DERIVING AN OPTIMAL ENVIRONMENTAL CERTIFICATION STANDARD WITH A SPATIAL PRODUCT DIFFERENTIATION MODEL

Transcription

1 DERIVING AN OPTIMAL ENVIRONMENTAL CERTIFICATION STANDARD WITH A SPATIAL PRODUCT DIFFERENTIATION MODEL Abstract Christopher D. Clark 1 June, 2002 Attempting to take advantage of recent displays of preferences for goods with superior levels of environmental performance, many governments and independent organizations have implemented a variety of programs designed to disseminate information on the environmental performance of companies or products. The most popular type of program is known as an eco-labeling or environmental certification program. Under this type of program, products meeting a specified level of environmental quality or performance are awarded a certification signifying this achievement. This paper presents an analysis of these programs, using a spatial product differentiation model to optimize the choice of the level of environmental performance necessary to acquire the certification. The social welfare effects of an optimized certification program are reviewed and compared to those of more traditional forms of environmental regulation. JEL Classification: D62, D82, L15, Q00 Key words: Eco-labeling, environmental quality, product differentiation, information 1 Department of Agricultural Economics, University of Tennessee, 321D Morgan Hall, 2621 Morgan Circle, Knoxville, Tennessee USA. cdclark@utk.edu. The author would like to thank Clifford S. Russell and Thomas Büe Bjørner for their comments on an earlier version of this paper. 1

2 I. Introduction Numerous governments, regulatory bodies and independent organizations have recently implemented a variety of programs designed to disseminate information about the environmental attributes of companies or products. These programs run the gamut from highly-technical, plant-level data about toxic releases to simplistic labels meant to symbolize a particular company s or product s environmental worthiness. Some of the programs disseminate information about companies, but most focus on individual products. Possible targets of the information include consumers, investors, voters, neighbors, and local public health and safety officials. The nature of the information ranges from raw, technical data, to information that has been distilled into some form of label, grade or certification. 2 The most popular of these programs are those that disseminate distilled information about individual products to consumers. These programs, which are generally called eco-labeling or environmental certification programs, are the focus of this paper. 3 Environmental certification programs generally operate along the following lines: (i) product categories are chosen and defined, (ii) environmental standards or criteria for each product category are adopted (the standards are typically based upon an evaluation of the product s impact on the environment using some form of life-cycle analysis), (iii) firms are allowed to submit their products for examination, (iv) if the products meet the established standard or criteria, the product is awarded the certification and (v) companies awarded the certification are then allowed to use it in promoting their products. Programs providing information on the environmental attributes of goods have the ability to lessen the environmental damage associated with a polluting good in two different ways. First, to the extent that consumers have preferences for environmentally superior goods, the information provided by the program will allow consumers to alter their consumption in accordance with these preferences, thereby altering the mix of products consumed. Kennedy, Laplante and Maxwell (1994) model this process by allowing consumers to allocate their consumption between a clean and a dirty good, taking into consideration the effect of their consumption of the polluting good on the ambient environment. Thus, consumer preferences for a greener good depend upon the extent to which their consumption of the polluting good degrades the ambient environment. The authors utilize this model to illustrate the market failures that arise not only because consumers fail to internalize the effect of their consumption on others, 2 See EPA (1993) for a more detailed overview of environmental information provision programs. 3 Prominent examples of environmental certification programs include the European Union s Ecolabel, Germany s Blue Angel, and the Nordic Council s White Swan. 2

3 but also because they fail to internalize the effect of their acquisition of information on the effect of this consumption on others. Information provision programs can also engender a reduction in the environmental damage associated with the production of a good by encouraging firms to improve the environmental quality of their products, thus altering the mix of products offered for consumption. 4 This second mechanism presents a problem for traditional approaches to green consumption, such as the approach taken by Kennedy, Laplante and Maxwell, because these approaches treat a product s characteristics as inviolate and thus, they cannot directly address the consequences of changes in these attributes. Additionally, these traditional approaches link a consumer s preferences for an environmentally-superior good to the effect of the consumer s decision on the ambient environment, even though this effect is likely infinitesimal. Cremer and Thisse (1999) avoid these concerns by utilizing a spatial product differentiation model and assuming that consumers have a preference for environmentally-friendly products. By assuming that consumers have a preference for environmental quality, the authors are able to avoid linking changes in a single individual s consumption to changes in the ambient environment: If a consumer buys an environmentally-friendly product he produces a positive externality and helps preserving the environment. However, any individual consumer is likely to realize that his own impact on the environment is negligible. When he makes his own consumption decision, the overall state of the environment is in essence exogenously given. It is aggregate, rather than individual, behavior which affects the environment and the individual consumer has no leverage on what others will do. A possible explanation for the observed consumption pattern is that individuals consider environment-friendliness as a particular quality attribute of the products they buy. In other words, consuming a variant with a high environmental quality is very much like any other quality attribute. There certainly is an externality involved, but what matters from an individual consumer s perspective is the environmental quality of the product he personally buys. Cremer and Thisse (1999), p There are a number of different reasons why a firm might choose to improve its environmental performance as a result of the provision of information on this performance including, but not limited to, the possibility that consumers will engage in green consumption. For an overview of these other reasons, see Tietenberg (1998) and Clark (2001). 3

4 A somewhat similar approach is utilized by Arora and Gangopadhyay (1995), who motivate green consumption by assuming that the level of cleaning technology employed by the manufacturer of a product is an element in the consumer s utility function and that consumers have identical preferences over this element, but differ in their marginal utility of money because of differences in income. As a result, the consumption of environmentally-superior products in their model is determined by consumer wealth. 5 This paper follows Cremer and Thisse (1999) and Arora and Gangopadhyay (1995), in assuming that consumers have preferences over a product s environmental characteristics, but differs in the specification of these preferences. In those papers, consumers have preferences over absolute measures of environmental performance. In this paper, consumers are deemed to have preferences over relative measures of environmental performance. Relative measures are used to capture the notion that placing an environmental certification on a variety of a product may actually generate disutility for those who consume a different variety, which is relevant to any attempts to evaluate the effect of introducing an information-provision program or comparing the effects of one of these programs to other forms of environmental regulation. Another way in which this paper differs from earlier papers, is that it explicitly focuses on the most popular type of environmental information provision program - the environmental certification program ( ECP ). Information provision programs that allow firms to choose a level of environmental performance and then simply require the disclosure of this level to consumers, could be termed continuous information provision programs. However, this paper focuses on discrete programs, i.e., those that prescribe a level of environmental performance that must be met in order to acquire an environmental certification, and then allow the products that meet this standard to advertise this achievement in the marketing of their products. The implications of this type of program and the model used to analyze it are presented in the following section. After that, the level of environmental performance necessary to be awarded the certification is optimized over several different objective functions. Then, the effects of introducing an optimized ECP are examined. Finally, these effects are compared against a uniform emissions standard and a corrective tax. II. The Model The model used here assumes a duopoly in which the two rival firms - each 5 Kirchoff (2000) also uses a product differentiation model to analyze the incorporation of environmental information into consumption decisions. However, her focus is on the use of information provision as a monitoring device for firm assertions about the environmental quality of its product, which she treats as a credence good, or a good for which quality is unobservable to consumers even after purchase. 4

5 producing a single variety of a good that is differentiated by its environmental quality - play a two stage non-cooperative game. In the first stage, the firms choose a level of environmental quality or performance z i, such that the greater the value of z i the lower the environmental damage, E, for a given level of production, i.e.,, but the higher the firm s costs. The value of z i is normalized over the range [0, 1]. It is assumed that consumers and rival firms are unable to observe this value absent some form of information provision program. In the second stage, each firm sets prices. If an information program has been introduced, then firms set prices with the benefit of observing whether or not their rival has acquired the certification. The process for finding a perfect equilibrium is to first find a pure strategy price equilibrium for every possible pair of products and then find a Nash equilibrium in product locations, given this price equilibrium. 6 In the absence of an environmental information provision program, the problem is one of an asymmetry of information between firms and consumers, in which firms know the levels of the environmental attributes of their products, but consumers do not. Although clean firms could acquire and release the information on their own, it is assumed that consumers would disregard this information absent the objectivity of a third party to verify the firms claims. Thus, absent a program, consumers behave as if they have lexicographic preferences, basing consumption decisions solely on the values of observable attributes. Firms, in turn, minimize the costs associated with environmental quality by designing their products with the lowest possible environmental quality. On the other hand, in the presence of an information program, the agency is assumed to be able to determine whether or not a firm meets the standard set by the agency for awarding the certification and to accurately communicate both this level and which products meet this level to consumers. Since improved environmental performance is costly and, by assumption, firms cannot inform consumers of the environmental performance of their product independent of the program, firms improve environmental performance only in the event they are able to acquire the certification and, then, only to the extent necessary to do so. Consumers understand these incentives and expect firms to behave accordingly. For simplicity, all consumers are assumed to be identical, except in terms of the importance of the product s environmental performance to their evaluation of the product. Following Tirole (1988), consumers are assumed to have perfectly inelastic demand, purchasing one and only one unit of the good. 7 Assuming strong separability 6 The model is derived largely from the vertical differentiation model delineated by Tirole (1998). 7 This assumption seems reasonable given that the provision of information on environmental performance seems more likely to effect the choice between 5

6 and constant marginal utility equal to one for both money and environmental damage, the utility function for consumer i, consuming the variety of the good produced by firm j, may be represented as follows: (1) where A is a constant representing the utility from consuming the non-environmental attributes of the good, i represents a measure of the importance of the product s environmental performance to consumer i, z j and z k represent the environmental performance of the goods produced by firms j and k, Y i represents consumer i s income, and P j represents the price of firm j s good. i is assumed to be uniformly distributed over the interval [0, 1]. The degree of ambient environmental damage is a function of the demand for the different varieties of the subject good, D k, and the environmental quality of these varieties: E = ƒ[z 1, D 1, z 2, D 2 ] (2) The environmental damage function is assumed to be as follows: (3) Given constant demand for the products, this functional form was chosen, in part, because it generates a convex, negative relationship between z i and environmental damage, or. The first step in solving the game played by the firms, is to find a price equilibrium for every pair of products. To do so, the market shares of both goods must be determined. These shares are defined by a marginal consumer,, who is indifferent between consuming good 1 or good 2, and who can be found by setting and solving for. The result is: (4) competing varieties of a product than the decision on whether or how much of a product to purchase. 6

7 Assuming that z 2 > z 1, the demand for good 1 will be comprised of all consumers for whom, while the demand for good 2 will be comprised of all consumers for whom following demand functions:. Substituting the formula for the marginal consumer yields the (5) (6) Firms will attempt to maximize profit functions: (7) where c i represents marginal costs of production. The firms marginal cost functions are assumed to be equal and constant in quantity, but increasing in environmental quality, or:. (8) Substituting marginal cost and demand functions into firm profit functions, differentiating each firm s profit function with respect to own price, and solving for that price yields the following reaction functions: (9) (10) To find the Nash equilibrium, these reaction functions are substituted into each other and then solved for price: (11) 7

8 (12) Having found equilibrium prices, the next step is to solve for a Nash equilibrium in locations, given these prices. First, equilibrium prices are substituted into the demand functions, to provide demand as a function of product location: (13) (14) According to the principle of maximal differentiation firms will maximize the difference in their products so as to reduce price competition. 8 Given the nature of an ECP, maximizing differentiation means that one firm acquires the certification while the other does not. The alternative is that neither or both of the firms acquire the certification. In either of these events, the product varieties would be identical and consumers would buy from the lower priced of the two. As a result, the two-stage game would collapse into a single-stage Bertrand model, where both duopolists believe that the other will not change its price. In this event, no price above marginal cost would be sustainable as the firms would have an incentive to undercut each other and capture the entire market. Thus, the two firms would charge a price equal to their marginal costs, and neither firm would earn positive profits. Thus, maximal differentiation will be a Nash equilibrium, if it generates positive profits for both firms. Substituting the location of the firm that chooses not to acquire the certification (i.e., z 1 = 0) into the price equilibrium and demand functions derived above, produces equilibrium prices and demand as a function of z 2 : and (15) and (16) Given these functions, the next step is to optimize the level of environmental 8 Tirole (1998). 8

9 performance necessary to acquire the certification. III. Optimizing the Standard The standard of environmental performance upon which the certification is awarded can be optimized by maximizing a social welfare function over z 2. The program could affect social welfare through changes in the utility consumers derive from purchasing the good, the environmental damage caused by the production of the good, and the cost of producing the good. 9 Given that z 1 = 0, a social welfare function incorporating all of these effects may be represented as follows: (17) Maximizing this social welfare function with respect to z 2 yields the optimal standard. While including all of the effects of changes in the value of the certification on social welfare may seem the obvious approach, it is not the only one. In fact, the more traditional approach is to ignore the possibility that consumer utility might be directly effected by the environmental attributes of a good and limit consideration to the welfare effects of the ambient environmental damage caused by the production of the good and the costs associated with ameliorating that damage. 10 Again, given that z 1 = 0, this approach implies the following objective function: (18) 9 There would also likely be costs incurred in the implementation of the program including costs of collecting, disseminating and processing the information. However, it seems unlikely that these costs would vary with the level of the standard and, as a result, are not relevant to this analysis. 10 After all, green consumption could be considered something of an oxymoron, as aptly illustrated by the following satire: A ceramic reusable mug is the most environmentally sound choice for coffee drinkers... But a mug only makes you feel good once at the moment when you first buy it. On the other hand, using a new disposable cup made from recycled materials every single day will make you feel like you re doing your part to help the environment every single day. Adbusters (1997). 9

10 Solving this maximization problem leads to a second optimal level of environmental performance,. A third possibility is simply to set a standard that minimizes the environmental damage generated by the production of the good, or: (19) The optimal solution in this instance is. Table 1. Summary of Results. Elements in Agency Objective Function No Program Environmental Damage, Abatement Costs, and Consumer Utility Environmental Damage and Abatement Costs Environmental Damage Environmental Performance z 1 = 0 z 2 = 0 z 1 = 0 z 2 = z 1 = 0 z 2 = z 1 = 0 z 2 = Market Share D 1 = [0, 1] D 2 = [0, 1] D 1 = D 2 = D 1 = D 2 = D 1 = D 2 = Product Prices P 1 = 0 P 2 = 0 P 1 = P 2 = P 1 = P 2 = P 1 = P 2 = Production Costs Costs = 0 Costs = Costs = Costs = Firm Profits 1 = 0 2 = 0 1 = = = = = = Environmental Damage EDF = 1 EDF = EDF = EDF = Proposition 1: Maximal differentiation, or one firm acquiring the certification and the other not, is a Nash Equilibrium regardless of which of the three objective functions is used to optimize the certification. Given the presence of the program and the assumptions made herein, firms are effectively constrained to choosing to either acquire the certification or minimize environmental performance. As noted earlier, if either, both firms acquire the certification, or neither do, then the good is not actually differentiated at all, and the two firms end up charging a price equal to their marginal costs and, thus, earn zero profits. On the other hand, if one firm acquires the 10

11 certification and one does not, then the firms are able to reduce the degree of price competition between them and earn positive profits under all three of the different objective functions, as is illustrated in Table 1. Thus, one firm acquiring the certification and the other not constitutes a Nash equilibrium under all three of the objective functions. Table 2 depicts the net benefits of an ECP optimized under these three different objective functions, both including and excluding the effects of consumer preferences over environmental performance. Table 2. Net Benefits of an Optimized ECP*. Elements in Objective Function Environmental Damage, Abatement Costs, and Consumer Utility Environmental Damage and Abatement Costs Environmental Damage Reduction in Environmental Damage Consumer Utility Firm Costs Net Benefits Including Consumer Utility Net Benefits Excluding Consumer Utility * Less any costs associated with the implementation of the program. Proposition 2: Setting the standard as high as possible is not an optimal strategy for the agency, even if the agency s goal is simply to minimize environmental damage. Maximizing the level of environmental performance necessary to acquire the certification does lead to less environmental damage per certified unit and thus, makes the certified variety more desirable to consumers. However, this increased desirability creates market power for the clean firm, which exploits this market power by increasing its price. The net result in this model is a monotonic reduction in market share. Due to the shape of the environmental damage curve, the reduction in Figure 1 11

12 environmental damage per certified unit outweighs the loss in market share, but only to a point. Eventually the loss in the certified good s market share outweighs the increased abatement and further increases in the level of environmental performance necessary to acquire the certification actually increase the environmental damage from the production of the differentiated good. The point where this occurs is the point where the level of environmental performance minimizes the environmental damage function, or in the current model, at z 2 = , as illustrated in Figure 1. Increasing the level of environmental performance needed to acquire the certification above this point actually increases the environmental damage associated with the production of the good. Proposition 3: Since the program provides firms with the means to differentiate their products and reduce the degree of price competition between them, its introduction will increase firm profits, as long as the firms shares of the costs of implementing the program are not too large. 11 Firm profits under the three different objective functions as well as in the absence of a program are shown in Table 1. The implementation costs would include costs associated with collecting, analyzing, and disseminating the information and could be borne by the firms directly or imposed on the firms by the agency sponsoring the program. 12 In any event, this result may help to explain some of the anecdotal evidence of firms lobbying for the introduction of environmental certification programs. 13 Proposition 4: The performance of an optimized ECP relative to a uniform emissions standard or a corrective tax, depends upon whether or not the utility consumers derive from consuming the differentiated good is included in the welfare calculations. If it is not, then uniform emissions standards and corrective taxes can both 11 The ability of the firms to differentiate and raise their prices is driven, at least partly, by the elasticity of demand for the polluting good, which in this model is assumed to be perfectly inelastic. 12 How the costs are allocated among the firms would seem to depend upon the type of information provision program implemented. For instance, if the program is voluntary, as most ECPs are, it is likely that only the firms that attempt to acquire the certification will bear any of the implementation costs. In the model employed in this paper, these costs would be included in the increase in marginal costs associated with improving the environmental performance of the good. Under an involuntary program, it seems more likely that the firms would bear an approximately equal share of the costs. 13 Kirchoff (2000). 12

13 generate pareto optimal outcomes, while an optimized ECP generally cannot. If it is included, then the optimized ECP can generate a pareto optimal outcome while a uniform emissions standard or a corrective tax generally cannot. In the current example, when the consumption utility is excluded, the firms have identical marginal damage and cost functions and thus identical efficient levels of environmental quality. More specifically, we can differentiate the environmental damage function and marginal cost function with respect to the joint level of environmental quality and (after multiplying the marginal damage by negative one to find the marginal benefit of environmental improvement), set the two equal: (20) (21) Thus, in the absence of direct utility from consumption, the efficient level of environmental performance is z 1 = z 2 = 0.5. While a uniform emissions standard or corrective tax could achieve this result, an optimized ECP cannot. Following the principle of maximal differentiation, if the standard for acquiring the certification under an ECP is set to 0.5 or, for that matter, any level between 0 and 1, then one firm will acquire the label while the other will not, or z 1 = 0 and z 2 = 0.5. However, if the utility consumers derive from consuming the differentiated good is included in the social welfare calculations, then an optimized ECP produces a Pareto optimal result when neither a uniform emissions standards nor a corrective tax will generally do so. This change is driven by the ECP s ability to exploit the differences in the strength of preferences for environmental quality among consumers. With heterogeneous consumers, identical levels of environmental performance will not generally be an efficient result. To find the optimal levels, we maximize the objective function that includes consumption utility, reduction in environmental damage and abatement costs over both z 1 and z 2. Given the relevant range for z i, the result is a boundary solution for z 1, so that z 1 = 0. Given this value of z 1, the optimization problem is as before, and again z 2 = Thus, the optimized ECP generates a Pareto optimal result. On the other hand, a uniform emissions standard cannot, by itself, generate different levels of environmental performance and while taxes could theoretically be set in such a way to achieve this result, there is no rational basis for discriminating between the two firms 13

14 for taxing purposes. 14 A summary of the results of optimization under these two different regimes is provided in Table 3. Table 3. Comparison of Pareto Optimalities with and without Consumption Utility. Attribute Value Pareto Optimality with Consumption Utility (ECP) z 1 = 0.0 z 2 = Pareto Optimality without Consumption Utility (Taxes/UES) z 1 = 0.5 z 2 = 0.5 Reduction in Environmental Damage Consumption Utility Firm Costs Net Benefits with Consumption Utility Net Benefits without Consumption Utility The implications of this proposition are twofold. First, there is no benefit to combining an optimized ECP with either an optimal corrective tax or an optimal uniform emissions standard, regardless of whether or not the direct effects on utility from consumption are considered. Since an ECP generates a Pareto optimal result when the utility from consumption is considered, while a corrective tax or a uniform emissions standard does when the utility is not considered, there can be no benefit to combining the two programs in either instance. Second, if we believe in the existence of a willingness-to-pay for environmental performance distinct from the actual ambient effects of improved environmental performance, then we may need to reconsider our traditional notions of Pareto optimal policies for polluting goods, as the programs that can exploit these preferences may have an advantage over those that cannot. IV. Conclusion 14 Similarly, a continuous information provision program would be unlikely to generate a Pareto optimal result, as there is no reason to suspect that the profit-maximizing levels of environmental performance of the firms would correspond to the socially optimal levels. In this model, the principle of maximal differentiation would hold, so that the dirty firm would choose the optimal level of environmental performance, but the clean firm would actually choose a level above the socially optimal level. 14

15 This paper employs a spatial product differentiation analysis to model environmental information provision programs, including a specific application to an environmental certification program, allowing the level of environmental performance necessary to acquire the certification to be optimized in accordance with the goals of the agency responsible for the program. The possibility of different agency goals and the resulting optimal levels of environmental performance were found. Regardless of the agency goals, it was shown that setting the level as high as technically possible was unlikely to be an optimal result. Given these optimal levels, it was also shown that, for the duopoly case, one firm acquiring the label and one not, will typically constitute a unique Nash equilibrium. Further, as long as the firms share of the costs of acquiring and disseminating the information are not too large, the introduction of the program can actually increase firm profits. Finally, the social efficiency of an optimized ECP was compared to more traditional forms of regulatory policies under alternative conditions - one where consumers had preferences for environmentally superior goods and these preferences were included in social welfare calculations, and one without these preferences. The result of this comparison was that the optimized ECP generated a Pareto optimal result under the former conditions, while the traditional forms of regulation could typically not, but that the converse was true without the preferences. This last finding, in addition to casting doubt on the idea of combining ECP s with traditional forms of regulation, presents a challenge to the way we think about environmental policy. If these preferences do exist and if people are willing to act on the basis of these preferences, then policy instruments that are able to exploit these preferences by providing information on the environmental performance of individual products may have advantages over traditional forms of environmental regulation. While there are a number of different directions in which this research could be extended (allow firms to compete in multiple dimensions or to enter or exit the industry; provide for a non-uniform consumer distribution or elastic demand for the polluting good; analyze a multiple-standard program - where there is more than one certification for each product group - with more than two firms), the most obvious is to test the generality of this result. 15

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