524 �85.10928 53.8903
100 51.55458 �84.30690 48.6755
150 51.06392 �83.50453 43.4607
200 50.57326 �82.70215 38.2459
250 50.08260 �81.89978 33.0311
300 49.59194 �81.09740 27.8163
A
j
1 = �
j
1q
j
1 , j = ", m, �, � is the leader’s level of abatement, and �A
m
1 � �A
�
1 =
(Am1 �A
�
1) � (A
�
1 � A
�
1). Both parentheses are negative and thus, �A
m
1 � �A

�
1 >
0 implies that j�Am1 j > j�A
�
1 j. (NE
d
1 )
j, j = ", m, �, � is the leader’s net demand
for permits at the respective equilibrium and �(NEd1 )
m
� �(NEd1 )
� = [(NEd1 )
m
� (NEd1 )
"] � [(NEd1 )
�
� (NEd1 )
�].
The superscript � denotes equilibrium values under competition
when three firms
share the market and the superscript � equilibrium values under
leadership.
the market. Column three of Table IV shows that this result
holds regardless of
firms’ abatement efficiency. Sartzetakis (1993) shows that as
the product market

tends to competition, the leader’s power in the permits market
vanishes completely.
Second, the welfare effect of deterring entry is positive in most
cases. Table
V presents the simulations when permits are distributed equally
between the two
incumbent firms. Column two presents the profits of the entrant
under competition
��3. Firm 3 is assumed to be as efficient as firm 2, but firm
2’s profits are always
higher than firm 3’s because firm 2 has a positive endowment of
permits. Column
three presents the profits of the entrant in the case of
leadership, ��3 . Entry is
profitable only if the entrant is more efficient in abatement than
the leader, i.e.
�
�
3 > 0 only if d3 < d1. Raising rivals’ costs strategies lead to
entry deterrence
in the cases that the potential entrant is equally or less efficient
in abatement than
the leader. Firm 1’s profits are higher when it acts as a leader,
and the increase in
leader’s profits is larger when leadership deters entry as shown
in column three
of Table V. Entry deterrence results in a decrease in output,
since competition in
the product market decreases. In contrast, industry’s profits
increase, since entry
is blockaded only when the potential entrant is less efficient
than the leader. The
increase in industry’s profits dominate the decrease in consumer
surplus resulting

in higher welfare, as illustrated in column five.13 Furthermore,
entry deterrence
yields an improvement in environmental quality because firms
are engaging in
higher levels of abatement in order to deter entry,14 as
illustrated in the last column
13 This result is more general. Dixit and Stiglitz (1977) and
Spence (1976) have shown that there
are cases in which there is too much entry and facilitating more
does not improve economic welfare.
14 In the case of entry deterrence, the two incumbent firms
make their decisions based on P�; the
equilibrium in this case is denoted with a superscript 2�. Total
emissions are lower than the required
Table V. Effect of entry deterrence on social welfare.
Grandfathering according to pre-
regulation market share: ( �Ei = �q̂ i)
d2 = d3 (d1 = 250) �
�
3 �
�
3 �
�
1 � �
�

1 W
�
� W�
0 129,659.5 112,026.1 12,248.8 �8,001.5
50 106,456.1 87,033.4 13,841.2 �9,041.7
100 84,288.0 62,995.4 15,530.8 �10.145.5
150 63,155.1 39,912.4 17,317.7 �11,312.7
200 43,057.5 17,784.2 19.201.8 �12,543.6
�
2�
1 � �
�
1 W
2�
� W� E2� � �E
250 23,995.2 �3,389.1 183,913.7 46,790.6 �131.746
300 5,968.2 �23.607.6 179,009.1 63,288.2 �174.799
350 �11,023.5 �42.871.2
Where, Wj, j = �, �, 2�, mon is the social welfare at the
respective equilibrium. Social welfare
is defined as the summation of consumer and producer surplus:
Wj = uj(qj1 + q
j
2 ) �
P2
i=1

TC
j
i , where u
j is utility derived from the consumption of good q, and
P
Tc
j
i is aggregate
cost of producing Q. The superscript 2� denotes values of the
variables in the case that entry
of firm 3 is deterred and the two incumbent firms are price
takers at permit price P�.
of Table V. Raising rivals’ cost strategies may blockade the
entry of even equally
efficient firms, but at the same time ameliorate social welfare
and environmental
quality. Policy makers should take into consideration the
welfare effects of raising
rivals’ cost strategies before intervening to facilitate entry.
Finally, since the initial permits distribution affects the leader’s
ability to manip-
ulate the permit price, it also affects its ability to deter entry.
Should policy makers
change the initial permit distribution in order to facilitate entry?
To answer this
question, we compare the case that permits are equally
distributed between the
two firms to the case of auctioning. The latter case, i.e. zero
initial endowment of
permits for all firms, is presented in Table VI. Although

incumbent firms have no
advantage over potential entrants, entry deterrence is still
feasible, but only when
the leader is more efficient in abatement. Auctioning of permits
reduces the leader’s
ability to raise the permit price. Thus, permits allocation is an
efficient instrument
in controlling the leader’s power and facilitating entry.
However, facilitating entry
does not necessarily increase social welfare. This point is
clearly demonstrated
in the case that all three firms are equally efficient in abatement
(bolded row in
Tables V and VI). When �E1 = �E2 = �E=2 entry of firm 3 is
deterred, but social
welfare is larger relatively to the case that permits are
auctioned, �E1 = �E2 = 0
and entry is facilitated. Changing the mode of permits
allocation from grandfather-
ing to auctioning, increases competitiveness in the product
market but decreases
social welfare. Although not shown in our simulations, permits
distributions that
could increase both competitiveness and social welfare exist.
However, the spec-
ceiling �E, because P� > Pm implies that aggregate abatement
is higher than what is required by
the emissions ceiling.
763
Table VI. Effect of entry deterrence on social welfare.

Auctioning of permits: ( �Ei = 0)
d2 = d3 (d1 = 250) �
�
3 , �
�
2 �
�
3 , �
�
2 �
�
1 � �
�
1 W
�
� W�
0 129,659.58 122,331.15 1,834.8 �12,822.1
50 106,456.17 97,647.42 2,480.9 �15,136.7
100 84,288.04 73,918.56 3,224.2 �17,514.7
150 63,155.17 51,144.56 4,064.9 �19,956.4
200 43,057.58 29,325.42 5,002.8 �22,461.5
250 23,995.27 8,461.15 6,037.9 �25,030.3
�
2�
1 � �

�
1 W
mon
� W�
300 5,968.23 �11,448.25 652,130.7 �11,009.1
350 �11,023.54 �30,402.79
Where, Wj, j = �, �, 2�, mon is the social welfare at the
respective equilibrium.
Social welfare is defined as the summation of consumer and
producer surplus: Wj =
uj(q
j
1 + q
j
2 ) �
P2
i=1
TC
j
i , where u
j is utility derived from the consumption of good
q, and
P
TC
j
i is aggregate cost of producing Q. The superscript mon denotes

values
of the variables in the case that entry of the firm 3 is deterred,
firm 2 exits the industry
and firm 1 monopolizes the product market.
ification of such distributions requires a vast amount of
information on the part
of policy makers. Intervention in the case of incomplete
information can be detri-
mental to both competition and welfare. An example is
presented in row seven
(d2 = d3 = 300, d1 = 250) of Table VI. Firm 2 that has zero
endowment of
permits makes negative profits under leadership and exits the
market. The leader
buys all permits at price P�, and monopolizes the product
market. The equilibrium
is denoted by a superscript mon. Both the level of competition
and social welfare
decrease. Thus, informational requirements and the ambiguity
of the welfare effect
render policy intervention problematic.
V. Conclusions
We examine cases in which emission permits markets are used
as vehicles in
lessening competition in the product market. We focus our
attention on moder-
ate cases of predatory behaviour in the form of raising rivals’
cost strategies.
In these cases, the leader in the permits market employs
positioning rather than
exclusionary strategies; i.e does not attempt to exclude existing
rivals. Positioning

strategies though, can lead to entry deterrence under certain
conditions. We find
that although in many instances competition is lessened
substantially, overall effi-
ciency may increase when the market share of the more efficient
firms increase.
However, there are situations that should be examined closely
by policy makers.
For example, the case of a large entrenched inefficient firm that
overbuys permits
calls for policy intervention. According to our analysis this is a
case of an inefficient
leader and can lead to large decreases in social welfare. In such
cases as well as
when consumers’ protection is a policy priority, policy makers
can use the initial
distribution of permits to control power in the permits market.
Such interventions
though can succeed only when policy makers have substantial
information on the
technological structure of the industry, and thus, should be used
with caution. Given
the importance of information, sharing of information and
coordination of actions
between policy makers (environmental and competition policy
agencies, or any
other type of regulators involved) is very important.
Appendix A. Notation of the Model Used in the Simulations
Inverse demand: p = a � b(q1 + q2), where qi, i = 1, 2, is firm

i’s output.
Cost of production: CPi = qi +�q
2
i
, where c, � � 0 are technological parame-
ters and k = k1 = k2.
Emissions generation: ei = �iqi, where � is the rate of emission
per unit of
output, with �1 = �2.
Cost of abatement: CAi = d1�iqi + e�
2
i
q2
i
, where � is the abatement per unit
of output, and d, e � 0 represent technological parameters, with
e1 = e2 = e.
Supply of emission permits: �E = �Q
̂ , where Q = q̂ 1 + q̂ , is
industry’s pre-
regulation level of output, and � 1.
Methods of permits distribution examined: (1) according to
firms’ pre-regulation
level of emissions: �Ei = �qi; (2) equiproportional: �Ei =
�E=2; (3) auctioning:
�Ei = 0; where �Ei is firm i’s endowment of permits.
Appendix B. Initial Values of the Parameters Used in the
Simulations

a = 1,500; b = 0.20; k = 0.07; e = 0.30; � = 0.60; = 0.40; d1 =
d2 = 250;
c1 = c2 = 200; and F1 = F2 = 333:000. We start with the
assumption that both
the leader and the price taker have identical production and
abatement technologies,
in order to demonstrate that leadership in the permits market
translates into raising
rivals’ cost strategies without requiring technological
asymmetries. We then allow
the technological parameters to vary. Technological parameters
and the required
percentage reduction in emissions are chosen such that the cost
of compliance is a
significant part of firms’ total cost.
References
Borenstein, S. (1988) ‘On the Efficiency of Competitive
Markets for Operating Licenses’, Quarterly
Journal of Economics, 103, 357–387.
Brown-Kruse, J., S. R. Elliot, and R. Godby (1995) ‘Strategic
Manipulation of Pollution Permit
Markets: An Experimental Approach’, Paper presented at the
Canadian Economic Association
Meetings, Montreal, Québec, June 1995.
Coate, M. B., and A. N. Kleit (1994) ‘Exclusion, Collusion, or
Confusion?: The Underpinnings of
Raising Rivals’ Costs’, Research in Law and Economics, 16,
73–93.
Dixit, A. K., and J. E. Stiglitz (1977) ‘Monopolistic
Competition and Optimal Product Diversity’,
American Economic Review, 67, 297–308.

765
Fershtman, C., and A. de Zeeuw (1996) ‘Tradeable Emission
Permits in Oligopoly’, Working Paper,
Department of Economics, Tilburg University.
Gaudet, G., and N. V. Long (1993) ‘Vertical Integration,
Foreclosure and Profits in the Presence of
Double Marginalization’, Working Paper, Université du Québec
à Montreal.
Hahn, R. W. (1984) ‘Market Power and Transferable Property
Rights’, Quarterly Journal of Eco-
nomics, 99, 753–765.
Hahn, R. W. (1989) ‘Economic Prescriptions for Environmental
Problems: How the Patient Followed
the Doctor’s Orders’, Journal of Economic Perspectives, 3, 95–
114.
Hanley, N., and I. Moffat (1992) ‘Efficiency and Distributional
Aspects of Market Mechanisms in
the Control of Pollution: An Empirical Analysis’, Working
Paper, Department of Economics,
University of Stirling.
Hart, O., and J. Tirole (1990) ‘Vertical Integration and Market
Foreclosure’, Brookings Papers on
Economic Activity: Microeconomics, 4, 205–286.
Hung, M. N., and E. S. Sartzetakis (1994) ‘Is Tradeable
Emission Permits Systems Superior to

Command and Control?’, Working Paper, GREEN, Université
Laval, Cahier 94-13.
Krattenmaker, T. G., and S. C. Salop (1985) ‘Anticompetitive
Exclusion: Raising Rivals’ Costs to
Achieve Power over Price’, Yale Law Journal, 96, 209–295.
Krattenmaker, T. G., and S. C. Salop (1986) ‘Competition and
Cooperation in the Market to Exclu-
sionary Rights’, American Economic Review, Papers and
Proceedings, 16, 109–113.
Krattenmaker, T. G., and S. C. Salop (1987) ‘Analysing
Anticompetitive Exclusion’, Antitrust Law
Journal, 56, 71–89.
Malueg, D. A. (1990) ‘Welfare Consequences of Emission
Credit Trading Programs’, Journal of
Environmental Economics and Management, 17, 66–77.
Misiolek,W. S., and W. Elder (1987) ‘Exclusionary
Manipulation of Markets for Pollution Rights’,
Journal of Environmental Economics and Management, 16, 156–
166.
Ordover, J. A., G. Saloner, and S. C. Salop (1990) ‘Equilibrium
Vertical Foreclosure’, American
Economic Review, 80, 127–142.
Requate, T. (1993) ‘Pollution Control in a Cournot Duopoly Via
Taxes or Permits’, Journal of
Economics, 58, 255–291.
Salop, S. C., and D. T. Scheffman (1981) ‘Strategic Interaction
in Multiple Markets: A Beginning to
a General Theory of Dominant Firm Industries’, Mimeo.

Presented at the Summer Meetings of
the Econometric Society. San Diego, June 1981.
Salop, S. C., and D. T. Scheffman (1983) ‘Raising Rivals’
Costs’, American Economic Review, 73,
267–271.
Salop, S. C., and D. T. Scheffman (1987) ‘Cost-Raising
Strategies’, Journal of Industrial Economics,
26, 19–34.
Sartzetakis, E. S. (1993) Emission Permit Trading and Market
Structure, Ph.D. Dissertation, Depart-
ment of Economics, Carleton University, Ottawa, Canada.
Sartzetakis, E. S. (1996a) ‘Emissions Permits Trading as
Vehicle for Raising Rivals’ Costs Strategies’,
Working Paper, Fondazione Eni Enrico Mattei, Milano, Italy,
Nota di Lavoro 59.96.
Sartzetakis, E. S. (1996b) ‘Interaction of Competitive Markets
for Tradeable Emission Permits with
Oligopolistic Product Markets’, Environmental and Resource
Economics, forthcoming.
Spence, A. M. (1976) ‘Product Selection, Fixed Costs and
Monopolistic Competition’, Review of
Economic Studies, 43, 217–236.
Tietenberg, T. H. (1985) Emissions Trading: An Exercise in
Performing Pollution Policy. Washington
DC: Resources for the Future, Inc.
Tietenberg, T. H. (1989) Environmental and Resource
Economics, Harper Collins Publishers, Second
Edition.

von de Fehr, N.-H. M. (1993) ‘Tradeable Emission Rights and
Strategic Interaction’, Environmental
and Resource Economics, 3, 129–151.
Ware, R. (1994) ‘Understanding Raising Rivals’ Costs: A
Canadian Perspective’, Canadian Compe-
tition Record, March 1994, pp. 9–17.
Week Four Guidance
Congratulations, we have gotten past the half-way point
of the class. I have enjoyed reading your posts and written
assignments. Just a note on the use of old papers from past
classes: Partial recycling of papers is allowed in this course
however, all submissions in this course must demonstrate
substantial new learning related to the course concepts and
learning objectives. Under no circumstances are you allowed to
submit an exact copy of a prior paper in an attempt to satisfy an
assignment in this course.
Also just a reminder, to receive full credit for your
initial discussion posts you must include at least two citations
(Author, Year, pg. #) as support to your ideas and answers.
Also your initial postings should be at least 200 words and have
a scholarly voice or tone. On to our week four topics emission
charges, fuel economy and economic incentives.
You will be reading chapters fourteen, fifteen,
seventeen and eighteen. Your first discussion question involves
emission charges and this topic will also be part of your weekly
written assignment. You will compare how Europe is leaning
towards emission charges versus the method of emission permits
in the United States. Also decide if the United States should
move towards emission charges similar to Europe. Tietenberg

and Lewis (2012) state, “One approach, the choice of several
countries including the United States, is to select specific legal
levels of pollution based on some other criterion, such as
providing adequate margins of safety for human or ecological
health” (p. 368). The authors go further and explain what an
emission charge is, “An emissions charge is a fee, collected by
the government, levied on each unit of pollutant emitted into the
air or water” (p. 371). The thought here is that companies
would limit pollution due to the increased costs due to the
emissions charge. The authors then go into emissions trading
which will be the topic of your written assignment.
The second discussion question is on fuel economy and
the government’s role in it. Should the government increase
fuel taxes or should the government have the manufacturers
increase fuel efficiency standards? Remember that fuel taxes
would increase costs to the consumer but increasing fuel
efficiency standards for the manufacturer could also increase
costs to the consumers as the companies could pass these
increased fuel efficiency costs to the consumers by increasing
prices of these cars. Tietenberg and Lewis (2012) review CAFÉ
standards and fuel taxes in the Debate 17.1 section and review
the CAFÉ standards in chapter seventeen. The authors state,
“Manufacturers have paid more than $590 million in CAFÉ
fines since 1983” (p. 450). Make sure to review these topics in
chapter seventeen when preparing your responses.
Your assignment is based on emissions trading or cap
and trade as Tietenberg and Lewis (2012) describe as, “Under
this system, all sources face a limit on their emissions and they
are allocated (or sold) allowances to emit” (p. 373). Basically
there is a “cap” set and allowances are traded as the authors
state, “Firms emitting more than their holdings would buy
additional allowances from firms who are emitting less than
authorized” (p. 373). So a firm would make money being under
the cap established by selling their extra allowances, giving

firms incentive to be under the cap. But does creating a market
seem ethical to help the environment? That is the main topic of
your assignment. One ethical theory is Utilitarianism. This
view of ethics is described by Beauchamp and Bowie (2004) as,
“An action or practice is right if it leads to the best possible
balance of good consequences over bad consequences for all the
parties affected” (p. 17). Another theory is Kantian theory, that
address how people need to respect one another to be ethical as
Beauchamp and Bowie (2004) explain, “In Kantian theories
respect for the human being is said to be necessary-not just as
an option or at one’s discretion” (p. 23). Keep these ethical
theories in mind while preparing your written assignment. Also
make sure to review chapter fourteen to help with the
assignment. Here is a link to an interesting article on this
topic: http://www.studentpulse.com/articles/656/3/the-
challenges-of-climate-change-policy-explaining-the-failure-of-
cap-and-trade-in-the-united-states-with-a-multiple-streams-
framework , and also attached is another article related to
emissions trading and below a video on carbon credits.
Remember it is highly suggested that you use the parts of the
question (a, b, c) as headings in your paper to enhance the focus
and organization of your paper.
Your initial postings are due on Thursday 4/23, and to
respond to your fellow student’s initial postings during the
week. Your assignment is due on Monday 4/27. Please send me
specific questions on the assignments if you have any issues
completing them. Keep up the good work!
References
Beauchamp, T.L., & Bowie, N.E. (2004). Ethical theory and
business. (7th Ed.). Upper Saddle River, NJ: Prentice Hall.
Tietenberg, T., & Lewis, L. (2012). Environmental and natural

resource economics (9th ed.). Upper Saddle River, NJ: Pearson
Addison-Wesley. ISBN: 9780131392595
Week 4 Assignment - Economic Incentives
In the book, What Price Incentives?, the author, Steven Kelman,
suggests that the use of economic incentives (such as emission
charges or emissions trading) in environmental policy is
undesirable. He argues that transforming our mental image of
the environment from a sanctified preserve to a marketable
commodity has detrimental effects not only on our use of the
environment, but also on our attitude toward it. He believes that
applying economic incentives to environmental policy weakens
and cheapens our traditional values toward the environment.
Prepare a three-page paper (not including the title and reference
pages) on the following:
· Evaluate whether economic incentive systems are more or less
ethically justifiable than the traditional regulatory approach.
Consider the effects of economic incentive systems on prices
paid by the poor, on employment, and on the speed of
compliance with pollution control laws as well as the author’s
thesis.
· Kelman believes that emission allowances automatically
prevent environmental degradation since they are more ethically
desirable than emission charges. Compare and contrast the
advantages and disadvantages associated with the two systems:
emission allowances and emission charges. Discuss whether you
are in alignment or not with the author (Kelman). Defend your
position.
· If we were to allow the private market to bring about an
efficient outcome that society would deem desirable, could the
true market benefit and cost be effectively reflected? Explain
why and use an example to illustrate your response.
Format your paper according to APA style guidelines and use at
least three scholarly sources in addition to the textbook.

Review of Industrial Organization 12 751–765, 1997.c 1997 .docx

Review of Industrial Organization 12 751–765, 1997.c 1997 .docx

Recommended

Recommended

More Related Content

Similar to Review of Industrial Organization 12 751–765, 1997.c 1997 .docx

Similar to Review of Industrial Organization 12 751–765, 1997.c 1997 .docx (20)

More from healdkathaleen

More from healdkathaleen (20)

Recently uploaded

Recently uploaded (20)

Review of Industrial Organization 12 751–765, 1997.c 1997 .docx