Market Size, Heterogeneity, and the Effects of Environmental Regulation

Abstract

We examine how market size and firm heterogeneity shape environmental regulation effects. Stricter regulation reduces the supply of skilled labor, with stronger impacts in smaller economies. We develop a spatial model with heterogeneous firms where emissions create negative externalities. Regulation affects firm entry through productivity cutoffs and skilled labor allocation. Simulations show market size critical conditions outcomes: larger markets experience smaller productivity cutoff increases, while smaller economies face tighter regulatory binding and larger firm contractions. Firm heterogeneity further mediates these effects–more even productivity distributions mitigate impacts, while greater richness amplifies them by introducing low-productivity firms disproportionately eliminated by regulation.