The Costs of Environmental Regulation in a Concentrated Industry

The typical cost analysis of an environmental regulation consists of an engineering estimate of the compliance costs. In industries where fixed costs are an important determinant of market structure this static analysis ignores the dynamic effects of the regulation on entry, investment, and market power. I evaluate the welfare costs of the 1990 Amendments to the Clean Air Act on the US Portland cement industry, accounting for these effects through a dynamic model of oligopoly in the tradition of Ericson and Pakes (1995). Using a recently developed two-step estimator, I recover the entire cost structure of the industry, including the distribution of sunk entry costs and adjustment costs of investment. I find that the Amendments have significantly increased the sunk cost of entry. I solve for the Markov perfect Nash equilibrium (MPNE) of the model and simulate the welfare effects of the Amendments. A static analysis misses the welfare penalty on consumers, and may even obtain the wrong sign of the welfare effects on incumbent firms. ∗This paper is a revised version of my job market paper. I would like to especially thank Pat Bajari for guidance and support. I have also benefited from conversations with Tom Ahn, Arie Beresteanu, Jane Cooley, Paul Ellickson, Han Hong, Shanjun Li, Chris Timmins, Justin Trogdon, and seminar participants at Arizona, Arizona State, Brown, Chicago, Clemson, Harvard, Illinois, the Kellogg School of Management, the Kennedy School of Government, Maryland, Minnesota, MIT, and Princeton. All remaining errors are my own. †Department of Economics, MIT, Cambridge, MA, and NBER.