Optimal environmental regulation and firms’ location choice under yield uncertainty

Abstract

Environmental regulations have led to firms considering offshoring their production to avoid compliance costs. However, overseas production comes with yield uncertainty. This study examines optimal environmental regulations and firms’ responses under three production scenarios. The government’s objective is to maximize social welfare by selecting the type and intensity of regulatory instruments, while firms seek to optimize profits by adjusting their optimal production quantities. Our analysis finds that price and quantity regulation instruments have similar impacts on social welfare, but firms prefer quantity instruments despite price instruments being more beneficial for consumers. Furthermore, both pollution damage coefficient and yield uncertainty are important factors affecting social welfare and firms’ location choice and there exist win–win situations that benefit the government, firms, and consumers. Additionally, offshoring tends to be more environmentally friendly to the local environment. To further validate the main model, we examine various extensions. Results show that the hybrid instrument does not significantly enhance social welfare, but it does offer flexibility in adjusting firms’ production transfer motivations. Additionally, factors such as positive production and fixed costs, as well as multi-market issues, do not alter the government’s preference for regulatory instruments.