SIGNALLING GREEN TECHNOLOGY THROUGH PRICE AND ECO- LABEL

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1 Annals of the Constantin rânuşi University of Târgu Jiu, Eonomy Series, Issue 6/2013 SINALLIN REEN TECHNOLOY THROUH PRICE AND ECO- LAEL SLAĐANA PAVLINOVIĆ, PhD University of Split Faulty of Eonomis Cvite Fiskovića 5, Split, Croatia Phone: ; Fax: Abstrat We apply signalling games to investigate the effet of environmental friendly tehnology on the adoption of eo-labels. The framework is information asymmetri beause the onsumers do not observe a firm type diretly, but may infer it indiretly through the market prie and eo-label. Also, we assume that eo-labels are unreliable sine they imperfetly reveal the atual firm tehnology. A monopoly signalling game is studied, where a firm is a sender, and a onsumer is a reeiver of two signals, prie and eo-label. Sine the purpose of eo-labels is to distinguish environmentally friendly produer type, we elaborate the fators whih affet the existene of the separating equilibria. We find neessary ondition for the existene of the separating equilibrium in whih both types extrat the whole onsumer surplus. Furthermore, if the labelling osts exeed the quality differene between the green and the brown type, then the separating equilibrium does not exist. While the pooling equilibrium without eo-labelling exists for any set of parameters, we identify the parameters values under whih the pooling equilibrium with eo-labelling does not exist. Key words: signalling game, green firm, eo-labelling 1. Introdution Eo-ertifiation beomes an important part of the business praties. For instane, [19] show that ISO ertifiation impats positively firms profitability. Author in [15] also points out that the number of firms whih obtained an eo-label has rapidly inreased. In this paper we explore the effet of environmentally friendly tehnology on eo-labelling praties. We study the information asymmetry problem whih is similar to the one formalised in [1]. A framework with redene good is applied, so that the atual produt type (green or brown) is not observed by the onsumer, even after purhase and onsumption, but is known by the firm. The differene between redene, experiene and searh goods is explained in [12].The onept of redene good is usually applied to study environmental tehnology hoie. For example, [16] differs dirty and lean produer tehnology whih is known to the firm but not to the onsumer. Similarly, [15] points out that eo-labelled goods are losely related to redene goods. Different mehanisms may be applied to resolve information asymmetry, suh as branding, warranties, liensing and ertifiates [6]. In the ontext of environmentally friendly tehnology, the fous is on eo-labelling. One an onsult [14] for the basi definitions and aspets of eo-labelling. There are two important issues about eo-labelling emphasised by many authors (for instane, [15], [13] and [17]): the osts of labelling and the reliability (whih may be orrelated). The proess of obtaining an eolabel may be rather ostly (see [13] and [17]) so that many environmentally friendly produts are not labelled. An effort to derease the osts of eo-labelling may result with a derease in reliability of eo-labels, so that eolabels may fail to diminish the information asymmetry [18]. Septiism surrounding organi good labels and distrust of onsumers are identified in [10] as important issues. Authors in [4] on page 115 point out that environmental label may sometimes be unable to disriminate environmentally friendly produts from other produts even with an eo-label. Sustainability labels should improve onsumer awareness. However, a strong inrease in labelling laims on food produts in reent years inreased the risk of onsumer onfusion and information overloading [2]. ACADEMICA RÂNCUŞI PULISHER, ISSN /ISSN-L

2 Annals of the Constantin rânuşi University of Târgu Jiu, Eonomy Series, Issue 6/2013 Two solutions to the information asymmetry problem related to adoption of environmentally friendly tehnology are proposed in [15]. One is signalling by prie and another is eo-labelling. There is a branh of literature whih studies prie signalling (e.g. [9], [5], [11]) whih proposes various mehanisms whih enable signalling buy prie, from advertising, word-of-mouth, to the differene in osts of prodution and oligopolisti setting. The last mehanism is applied to the ontext of environmental tehnology in paper of [16]. However, sine eo-labels may be unreliable they may as well serve as signals. This effet is aptured in the game proposed by [12] where the onsumer observes an eo-label but still does not observe the produt type. Thus, we onstrut a similar signalling game where the firm may signal her hoie of tehnology through an eo-label. Thus, we elaborate the signalling properties of an eo-label. 2. Model There is a single firm in the market with two traits: friendly behaviour and eo-labelling praties. Environmentally friendly behaviour refers to the firm's polluting praties, and in this respet there are two types of firm: green and brown. reen type undertakes neessary measures to derease environmental impat of its ativities whih is ostly. rown firm does not have suh osts sine it does not are about the environmental impat of its ativities and produts. In fat, [4] point out that the green produts are generally more labour intensive and/or produed at a small sale. On the ontrary, the brown (polluting) firms avoid suh osts by ignoring environmental impats of their business praties. However, here we suppose that both firms, green and brown, have the same prodution osts beause we fous on effets of eo-labelling and this simplifiation does not affets results. Furthermore, we assume that eo-labelling is not reliable and we apture this by allowing to the brown firm to obtain an eo-label, but at a higher ost. Thus, eo-label ost of green and brown firm is g and b respetively, where g < b. The onsumers are homogenous and there is a vertial produt differentiation so that the onsumers prefer the green produt to brown one. Furthermore, unit money metri onsumer utility funtion is assumed, like in [3], so that the onsumer surplus is equal to θ p or θ q where θϵ{g,b}and g>b. Sine we imply a vertial produt differentiation, all the onsumers prefer the less polluting tehnology. However, environmental friendliness may be viewed as well as horizontal or publi harateristis whih are disussed in [4] while [8] differentiate polluting and non-polluting tehnology both vertially and horizontally. The produer observes his tehnology (brown or green) and hooses prie and eo-label. The onsumer does not observe the tehnology, but his buying deision is based on ayesian beliefs whih onsumer onstruts after observing the prie and the eo-label implementation. The onsumer knows the probability that the green tehnology ours. Therefore, the onsumer makes buying deision based on the expetation about tehnology. The prie of a produt with an eo-label annot exeed the expeted onsumer utility after the onsumer observes signals based on the ayesian updating: p µg + (1 µ)b = E[θ p] where b p g. µ is an updated probability that the firm is green if it holds an eo-label. Non-labelled produt an be green or brown as well, so its prie annot surpass the onsumer expeted utility: q νg + (1 ν)b= E[θ q] where b q g. ν is an updated probability that the firm is green if it does not hold an eo-label. It is evident that pries p and q may both vary from 0 to g. Sine we onsider a monopoly framework it is reasonable to onsider pries from b to g. The firm profit is a differene between the prie and aompanying osts. Depending on the firm tehnology and eo-labelling hoie the profit is defined as follows, where π L, π N, π L and π N refer to green labelled, green non-labelled, brown labelled and brown non-labelled firm respetively: π L = p π N =q π L =p π N =q ACADEMICA RÂNCUŞI PULISHER, ISSN /ISSN-L

3 Annals of the Constantin rânuşi University of Târgu Jiu, Eonomy Series, Issue 6/2013 If the onsumer refuses to buy the produt, the firm profit is zero. The game We define a two-stage game with three players: nature, firm and onsumer. The players make hoies in the following order: (1) nature hooses the produer type (tehnology) ; (2) based on the private information about his tehnology, the produer hooses if to eo-label his produt; (3) the produer hooses prie; (4) the onsumer observes labelling deision and aompanying prie p or q and makes buying deision x 0, 1. It is evident from the struture that this is a signalling game with two signals, label and aompanying prie. The onsumer does not observe the atual tehnology but observes the signals. We apply the definition of the signalling equilibrium provided in [7] on our model. Pair of prie and labelling deision, and onsumer buying deision whih are the best responses to eah other onstitute the signalling equilibrium if the supporting onsumer posterior beliefs about the produer type after observing prie and label are based on the ayesian updating. The signalling equilibrium may be separating, suh that different types hoose different eo-labelling praties, or it an be pooling suh that both types hoose the same eo-labelling pratie (both types apply the label or both types do not apply the label). An important ondition for the existene of the separating equilibrium is the single-rossing property. Applied to our model, the types will separate (the green type labels the produt while the brown type does not label the produt) if: L N and L N p q and p q require that p q (Please, note that the opposite ase, L N and L N whih is opposite to the relevant assumption in this model.) is not possible, beause that would Impliations of the monopoly assumption: The produer sets the maximum prie at whih the onsumer buys the produt. If the onsumer belief ( q ) 0 for all q, then the maximum prie of non-labelled produt at whih the onsumer buys is b. Sine the produer hooses the maximum equilibrium prie, in the subsequent analysis of the signalling equilibria we fous on the maximum equilibrium prie whih we denote by p and q Existene of signalling equilibria,, g and b an be in various ratios, whih predetermines the existene of the separating (signalling) equilibria. There are three possible ases: Case 1: Case 2: Case 3: g b Sine q=b is fixed, we an only onsider different values of p, but whih annot exeed g. We define p as lower and upper bound of p in the separating equilibrium. In other words, if p b and b p is within these bounds the separating equilibrium exists. ACADEMICA RÂNCUŞI PULISHER, ISSN /ISSN-L

4 Annals of the Constantin rânuşi University of Târgu Jiu, Eonomy Series, Issue 6/2013 Case 1: The signalling equilibrium exists if p >p. Case 2: The signalling equilibrium does not exist. (There are no beliefs whih support the signalling equilibrium). The pooling equilibria with labelling do not exist. Case 3: The signalling equilibrium exists if p <p < p. We provide the proofs whih are related to the listed ases. Proposition 1: If and only if type sets prie p=g, and the brown types sets prie q=b. Proof of Proposition 1:, there exists a separating equilibrium suh that the green Suppose that ν(b)=0 at any q. Furthermore, suppose that onsumer buys at any p 0,g. The best response of the green type is to set p=b beause in suh a ase he obtains profit g- whih is larger than b-e and it is larger or equal to any b-. The best response of the brown produer is to set q=b beause in suh a ase he obtains profit b and b>g p-. The beliefs based on the ayesian updating at a given prie inlude only a type who hooses suh a prie in the equilibrium. Thus, this equilibrium is supported by beliefs μ(g)=1 and ν(b)=0. At out-of-equilibrium pries, the beliefs an be set arbitrarily. Proposition 2 shows the existene of the separating equilibria in Case 1 and Case 3. Proposition 2: If p' b there exists a separating equilibrium suh that the brown types sets prie q=b, green type sets p and ayesian belief are ( p ) 1p 0, p' and ( p ) 0p p'. Proof of Proposition 2: Suppose that ν(b)=0 at any q. The best response of the green type is to set p beause in suh a ase he obtains profit p - whih is larger than b. The best response of the brown produer is to set q=b beause in suh a ase he obtains profit b and b>g- p-. The beliefs are based on the ayesian updating at a given prie inlude only the type who hooses suh a prie in the equilibrium. Thus, this equilibrium is supported by beliefs μ(p )=1 and ν(b)=0. At out-ofequilibrium pries p 0, p', the beliefs an be set arbitrarily beause neither green nor brown type deviates to suh pries. reen type does not deviate beause 0 p p'. rown type does not deviate as well beause p' p. At out-of-equilibrium pries p>p, μ(p) must be suh that E[θ p]<p. That is, µ(p)g + (1 µ(p))b<p; µ(p)(g-b)<p-b. Corollary 1: Sine ondition µ(p)(g-b)<p-b for pries p>p must be satisfied in order to sustain the signalling equilibrium, it follows that as out-of-equilibrium pries inreases, a larger value of out-of-equilibrium belief µ(p)an support the signalling equilibrium. y this we exhaust all the separating equilibria. One an note that we onsider q=b only. The reason for this is the following. Sine the produer is a monopolist, than he will set the maximum prie at whih the onsumer buys the produt. We onsider only pure strategies and beliefs ν(q=b)=0. From this follows that the maximum prie of non-labelled produt at whih the onsumer buys is q=b. There are no beliefs whih an fore the produer to derease prie q bellow b. In an oligopoly prie q ould be set bellow b due to the ompetition Existene of pooling equilibria If the single rossing property is not satisfied, then the pooling equilibrium emerges. There are two types of pooling equilibria, one where green and brown produers label the produt, and another where both abandon the labelling pratie. ACADEMICA RÂNCUŞI PULISHER, ISSN /ISSN-L

5 Annals of the Constantin rânuşi University of Târgu Jiu, Eonomy Series, Issue 6/2013 The pooling equilibria may emerge due to the tehnial reasons (levels of labelling osts, g and b), or due to the onsumer beliefs. Firstly we elaborate the tehnial reasons. Proposition 3 refers to pooling equlibria without labelling and to separating equilibria in Case 2. In this ase the pooling equilibria with labelling do not exist. Proposition 3: If > >g-b, then, there exists a multipliity of pooling equilibria with q αg+(1-α)b whereas the separating equilibria do not exist. Proof of Proposition 3: If > >g-b, there is no prie p between b and g whih an over the osts of labelling. Therefore, neither green no brown firm label their produts. We demonstrate by ontradition that q > αg+(1-α)b an not onstitute the pooling equilibrium. Suppose that the onsumer beliefs are suh that q > αg+(1-α)b. Then, the best response of the both firm types is to set q, but then the expeted utility (based on the ayesian belief) is negative sine q >αg+(1-α)b. Thus, the best onsumer response is not to buy. Thus, q > αg+(1-α)b annot onstitute an equilibrium, and this is a ontradition. Suppose that the onsumer beliefs are suh that q < αg+(1-α)b. The best response of both produer types is to set q and the best response of the onsumer is to buy. Sine some q suh that q <q<αg+(1-α)b is an out-of-equilibrium prie, the beliefs at q an be set arbitrarily, so that onsumer expetation is lower than prie and the best response of the onsumer is not to buy at suh a prie. Next, we elaborate the existene of the pooling equilibria due to the beliefs. We demonstrate in Proposition 4 that the pooling equilibrium without labelling exists in all three ases. Proposition 4: For any values of parameters there exist equilibrium beliefs whih sustain pooling equilibria where both firm types do not label. Proof of Proposition 4: Consider an out-of-equilibrium prie p suh that b<p < +b. Then the best response of the green type is not-label and set q=b sine p - <b. If the onsumer beliefs above p are suh that the onsumer does not buy, then the separating equilibrium does not exist and both produer types do not label and set the same prie. In proposition 5 we demonstrate under whih partiular ondition the pooling equlibria with labelling exist. Corollary 2 emphasises that there is a set of parameters under whih the pooling equilibrium with labelling does not exist even in Case 3. Proposition 5: If g-b> > and if αg+(1-α)b> +b there exists a pooling equilibrium suh that all types set prie p. Proof of Proposition 5: If p > +b, i.e. p - >b, then the best response of the brown firm is to label and set p. Sine αg+(1-α)b>p, the best response of the onsumer is to buy at p. Thus p onstitutes the pooling equilibrium. Corollary 2: If g-b> > and if +b> > αg+(1-α)b there does not exist a pooling equilibrium in whih both types label. Proof of Corollary 2: If p > +b, i.e. p - >b, then the best response of the brown firm is to label and set p. Sine p >αg+(1-α)b the best response of the onsumer is not buy. Thus, the pooling equilibrium with labelling does not exist. ACADEMICA RÂNCUŞI PULISHER, ISSN /ISSN-L

6 Annals of the Constantin rânuşi University of Târgu Jiu, Eonomy Series, Issue 6/ The disussion In order that the separating equilibrium exists, relevant onditions applying to green and brown produer type need to be satisfied. efore we proeed with the elaboration, we omment the relation between the onsumer beliefs and pries. Please, not that as the prie inreases, the higher believes that the produt is green need to hold in order that the onsumer is ready to buy the produt. I.e. as Corollary 1 point out, the larger set of out-of-equilibrium beliefs for the pries about the equilibrium prie of the labelled produt sustain the separating equilibrium. The differene in pries of labelled and non-labelled produt must be suffiiently large relative to the ost of labelling of the green produer. In other words, if the prie of non-labelled produt is suffiiently large, then non-labelling pratie may beome attrative even for the green produer. Thus, the key is in keeping the ost of labelling for the green onsumer suffiiently small. In other words, in order to reate effiiently eo-labelling program, Case 2 needs to be avoided. If the differene between the pries is too large relative to the osts of eo-labelling for brown produer, then the brown produer may deviate and eo-label his produt. However, under partiular set of parameters this annot be the ase, whih is elaborated in Proposition 5 and Corollary 2. Namely, if <g-b< /α, then the pooling equilibrium with labelling does not exist. We provide a summary of the mentioned ases in Table 1. The seond olumn refers to ases defined in Setion 2.1. One an note that separating equilibria exist only if partiular onditions are satisfied. The least stringent onditions refer to the ase where osts are suffiiently different ompared to the differene in environmental impats between two produts. In this in is reasonable to study separating equilibria with labelling only sine we neglet eventual differenes in prodution osts between brown and green firm. Furthermore, we identified two soures of pooling equilibria: tehnial reasons and beliefs. Tehnial reasons refer to relationsips between atual pries, fration of green types (prior probability that green type ours), osts and, and tehnology g and b. The tehnial reasons an be responsible for the existene of pooling equilibria in both irumstanes, with and without eo-labelling praties. The last olumn refers the existene of pooling equilibria without labelling due to appropriate onsumer beliefs. It is always possible to find suh onsumer beliefs (whih affet expetations about produt) that onsumer is ready to buy the produt where both produer types set the same prie. Table 1: Equilibria existene EXISTENCE EXISTENCE OF POOLIN EQUILIRIA OF TECHNICAL REASONS ELIEFS CASE SEPARATIN with labelling without labelling EQUILIRIA 1 exists if no no exists p > +b 2 exists if no no exists q >αg+(1-α)b 3 g b exists if exists if no exists +b<p < +b αg+(1-α)b> +b 2.4. The poliy impliations There are a few measures by whih the government an assure the separating equilibrium. Firstly, should be redued to zero, while should be raised. Fous and magnitude of these measures depends on the utility of the green produt. More speifially, if the utility of the green produt is relatively low, the ost of eolabelling for suh a produt must be redued. On the other hand, when the utility of the green produt is very high, the ruial intervention is in the ost of eo-labelling the brown produt. In suh a ase, the ost of labelling the brown produt must be raised, so that the brown produer type does not take an eo-label. Furthermore, the onsumer expetations signifiantly influene the existene of signalling equilibria. In the ase of the separating equilibrium, the beliefs plaed on the green produt after observing high pries of eolabelled produt should be lose to one, and the opposite holds for the prie of a non-labelled produt. Thus, here ACADEMICA RÂNCUŞI PULISHER, ISSN /ISSN-L

7 Annals of the Constantin rânuşi University of Târgu Jiu, Eonomy Series, Issue 6/2013 we arrive to the issue of eo-label reputation and reliability. The government may affet the reputation of an eolabel by inreasing the transpareny of the labelling proess. As the ayesian updated beliefs onstitute the separating equilibrium, an important fator is the level of prior belief α. For example, if α is very larger, then it is very likely that both, brown and green produer type, label their produts. 3. Conlusion Eo-labelling beame widely applied tool to foster environmentally friendly business. However, the onerns about eo-labels trustfulness urges for a more omprehensive analysis of firms' motives with respet to eo-friendly business praties and eo-labelling. We analysed the adoption of the eo-label by a firm with given tehnology (green or brown). We onstruted a signalling game and we foused on the analysis of the separating equilibria. We onlude that the existene of the signalling equlibria depends first of all on the aessibility of eo-labelling to the green firms, and on the impediment for the brown firms to eo-label their produts. Furthermore, the beliefs have an important role in eo-labelling. If the prior belief about eo-friendliness of an industry is very high, then the eolabelling might not be very effetive sine the produers may have high expetations about the non-labelled produt. The trust in eo-label is related to the posterior belief. If the onsumer trusts the label, he will plae high expetations on the eo-labelled produt. We may speulate that if utility of a green produt is very high, then one should fous on the impediments to eo-labelling of brown produts. On the other hand, if the utility of a green produt is rather low, it may ruial to redue the eo-labelling osts of the green produt in order to sustain the separating equilibrium. There are many diretions for improvements of this analysis and future researh. One may onsider the endogeneous tehnology and/or oligopoly framework. Furthermore, the equilibria an be refined by Intuitive Criterion and D1 refinements. 4. ibliography [1] Akerlof, J., The market for lemons: Quality unertainty and the market mehanism, Quartarly Journal of Eonomis, 84(3): , 1970; [2] anterle, A., Cereda, E. and Fritz, M., Labelling and sustainability in food supply networks. ritish Food Journal, 115(5): , 2013; [3] reard, D., Environmental Quality Competition and Taxation in the Presene of reen Network Effet Among Consumers, Environmental and Resoure Eonomis, 54(1):1-19, 2013; [4] reard, D., Hlaimi,., Luas, S., Perraudeau, Y. and Salladarre, F., Determinants of demand for green produts: An appliation to eo-label demand for fish in Europe. Eologial Eonomis, 69: , 2009; [5] Daughety, A. and Reinganum, J., Imperfet ompetition and quality signaling. The RAND Journal of Eonomis, 39(1): , 2008; [6] Dranove, D. and Zhe Jin,., Quality dislosure and ertifiation: Theory and pratie. Journal of Eonomi Literature, 48(4): , 2010; [7] Fudenberg, D. and Tirole, J., ame theory. The MIT Press, Cambridge, Massahusetts, 1991 [8] Hamilton, S.F. and Zilberman, D., reen markets, eo-ertifiation, and equilibrium faud. Journal of Environmental Eonomis and Management, 52: , 2006; [9] Hertzendorf, M.N. and Overgaard, P.., Prie Competition and Advertising Signals: Signaling by Competing Senders. Journal of Eonomis and Management Strategy, 10(4): , 2001; ACADEMICA RÂNCUŞI PULISHER, ISSN /ISSN-L

8 Annals of the Constantin rânuşi University of Târgu Jiu, Eonomy Series, Issue 6/2013 [10] Hughner, R.S., MDonagh, P., Prothero, A., Shultz II, C.J., Stanton, J., Who are organi food onsumers? A ompilation and review of why people purhase organi food. Journal of Consumer ehaviour, 6:94-100, 2007; [11] Janssen, M.C.W. and Roy, S., Signaling quality through pries in an oligopoly. ames and Eonomi ehavior, 68(1): , 2010; [12] MCluskey, J.J., A ame Theoreti Approah to Organi Foods: An Analysis of Asymmetri Information and Poliy. Agriultural and Resoure Eonomis Review, 29(1):1-9, 2000; [13] Lozano, J., lano, E. and Rey-Maquieira, J., Can eolabels survive in the long run? the role of initial onditions. Eologial Eonomis, 69(12): , 2010; [14] OECD, Fisheries and Aquaulture Certifiation, OECD Publishing, 2011; [15] Shumaher, I., Eolabeling, onsumers' preferenes and taxation, Eologial Eonomis, 69: , 2010; [16] Sengupta, A., Investment in leaner tehnology and signaling distortions in a market with green onsumers, Journal of Environmental Eonomis and Management, 64: , 2012; [17] Trevers, A. and Jones, S.M., Strategi tradeoffs for wildlife-friendly eo-label, Frontiers in Eology and the Environment, 8(9),491:498, 2010; [18] van Amstel, M., Driessen, P. and lasbergen, P., The Netherlands Eo-labeling and information asymmetry: a omparison of five eo-labels in the Netherlands, Journal of Cleaner Prodution, 16(3), , 2008; [19] Yang, X. and Yao, Y., Environmental Compliane and Firm Performane: Evidene from China. Oxford ulleting of Eonomis and Statistis, 74(3): , 2012; ACADEMICA RÂNCUŞI PULISHER, ISSN /ISSN-L