Thus far in Part II of the book we have not explicitly considered output markets in our analysis of environmental policy. This simplification has allowed us to derive several useful results based only on firms’ abatement cost functions and the social damage function. In general, however, firms have both production costs and abatement costs, and except for “end of the pipe” type abatement technologies, these costs cannot always be separated. Moreover, for some pollutants, such as carbon dioxide emissions from fossil fuels, the only abatement possibility may be to reduce output. To analyze these types of cases, we need a richer model that explicitly accounts for the output market. In this chapter we focus on competitive output markets, and examine whether the results derived so far hold only for the separable case, or if they are indeed general.

In addition to accounting for a larger range of technologies, there are several policy motivations for considering output markets. Political debates on environmental policy often focus on distributional considerations, such as how a policy will impact output prices. Will polluting firms simply pass on higher prices to consumers? To consider this explicitly, attention needs to be given to firms’ output cost structure and consumers’ demand. Debate also focuses on the impact that policies may have on firms’ survival, scale of operation, and employment levels. For these types of questions it is necessary to consider the long-run entry and exit behavior of firms in response to the various policy options. Since entry and exit decisions in competitive markets are driven by zero profit conditions, we need to explicitly consider profit maximization, and therefore output markets.

Furthermore, we have modeled environmental standards in a stylized way, as emission caps for firms. In reality, command and control policies often work quite differently. They may fix emissions per unit of output, or limit quantities of a particular pollutant relative to the total amount of effluent released. These kinds of relative or performance standards are historically used to regulate vehicle emissions and wastewater disposal. A contemporary example is the European Union's target of producing 20 percent of its energy from renewable sources. To model relative standards and to study their performance, we again need to explicitly account for output levels.