5. Conclusion
This paper developed a multi-sector general equilibrium model to account for the direct cost of regulations and the indirect cost associated with factor reallocations and loss of variety. The model derives an analytical marginal abatement cost function, dividing the cost according to three distinct effects: cost, average-productivity, and variety effects. While the indirect effects are confounding in nature, the model demonstrates that the variety effect exceeds the average-productivity effect, implying that accounting for indirect effects increases the welfare cost of regulations. Moreover, the welfare cost of regulations is proportional to the direct compliance cost, where the proportionality factor is a fixed constant that depends on the elasticity of substitution between product varieties and the shape parameter of the distribution of firm productivities. Finally, the model sheds light on the implications for optimal environmental policy.
The model is numerically simulated using parameters for the U.S. manufacturing sector for criteria air pollutants. The numerical model demonstrates that the marginal abatement cost at current levels of pollution ranges between $144 and $194 per ton of pollution across industries. Consistent with the direct cost of regulations understating the true welfare cost, the indirect cost of regulations ranges between $5 and $30. The aggregate marginal abatement cost is $159 at current levels of pollution, increasing to $232 after reducing pollution by 30%.
