The equilibrium effects of environmental regulation on heterogeneous competing firms: Theory and evidence from Chinese manufacturing

Environmental regulation has the potential to reshape market competition, thereby influencing the market power of regulated firms and potentially impacting social welfare. We show that in certain scenarios, both high-pollution and low-pollution firms may respond to environmental regulation by reducing overall output, thereby increasing price-marginal cost markups. This approach allows them to transfer some of the regulatory costs onto consumers. However, welldesigned and appropriately implemented environmental regulations can still increase social welfare. Our empirical analysis of Chinese manufacturing firms supports this assertion, indicating that environmental regulations in China lead to an increase in markups while simultaneously reducing the welfare losses caused by markups.