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Emission control policies and endogenous market structure: the price vs. quantity dilemma

In a competitive industry where production entails pollution, a welfare-maximizing policy maker considers, as control instruments, setting a cap on market output or levying an emission tax. We embed this scenario within a dynamic setup where market demand is stochastic and entry is irreversible. We firstly determine the industry equilibrium under both policies and then the cap level and the tax rate maximizing welfare. Our main findings are: (i) the optimal tax policy dominates the optimal cap policy; (ii) the optimal tax policy implements the first-best outcome.