Regulation Theory and Analysis: Firm Impacts and Decision-Making

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What are the effects of environmental regulation on companies and how do firms respond?  When governments enact increasingly stringent regulation on the private sector, a variety of theories abound regarding the impact.  1) A race to the bottom.  Environmental regulation, with its attendant costs of implementation and compliance, adds costs to firms that used to be able to externalize the costs of pollution and environmental degradation.  For example, a factory that formerly dumped its industrial waste into a body of water would be required to spend money to ensure proper disposal, or face penalties and potential lawsuits.  In the automobile industry, the added costs of compliance with stricter emissions standards may lead to lower profits.  Firms, in an attempt to maximize profit, will move to the region with the least restrictive environmental regulation.  This applies on an interstate level, when different states in the US have varying levels of environmental regulation.  The race to the bottom also applies on an international level, as companies seek to leave the more regulated developed countries for underdeveloped nations that lack the political will or that are willing to sacrifice the environment in order to develop. 

2) More optimistically, firms may not always lose money as a result of environmental regulation.  This would avoid the “race to the bottom” phenomenon, as firms would have no financial incentive to move their operations.  By internalizing the cost of pollution, firms simply pass along the cost to consumers, who then pay the “true” cost of their purchases.