Those who believe the United States should be a leader in development of environmental technology advocate industrial policies to improve the performance of U.S. industry. These policies include the subsidization of research and development in the area of environmental technologies and, paradoxically, the strengthening of domestic environmental regulations. Researchers at Resources for the Future recently examined three potential justifications for using such subsidization or tough environmental regulations as ways to enhance the international competitiveness of domestic firms. They find each to be based on unlikely assumptions and inconclusive anecdotal evidence. Subsidization of research on environmental technologies might be more effective in conferring an advantage on domestic firms vis-a-vis foreign rivals than the use of environmental regulation as an industrial policy tool, but both options may represent an unreasonable "something-for-nothing" view of environmental policy alternatives.
A number of political figures have recently argued that the United States needs to encourage the development of environmental technologies more actively. These individuals have noted with concern the fact that the United States invests a smaller proportion of research and development (R&D) funds in environmental technologies than do Japan, Germany, and some other major industrial countries. They have also cited a number of instances in which countries with strict environmental regulation have taken the lead in industries affected by the regulation. For those who believe the United States must become a leader in the development of environmental technologies if it is to enhance the international competitiveness of U.S. industry, the announcement by The Ministry for International Trade and Industry (MITI) in Japan of plans to launch a long-term program to develop so-called green technologies is perceived as a challenge.
This challenge is being answered in attempts to advance such technologies as an element of U.S. industrial policy. For example, Senator Barbara Mikulski (Maryland) has proposed the establishment of a National Environmental Technologies Agency; Vice President Gore has advocated a Strategic Environment Initiative; congressional committees have held hearings on other environmental initiatives in recent months; and the Clinton administration has argued for collaborative research on low-emission vehicles.
Calls for public assistance in the development of environmental technologies are occurring simultaneously with the growth in popularity of a new perspective in the debate on environmental regulation and competitiveness. Subscribers to this new perspective, which we label the revisionist view, make the paradoxical claim that strict environmental regulation may actually enhance industrial competitiveness.
This claim is contrary to conventional economic wisdom, which suggests that such regulation compromises industrial competitiveness. If the United States adopts environmental standards stricter than those of its foreign industrial rivals, U.S. firms would experience increasing costs, declining production, reduced employment, and decreased profits. Thus the United States may end up importing products it now makes domestically and "exporting" jobs, profits, and environmental degradation to countries with laxer environmental standards.
In contrast, the revisionist view suggests that, rather than placing the United States at a disadvantage relative to its industrial rivals in Europe and in Asia, the tightening of U.S. environmental standards will stimulate U.S. growth. According to one of the most noted proponents of the revisionist view, Dr. Michael Porter of the Harvard Business School, there is no real conflict between environmental protection and economic competitiveness. In "America's Green Strategy" (Scientific American, April 1991), Porter suggested that, rather than stifling productivity, environmental protection enhances competitiveness in the long run. Tough environmental standards will lead firms to make better products by less costly methods. U.S. firms will become world leaders in their industries, and they will be in a position to export or license their newfound technologies abroad.
Is there any validity to the arguments put forth by Porter and other proponents of the use of environmental policy to achieve industrial policy objectives? To find out, we recently analyzed the assumptions underlying and anecdotal evidence offered in support of three potential justifications for using environmental policies, such as the subsidization of R&D in the area of environmental technology and the promulgation of tough environmental regulations, as industrial policy tools. The first justification is that U.S. firms are inefficient and fail to recognize and pursue profitable opportunities to innovate in the area of environmental technology. The second is that firms find it difficult to prevent other firms from appropriating their innovations in environmental technology. This difficulty limits firms' incentives to engage in research on environmental technologies. The third is that the international performance of U.S. firms can be improved through the strategic setting of domestic environmental policy goals.
Inefficient production practices and short-sighted firms
It is sometimes suggested that firms are unable to recognize profitable innovation opportunities without a prod from the government. The failure of U.S. firms to develop new environmental technologies is seen as a failure on their part to anticipate future demand for these technologies, even in light of the expected tightening of environmental standards worldwide. Assuming that U.S. firms cannot identify profitable new technologies, is it likely that government regulators or legislators can consistently identify them? Probably not. If a lack of information prevents firms from identifying profitable investment opportunities, it seems likely that government agencies would face more, rather than fewer, difficulties in identifying them. Government intervention or regulation has sometimes led to firms' superior performance in the marketplace, but whether such intervention generally results in enhanced competitiveness is hotly disputed.
It is, of course, indisputable that private companies have blown many a sterling investment opportunity. One must ask, however, if such oversights are systematic failings or simply unfortunate occurrences. What might appear to have been foolish behavior on the part of a firm that did not make a certain investment may in fact have been perfectly rational given expectations about the prospects of gain. Analyzing a wide range of possible new ways to reduce costs or improve product quality is costly. Profit-maximizing firms will continue to search for ways to reduce costs or improve product quality until the expected cost of doing so exceeds the expected gains.
It may well be that a new environmental regulation, or a subsidy for research on environmentally friendly technologies, leads to the discovery of unanticipated benefits. There are numerous instances in which this has been the case. However, it would be incorrect to infer that this implies a deficiency in private firms' research strategies. Before reaching this conclusion, one would want to know not only how many successes result from pursuing research, but also whether the successes are balanced by failures of environmental regulation or subsidization of research to bring about new production processes or products.
Policies designed to promote development of environmental technologies must discount the future benefits of that development according to society's willingness to forgo resources that could be used today for other purposes.
We must also note that being a leader in the development of green technologies is not necessarily an end in itself. A firm may be profitable once it becomes a leader, but acquiring the position is expensive. The costs of developing new technologies are often incurred well in advance of the benefits. Moreover, the benefits are often speculative and uncertain. Firms will discount expected future benefits when deciding whether or not a particular R&D project is worth pursuing. U.S. firms that sell technologies to foreign firms or that abandon a particular R&D project in environmental technology may be behaving rationally if the current costs of bringing these technologies to market outweigh the present discounted value of expected future profits. Any policy designed to promote development of environmental technologies must discount future benefits according to society's willingness to part with resources that could be used for other purposes today.
Numerous anecdotes suggest that the United States may be losing its position of leadership in the development of certain environmental technologies. Citing examples of the yielding of technology leadership by U.S. firms to foreign firms, advocates of a strong U.S. environmental technologies policy propose that the United States needs a national policy to reestablish U.S. industry as an environmental leader. This proposal is not soundly motivated. It would be unwise and, in fact, impossible to lead in all technologies and in all phases of the development of technologies. At times a country may find it is wiser to cede some projects to other countries better able to develop them and instead concentrate on those projects in which it enjoys an advantage.
On occasion, it may be perfectly reasonable, logical, and efficient to pass up opportunities for developing environmental technologies. However, there may be situations in which the reticence of firms to develop technologies arises more from laziness than from deliberation. Firms and their managers may be unable or unwilling to minimize production costs.
Deviations from cost-minimizing behavior are more likely to occur if there is little competition in the market for a firm's product than if there is great competition. The firm's managers may then be able to trade efforts aimed at reducing product costs for a less strenuous work schedule for their employees and themselves without fear of losing market share to a competitor that offers a similar product at a lower price. This may lead the firm to overlook R&D opportunities that could result in long-run cost reductions. If it were the case that U.S. firms are so effectively insulated against more efficient foreign competitors as to ignore cost-reducing opportunities with impunity, then U.S. firms would not require an industrial policy aimed at improving the performance of U.S. firms in order to save them from foreign competition.
Even if the objective is to improve the performance of U.S. firms—without regard to their stance relative to foreign competitors—failure to minimize production costs would be sustainable only if there were also information barriers or other imperfections in capital markets that prevent efficient managers from identifying the existing inefficiency and taking over the firm. The potential for the takeover market to discipline production costs may be limited when organizations are large and production processes are complex, and thus the process of identifying existing inefficiencies in operations is complicated. Of course, if organizations are large and production processes complex, it may be difficult for outsiders—such as government officials—to determine if there is, in fact, substantial inefficiency. Without concrete evidence of inefficiency, tightening environmental regulations in the hope of inducing increased efficiency would be unwise.
Difficulty of preventing appropriation of research and development
Another justification for environmental policies designed to promote research and development of environmental technologies is that, without such policies, firms may have little incentive to innovate when the benefits of a firm's R&D efforts are enjoyed by other firms. In many cases newly developed products may be "reverse-engineered" in order to uncover and replicate the process used to manufacture them. Preventing others from copying an innovation can be extremely difficult when the costs of replicating the innovation are very low. Patenting an invention or a new production process is one means of protecting an innovation from duplication, but the costs of obtaining a patent, the often narrowly defined limits of patent coverage, and the amount of information conveyed in a patent document all pose limits on the degree of protection a patent can provide.
Since 1984, the Idaho National Engineering Center has been conducting tests of electric-powered cars for the U.S. Department of Energy's electric vehicle dynamometer and road-testing program. In one attempt to advance so-called green technologies, the Clinton administration has argued that government and private industry should collaborate on research on low-emission vehicles such as electric-powered cars
A firm may accomplish too little research and development when the firm finds it difficult or impossible to prevent other firms from reaping the benefits of the innovations resulting from its R&D efforts. The government may need to subsidize R&D efforts in order to obtain the socially efficient level of investment in such efforts. This appropriation problem may provide some justification for a government-sponsored technologies initiative.
Whether any policy to promote the development of green technology can be effective in promoting U.S. industry is open to question, however. If firms engaging in research and development cannot fully appropriate the benefits of doing so, there may be little advantage conferred on U.S. companies by any such policy. A U.S. policy of promoting research and development would only promote domestic industry relative to foreign industry if the spillovers from research and development are dramatically reduced at the U.S. border. In this age of multinational firms and increasingly international markets, it seems very unlikely that this would be the case.
Environmental policy as strategic trade policy
In the preceding discussion we have implicitly assumed that international markets are perfectly competitive, and thus free trade is the optimal government policy. Given this assumption, steps taken by government to increase the profits of domestic firms always backfire. Even if policy interventions increase the profits of the firms affected by the interventions, the benefits would be more than offset by losses elsewhere in the economy. While business advocates and policymakers often argue that government should establish what we would call today a strategic trade policy, economists have traditionally believed that nonintervention is the best policy.
This view has been challenged by the economists who have developed strategic trade theory. These economists challenge the questionable assumption that firms competing against foreign rivals do not attempt to affect their opponents' behavior. Given that the markets for many products are dominated by a few large firms competing head-to-head, this assumption is probably not realistic in many circumstances. Large firms can and do attempt to appease or intimidate each other by their choices of marketing, innovation, and export strategies.
Those who advocate strategic trade policy believe that profits may be shifted among international rivals. Aggressive marketing, innovation, and export strategies on the part of a nation's firms—or a nation's government—may create a competitive advantage relative to another nation's firms. Actions that lead to profit-shifting might be particularly important in understanding how environmental policy affects industrial performance. A U.S. firm might increase its profits at the expense of a Japanese or German rival, for example, by increasing its output. The foreign rival would respond by cutting its own output. Consequently, the U.S. firm would command a larger share of the market and earn higher profits.
One possible strategic trade policy scenario (described in greater detail below) that links environmental policy changes and increased profits for U.S. firms can be summarized like this: tougher environmental policies may induce innovation; innovation may reduce costs; reduced costs may result in increased output; increased domestic output may displace the output of foreign competitors; and the result may be increased domestic profits.
The developers of strategic trade theory recognize that domestic firms will increase their production if their costs decline. Costs might be made to fall through a number of means. A direct means is government subsidization of production, which decreases a firm's cost of production by the amount of the subsidy. An indirect means is government subsidization of investment in research and development, which leads to the creation of better products or to the ability to make a product at lower cost. Subsidization of either production or research and development expenditures might result in greater domestic production, sales, and profits.
It is suggested that tightened environmental regulation will secure competitive advantage by spurring innovation: if firms undertook innovations resulting in production processes that are cleaner and less expensive than the processes they replace, they would gain a cost advantage relative to their competitors.
Strategic trade theorists might make a somewhat more complicated argument in favor of toughening environmental regulation in order to secure industrial advantage. Investment in cost-reducing innovations is a substitute for expenditure on inputs into production. By developing an efficient steel furnace, for example, a steel company might be able to decrease its input of and thus its expenditure on coal. Environmental regulations that penalize the release of pollutants would make the use of coal more expensive. This would, in turn, spur innovation. More generally, if firms undertook innovations that resulted in production processes that are not only cleaner but also less expensive than the production processes they replace, they would gain a cost advantage relative to their competitors.
After carefully considering this argument for a country to toughen its environmental regulation in order to secure a competitive advantage for its industrial firms, we have come to mixed conclusions. While the scenario outlined above is theoretically possible, it is unlikely for several reasons. First, the entire argument rests on the presumption that innovations resulting in "clean" production processes also result in decreased production costs. This presumption should be carefully tested before it is made the basis of national environmental policy. Evidence concerning the effects of innovations in environmental technology on production costs consists more of anecdotes than of careful statistical analysis, and is inconclusive. Second, a policy that induces innovations in the long run necessarily raises costs in the short run. If output is to increase, the cost savings from innovations must more than offset the short-run costs of tightened environmental regulations. Third, the argument hinges on subtle assumptions, one of which is that firms compete with each other by choosing levels of production and then taking whatever price the market will bear for their products. The results arising from this assumption would not arise if, instead, firms compete by setting prices and producing whatever quantity of output consumers are willing to buy at the set prices.
Finally, and perhaps most important, the argument begs an important question: why should the government, by enacting stringent environmental policies, have to induce domestic firms to undertake innovation that would be in their own interest anyway? The answer to this question hinges on another subtle distinction—one that involves timing and credibility. In the strategic trade scenario we have sketched, both domestic and foreign firms would want to invest in more innovation to reduce production costs if they believed that by doing so their rivals would invest less in innovation. The reasoning here is that advantage lies not so much in having "good" technology, as in having "better" technology than one's rivals. To be induced to develop better technology than its foreign rivals, a domestic firm would have to be confronted with an environmental policy that compels it to increase investment in innovation. Absent this inducement, a domestic firm might be unable to convince its foreign rivals that it would in fact be investing in cost-reducing innovations. If the rivals are unconvinced, they would not scale back their sales plans; and if they do not scale back their sales plans, there would be no incentive for the domestic firm to invest in innovation.
The objective of conferring an advantage on domestic firms vis-a-vis foreign rivals could be accomplished with a less convoluted scheme, however. As noted above, government subsidization of production or of research and development expenditures might achieve this objective. Tough environmental regulation might not, given that it calls for a trade-off between lower long-run costs due to innovation and higher short-run costs due to strict environmental standards. It is not clear whether the lower long-run costs or the higher short-run costs would dominate.
Compared with more direct alternatives for enhancing the international competitiveness of domestic firms, environmental regulation as a strategic industrial policy has perhaps only one advantage—namely, that it would be difficult for its intended beneficiaries to manipulate. Industrial policies are only in the national interest if the gains—in this context, the increased wages and profits in industries receiving subsidies—more than balance the cost to taxpayers of providing the subsidies. Industry might solicit subsidies for production or for research on and development of innovations even under circumstances in which such subsidies would not be justified. In comparison, the circumstances under which it would seek tough environmental regulation might be more limited. If in seeking to increase its competitiveness abroad U.S. industry called for the government to enact tough environmental regulation, the argument for such regulation would merit at least a serious hearing. However, the fact that industry does not often make such a request should cast serious doubt on the validity of the claim that strict environmental regulation confers an advantage on the firms subject to the regulation.
Something for nothing?
It is important to point out that the question being debated is not whether there should be policies for environmental protection, but rather what policies are most appropriate. Environmental regulations yield important benefits, such as improved air and water quality, that are valued by society. The issue we focus on is the trade-off between increased pollution reduction on one hand and increased industrial production and economic growth on the other hand. The conventional economic wisdom suggests that there are indeed trade-offs to be made. Strengthening environmental regulation compromises production, jobs, and growth; subsidizing investment in environmental technologies imposes costs on taxpayers.
Some would argue that this is not the case. They would suggest that subsidies will provide net benefits above and beyond the environmental improvements they afford by making the United States the global leader in environmental technologies. Some also suggest that, by tightening its environmental standards, a country improves both the quality of its environment and its long-run industrial performance and does so without any sacrifice. This something-for-nothing environmentalism has to be questioned. Its plausibility is widely debated. While the subsidization of environmental technologies is attractive to the intended recipients of subsidies, it elicits considerable skepticism among less interested parties.
The revisionist view that U.S. firms would actually benefit from tightened environmental regulation is even more dubious than the case for environmental technologies subsidies. Such regulation has not garnered the support of the industries that would supposedly benefit from it. Advocates of the revisionist view imply that a sizable segment of American industry is incapable of figuring out what is in its own best interest. If this is not the case, and we assume it is not, ignoring the sentiments of American industry and designing environmental policies to achieve industrial policy goals would be dangerous.
There is another disturbing aspect of the revisionist view. It concerns the view's implications for international cooperation. If a country realizes a competitive advantage by quickly adopting environmental standards stricter than those of its industrial rivals, does the opposite conclusion—that a country would benefit if its industrial rivals slowly adopted tough standards—follow? Discussion of the merits of international harmonization of environmental standards raise a complex set of issues. Suffice it to say that this implication is not likely to be attractive to many environmental advocates.
Good environmental policies will confer net benefits, but even a good policy will create winners and losers relative to the status quo. Even if—especially if—society benefits from strict environmental policies, more meaningful progress toward the realization of improved environmental quality would be made by concentrating on how to share fairly the burden of cleaning up pollution than by making dubious assertions that solutions will be painless.
Karen L. Palmer is a fellow in the Quality of the Environment Division at Resources for the Future. R. David Simpson is a fellow in the Energy and Natural Resources Division at RFF.
A version of this article appeared in print in the June 1993 issue of Resources magazine.
A version of this article appeared in print in the June 1993 issue of Resources magazine.
