The Economics of Green consumerism (1993)

THE ECONOMICS OF GREEN CONSUMERISM

Alberto Cottica

University College London

The author gratefully acknowledges the vital contribution of Professor David Ulph tobringing order to this paper. We wish to thank Raffaele Miniaci and Giovanni Ponti for thelong, inspiring late-night discussions held together, and Francois Leveque for hisencouraging and helpful comments. The usual disclaimers apply.

This paper was funded by the Fondazione Luigi Einaudi. The Fondazione also took care ofpublishing it, in the Italian translation. The reference is A. Cottica, 1993, L’economia delconsumismo verde, Annali della Fondazione Einaudi, Torino, Vol. XXVII.

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INTRODUCTION

CHAPTER 1

1.1. Chapter contents

1.2. Environmental friendliness as product quality

1.3. Quality Assessment Modes

1.4. Trust Goods in Consumer Theory

CHAPTER 2

2.1. Chapter Contents

2.2. Repeat Purchase, Quality Premia and Market Structure

2.3. Signalling Quality: Brand and Green Reputation

2.4. Reputation and Market Structure

CHAPTER 3


3.2. The Firm

3.3. Green Watch

3.4. The Model.

3.4. The model in steady state

Appendix: a Fixed Costs Model

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CHAPTER 4


4.2. Environmental Policy by Circulating Information

4.3. Information-Based Environmental Policy Instruments: AProposed Taxonomy

4.4. Green Consumerism

4.5. Voluntary Agreements

4.6. Eco-Labeling

4.7. Possible Consequences on Foreign Trade

CHAPTER 5

5.1. Concluding Remarks

5.2. Directions for Further Research

BIBLIOGRAPHY

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Introduction

In 1992, the British branch of the environmentalist group Friends of the Earth waged a waron mahogany import. Mahogany, of which the UK. is the largest world importer, comesgenerally from the Amazon rainforest; its trade has very serious consequences over theAmazonian environment and the human rights of the forest peoples. The persuasiontechnique adopted by FOE was to organize demonstrations in the parking lots of the keyshowrooms of the four main British furniture retail chains, trying to hammer intoconsumers the idea that they, by buying mahogany furniture, are helping destroy a uniqueecosystem. This won the adoption of company policy to sell only "sustainable" mahoganyfrom three out of the four chains, and their commitment to lobby the Government for alegal ban of unsustainably managed mahogany. The latter point is easily understood. As aFOE spokesman pointed out, such a ban keeps high profile companies, that are beingtargeted by environmentalists, from losing sales to smaller businesses that their small sizesaves from being watched as closely, and can therefore sell mahogany furniture at a lowerprice.

On the 16th of January 1993, activists of the Italian environmentalist group Legambientemarched to the biggest supermarkets in their cities. They bought what they needed,regularly paid, and dumped on the supermarkets themselves empty boxes and bottles,residuals of earlier purchases. The aim of Legambiente is to get the Italian parliament toadopt an anti-packaging waste law, similar to the German Packaging Ordinance. This lawsets regulatory targets for packaging recycling rates and leaves to industry and commercethe choice (and the financial and organizational burden) of how to reach them.

In October 1992, the Belgian detergent manufacturer Ecover opened, in front of the formerEnvironment Commissioner Carlo Ripa di Meana (at the time he was the ItalianEnvironment minister), its new ultra-low environmental impact plant in Antwerp. It is amodel plant: the production process requires here only one sixth of the unit energy input ofits competitors, waste water is recycled after treatment through a reed meadow. There is noair emission. Even the plant iself is built wit natural materials; pinewood for the structures,bricks (made from recycled saw-dust and mining waste) for the walls, linoleum and bakedearth tiles for the floors, a grass roof for energy-saving insulation. Staff get a travelallowance that is highest if they cycle to work, lower if they car-pool, lowest if they drivein their own car. Ecover is a small firm (the new plant employs only 45 workers in anindustry dominated by corporate giants such as Unilever, Henkel, Procter&Gamble.

These three stories have a denominator in common, and that is the visibility of the firmsinvolved. Environmentalists, both British and Italian, could never demonstrate calling foraction on environmental problems in front of a small shop, run by a family enterprise. Theyneed counterparts that are big and powerful enough to infuence, with their behaviour, theoverall picture, and to take some of the blame for the existing problems. As for Ecover, itsseems the story of a firm trying to become even more visible to "its" consumers; bybuilding a model plant, and inviting environmentalist groups to visit it, it seems to beoffering a sort of warrant as to its determination in tackling environmental problems.

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These reflections suggest that information plays a crucial role in the firms' choice of theirbehaviour with respect to the enviroment. This conclusion is far from surprising, and tracesof it can be found in the mainstream literature on environmental economics. Pearce et.al.[1989], for example, write that "for ecological consumerism to be effective, consumersmust be informed as to the polluting potential of the products they buy". This intuition,however has not been developed: consumers as autonomous and capable of takinginitiatives social actors are totally absent from environmental economics textbooks. Thesame is true of firms' strategies to capture their demand. Also, it is not totally clear whatkind of information consumers really lack; Pearce et.al. seem to have in mind scientificknowledge, whereas the three stories just told deal with information pertaining more to thephysical characteristics of the goods manufactured ond of their production processes.

Developed by public economists and fiscal scientists, the theory of environmental policyhas developed as the theory of the internalization, via fiscal policy, of the negativeexternalities (i.e. pollution) generated by economic activities [Baumol and Oates, 1989].This approach has been recognized to be vulnerable to organizational failure objections[Veljanowsky, 1985]; despite this, it continues to dominate the field. The aim here is tosuggest an approach based on the existence of information asymmetries on productmarkets. These asymmetries prevent consumers to effectively express their preferences forthe "pollution content" of products in the same way they do for their quality. The behaviourof firms, environmentalists and "green consumers" in the face of information asymmetries,and the consequences of such behaviour in terms of policy, are the subject of thisdissertation.

Chapter 1

Making Green Consumerism Work

1.1. Chapter contents

This chapter looks at the information asymmetries hindering consumers' preferences forenvironmental friendliness to being exerted on the market place, and explores ways to getround them. Section 2 establishes a comparison between these asymmetries and thoseregarding product quality in markets for differentiated products. Section 3 introduces thenotion of quality assessment modes, and suggests that of "trust" for environmentalfriendliness. Section 4 sets the notions of quality assessment mode and trust good in theliterature on consumer theory.

1.2. Environmental friendliness as product quality

The notion of environmental friendliness seems to bear a striking resemblance to that,familiar to industrial economists, of product quality. Both are quite compatible to the ideaof a horizontal dimension in the product space (some consumers may prefer durable cars tofast cars; others may be much more concerned about the extinction of whales than aboutthe ozone layer), but suggest a strong verticality (there are longer-lasting and less long-lasting cars, and CFCs-free hairsprays do less damage to the ozone layer than non-CFCs-free ones). In other words, both these concepts imply that products can be ranked from"best" to "worst", and that this ranking is, at least in part, objective.

This reflection casts a different light on the view, expressed by Pearce et.al. [1989] andapparently quite widespread, that green consumerism can't work because consumers lackinformation on the environmental friendliness of products. In fact, consumers lackinformation about product quality as well, which does not always prevent some industriesfrom displaying a keen competition on quality grounds. Those industries have found a wayround the information asymmetries to exploit the consumers' willingness to pay for high-quality product. Enlightened politicians and the less anti-capitalist wing of theenvironmentalist movement have long been putting forward the vision of a greener, kindercapitalism whereby firms behave respectfully towards the environment. Such respectwould stem from the environment, just like product quality, having become a ground forcompetition. Can the theory of information asymmetries on product quality provide aneconomic rationale for what has so far largely been wishful thinking?

This chapter suggests it can. However, to do so it is necessary to tackle the problem ofhow consumers can assess environmental friendliness.

To begin with, it is useful to distinguish between two different kinds of information thatconsumers need to carry out such an assessment. One is the scientific knowledge needed tounderstand the relationship between productive activities and the environment; the cost ofacquiring this kind of information is, as Pearce et.al. point out, very high for the average

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consumer. The other is what kind of productive activities each product needs to bemanufactured: for example, that batteries contain or not mercury, or that bottles made ofrecycled plastic keep some waste out of landfills. The cost of acquiring information of thissecond kind is obviously very much lower than that of acquiring information of the firstkind, although still (as will be explained) quite high for the individual consumer. Thequestion then arises of what role is played by each of the two kinds in carrying out theassessment of environmental friendliness.

Consider a similar problem, that of consumption of cholesterol-free food. It does not seemreasonable that all consumers choosing to eat cholesterol-free food are aware of thebiochemistry of cholesterol, and of the complex ways in which diets differing in cholesterolcontent affect, over time and according to a stochastic relationship, human health. In asense, they do not need to know: a public awareness has formed, in complex ways wellworth investigating by sociologists, that cholesterol is best avoided. All consumers need toknow in order to do so is the cholesterol content of food products.

Similar processes seem to be at work behind green consumerism. The extraordinarycommercial success of phosphate-free detergents is not easily ascribed to consumers havinga thorough understanding of the effects of phosphates on aquatic environment. It certainlyseems more likely that consumers accept a "popular wisdom" that phosphates are "bad" forthe environment, and try to buy detergents that do not contain them if they can do so at areasonable cost.

The ways in which such beliefs form are not investigated in this work. The rest of thischapter is devoted to exploring the ways in which consumers may acquire information ofthe second kind.

1.3. Quality Assessment Modes

Nelson [1970] has divided goods in search and experience goods. The former areproducts the quality of which can be assessed prior to purchase, like, say, clothes; the latterare those the quality of which can only be assessed by buying them, like meals atrestaurants or electric appliances.

Search and experience are, in this context, alternative quality assessment modes. Nelsonruns a number of simple empirical tests the result of which suggest that information ispassed on to the consumers in ways aimed at bridging the informational gap betweenhimself and the purchase decision. So, advertising search goods tends to involve thetransmission of "hard" knowledge: a picture of a dress tells consumers a lot of what theywant to know about the dress. On the other hand, canned tuna is often advertised withmarine scenes; anyway, a picture of the can is not particularly informative as to the taste ofits content. The evidence suggests that consumer behaviour is significantly different acrossquality assessment modes.

How is environmental friendliness assessed? Certainly not by search. Very little can beascertained about it prior to purchase, by simply looking at the good. But not byexperience, either: evaluating the environmental impact of a good involves, even taking asgiven a system of beliefs about how dangerous certain productive activities are, at leastsome knowledge of the product content in dangerous substances (e.g. CFCs inhairsprays), of the production process (e.g. in the case of organic food products) with

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which it was manufactured, and of the method by means of which it will be disposed ofwhen it becomes waste (it is less risky to buy batteries when a separate collection methodfor waste batteries exists). The cost of acquiring this information is quite high forindividual consumers.

One of the main purposes of this study is to suggest that, despite these informationasymmetries, green consumerism can be made to work if the assessment of theenvironmental friendliness of goods is carried out by some better informed agent whomconsumers trust. Environmentalist groups are an obvious candidate for the job, and there issome evidence that they are beginning to carry it out.

Trust is, then, a third quality assessment mode. To preserve symmetry with Nelson'sterminology, we propose to call trust goods those goods the assessment of whose qualitytakes place mainly by trust.

1.4. Trust Goods in Consumer Theory

The purpose of this section is to clarify the notion of trust good and its relationship withconsumer theory in the literature on industrial organization. Two issues seem to be mostrelevant; the "goods vs. characteristics" dilemma and the comparison between "trust goods"and "credence goods".

Lancaster [1966] has suggested that consumers are not interested in goods at all. They seegoods as bundles of characteristics, which are the real utility yielders. In other words,consumers choose their consumption bundles in order to obtain certain characteristics: awell-known example is that two light bulbs with a durability of six months each yield thesame utility as one light bulb with a durability of one year. Consumers desire hours oflighting, not light bulbs in themselves. The general equilibrium tradition sees things from adifferent point of view: utility functions are entered by goods, which may differ from eachother as subtly as necessary to explain consumer behaviour.

A characteristics approach seems to have important advantages over a goods one whenlooking at quality assessment modes. The rationale for this is that, as a rule, the qualityassessment of any one good takes place through a combination of modes [Tirole, 1988].For example, the design of a car can be assessed by search; its durability, only byexperience; the environmental friendliness of its production process, by trust. Being thisthe case, it is quite natural to start thinking in terms of search, experience and trustcharacteristics. One can think of several other trust characteristics besides environmentalfriendliness; "Americanness" under President Nixon's "buy American" campaign, or"fairness of labour use", when consumers do not wish to buy products manufacturedexploiting, say, children's work, or "kasherness" of food products for orthodox Jews. It isworth noticing that consumers seem capable of providing themselves with the means ofassessing other trust characteristics besides environmental friendliness; for example, theobvious candidates to carrying out the assessment of the fairness of labour use of a productare trade unions1. This suggests that the notion of trust as a quality assessment mode, andthe economic theory derived from it, may find a wider field of application thanenvironmental economics; that of business ethics.

Reasoning in terms of characteristics rather than goods has, however, an all-importantdisadvantage: it makes it much more difficult to do empirical research. The approach

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suggested by Lancaster [1979] is to employ hedonic pricing procedures to extract thedemand curves of characteristics from those of goods; the existence of indivisibilities inconsumption2 introduces nonlinearities and further complications. In the original Nelsonarticle the problem was solved by applying the notion of main quality assessment mode:when buying tuna fish, consumers are basically interested in its taste, an experiencecharacteristic; on the other hand, jewels are largely bought for their design, a searchcharacteristic. This allowed Nelson to term tuna and jewels, respectively, experience andsearch goods, and therefore to run simple tests on consumer behaviour when buying theone and the other. Since the durability of a car is not bought separately from its style, itwould have been difficult to run those tests in terms of pure characteristics.

Much of the literature this study draws from thinks in terms of goods, and the term "trustgoods" will henceforth be employed here. The models we present, however, lendthemselves to be discussed in terms of characteristics as well.

It remains to be discussed the relationship between the notion of trust goods and that ofcredence goods, introduced by Darby and Karni [1973] shortly after the appearance ofNelson's article. The authors introduce this notion in the context of the "repair problem",i.e. the joint provision of diagnosis and services. How can the advantages of, say, theremoval of an appendix be evaluated? The average consumer simply can't do it; on theother hand, his doctor may have (indeed, Darby and Karni contend that he has) an incentiveto overstate the need for the operation to be done. Consumers have the choice of buyingdiagnosis from one doctor and their operation from another one, but this often involvesadditional monetary, time and transaction costs that must be compared with any expectedreduction in fraud.

An additional complication is introduced by the existence of a stochastic relationshipbetween repair services and the flow of services from sophisticated durable goods, such ascars, or from human beings. The doctor may advise me to remove my appendix because,although I have no symptoms now, I am likely to get problems in the future. If I follow hisadvice, his diagnosis is unfalsifiable; even if I don't, and I turn out not to have anyproblems, I cannot judge his performance as a diagnosis maker: I may just be one of asmall minority whose appendices resist deterioration under certain clinical conditions.

The conclusions reached by Darby and Karni along this line of reasoning are that themarkets for credence goods display an unusually high optimal amount of fraud. Since thegovernment is subject to the very same informational limitations that affect consumers, onecannot make a convincing case from government intervention.

It seems reasonable to distinguish credence goods from trust goods as defined above. ,Credence goods are those goods that are actually never, or very imperfectly, assessed.3

Trust goods are those goods a fairly accurate assessment of which is carried out by a thirdagent; the results of this assessment process are then made available, at a reasonable (andoften nonmonetary) cost to consumers. The reason why informational costs are low tosingle consumers is that they trust the assessing agent, so they don't need to go into thedetails of the assessment process as Darby and Karni's consumers would.

Chapter 2

Information Asymmetries And Market Structure


This chapter is concerned with the industrial organization side of the theory of informationasymmetries on consumer markets. It revolves around the notion of brand reputation as asignaling device for the persistence of quality. Section 2 provides an overview of the theoryof competition through capital investment in brand name promotion ("reputation"). Section3 defines the notion of reputation and outlines a role for it in the markets for trust goods;"green reputation" is introduced. Section 4 explores the relationship between competitionthrough reputation and market structure.

2.2. Repeat Purchase, Quality Premia and Market Structure

Information asymmetries imply moral hazard. If quality can not be assessed prior topurchase, manufacturers who sell experience goods have an incentive to undersupplyquality; this incentive is strongest where consumption is most transient or one-shot, like forservices directed to tourists or life insurance contracts. Industrial economists have foundrepeat purchase to be an effective mechanism to reduce moral hazard problems onexperience goods markets. The idea is here that a deceptive firm can be punished by turningone's demand to its competitors if one is deceived.

This point was developed by Klein and Leffler [1981]. Their model is built as follows.Consumers buy one unit of an experience good each period. They communicate costlesslyand immediately; so, if one firm supplies less-than-contracted for quality to one consumerat time t, by time t+1 it has become a notorious cheater and loses all of its sales. The marketis assumed to be perfectly competitive.There are no sunk costs.

Two prices are defined for the good, corresponding to basic and high quality. Assume, forthe moment, that the low and the high price are both perfect competition prices, althoughrelated to different cost curves. Since quality can only be assessed after purchase, the moralhazard problem for firms becomes a choice between three options.

• the first one is to sell the low quality product at the low price. By assumption, no profitis earned.

• the second one is to sell the high quality product at the high price. Again, no profit isearned.

• the third option is to cheat, sell the low quality product at the high price for one period,and exit immediately after. This third option does yield a positive profit (a one-periodquasi rent), and therefore will be the one chosen by a rational firm. Again, moral hazardleads to the undersupply of quality.

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Suppose, however, that there is a price, higher than the competitive high quality price,that, if it were the equilibrium price for high quality:

• would provide a stream of profit the present value of which is higher than that of thecheating one-period quasi rent;

• would not dissipate the entire consumer surplus.

If such a price exists, it can characterize an equilibrium. Klein and Leffler contend that,under very general cost conditions, this should be the case. Notice that a rational consumerwould not buy the high quality product at a price equal to its average cost; he knows thatfirms have no incentive to sell it at that price. The higher price, consisting of average costplus a quality premium, has then the property of being a quality guaranteeing one.

In the long run, the presence of extra profits to be earned triggers entry, and thereforeincreased competition. However, competition cannot occur on price: a reduction of pricebelow the premium price would result in zero sales. By the assumption of perfectcompetition, the long-run equilibrium must be a zero-profit one. This implies a rent-dissipating kind of competition; Klein and Leffler suggest that it occurs through sunkinvestments in firm-specific capital assets, such as the promotion of the firm's brand name.The competitive process will direct such investments towards those forms that provide thegreatest direct service value to consumers. The "real" price of purchase of the experiencegood, i.e. the premium price net of the services yielded by the jointly supplied brand nameassets, is thereby minimized. Net investment of this kind will go on until the average costreaches the premium price.

Notice that sunk costs are firm-specific, and therefore non-salvageable. This guarantees theunprofitability of the "cheat and exit" strategy described above. Bearing this in mind, thereason why the promotion of a firm's brand name yields services to consumers is fairlyintuitive: it provides them with information about the firm's commitment to staying in themarket and therefore being vulnerable to consumers' retaliation in the repeat purchasegame. So, when consumers do not know the minimum quality-guaranteeing price, themagnitude of a firm's brand name capital investment, relative to its sales, provides a usefulproxy for its motivation to produce the high quality product4.

2.3. Signalling Quality: Brand and Green Reputation

Klein and Leffler's article provides an elegant rationalization to an idea economists had hadfor at least twenty years: that brand reputations are information devices, used by firms tosend signals to consumers5. The purpose of this section is to clarify the notion ofreputation, and to investigate the role it can play in the markets for trust goods.

A good starting point is the following: single product firms, like those of Klein andLeffler's model, are rarely observed. Why, then, should reputation be attached to a brandname and not to a product name? The obvious answer is that the brand name has theadvantage of synthesis: by denoting all products of a brand, it is a less costly way toconvey information about product quality. This, however, has a far-reaching implication:for brand reputation to be informative about product quality, all products of the samebrand must be of the same quality. This must be true both across a range of products at agiven moment in time, and over time6.

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The role of time in reputation deserves particular attention. Klein and Leffler's staticframework should not conceal that, in a repeat purchase game, the interval betweenpurchases may be long enough to alter completely the range of products consumers canbuy. Cars are a good example: only very rarely do consumers, when they sell their old car,buy a new specimen of the same model (it may have gone out of production to begin with).They tend rather to be loyal to the brand. For reputation to be effective as a qualitysignaling device in such a context, past quality must imply present quality7 .

If this is true, it follows that reputations are slow to build. Spending ten million poundstoday in brand name promotion is just not as effective as having spent half a million poundsa year over the last twenty years. Symmetrically, they are slow to destroy: onceestablished, brand loyalty tends to persist even when the quality of single products hasdeclined [Paba, 1989]. For these reasons, it is useful to think of reputation as a firmspecific, intangible capital asset.

In the markets for trust goods repeat purchase plays a different role, in that purchase doesnot imply, in itself, quality assessment. The latter is carried out independently of purchase,by the more informed agent (in the case of environmental friendliness, environmentalistgroups); the repeat purchase mechanism provides consumers with the means of punishingmanufacturers if the results of such an assessment are negative.

The Klein-Leffler story can easily be told with regard to environmental friendliness. Thelong-run equilibrium involves sunk capital investments in promoting the "greenness" of thebrand name, and this process generates, by the dynamics described above, a brandreputation for environmental friendliness: a green reputation, as we shall henceforth call it.

2.4. Reputation and Market Structure

Paba [1986, 1989, 1991] explicitly links reputation effects to market structure. Hecontends that markets where information asymmetries are very important will generally becharacterized by

• a high degree of concentration; consumers can only remember and compare with eachother a limited number of brands. Reputation requires visibility.

• stable market shares by brand (although not necessarily by firm: concentration canincrease by takeovers);

• long-run efficiency.

The two last results are due to the role of time in building and destroying brandreputations. This implies that a firm, threatened by a successful new product launched by acompetitor, has time to respond, either by imitating or by developing an even betterproduct. A keen (nonprice) competition is then compatible with the stability of marketshares by brand. By this token, an oligopolist with a very good patent is prevented frombecoming a monopolist. Empirical evidence from durable consumer goods' industriesseems to fit very well this kind of model.

It seems reasonable to apply these same market structure features to markets whereinformation asymmetries of the "trust" kind are particularly important. However, it should

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be noted that a notoriously good environmental performance can also be used as a way toovercome barriers to entry, thereby reducing concentration. This seems to have been thecase with the detergent industry; with cost functions dominated by scale economies, newentry by "green" companies such as Ecover could take place at a profit in the early eightiesonly because of the existence of a quality premium on phosphate-free detergents. However,in the long run, it is reasonable to expect a further concentration process, the extent ofwhich will depend on the share of consumers who will switch to "green" detergents.

Chapter 3

Green Reputation : A Simple Model


This chapter presents a simple optimal control model of competition on environmentalfriendliness in a stationary environment. It is built on the idea that green reputation can beviewed as a capital asset. It is characterized by two parameters: its monetary value and itscapability of generating sales. A firm's cleanup expenditure decision is the result of themaximisation, over time, of a value function comprising cash-flow profit and the capitalgains from the change in value of the firm's green reputation.

Section 2 introduces the firm's demand and its cost function. Section 3 sets up a modellingdevice to allow for environmental friendliness assessment. Section 4 computes anddiscusses first-order conditions. Section 5 computes and discusses the steady stateequilibrium. Finally, an appendix presents briefly a different version of the model.

3.2. The Firm

Consider a firm competing on a market where environmental friendliness is the mainground on which competition takes place. The manufactured products have a negativeenvironmental impact only during the production phase of the life-cycle: it consists ofemissions discharged into the environment. Pollution can be reduced by applying filters tothe production line.The following assumptions are made:

• sales at time t+1 are a function of green reputation at time t alone. Therefore, for eachperiod, they are given.

• price p, the quality-guaranteeing price, is also given.

• production costs are normalized to zero. The only costs are those of increasing theenvironmental friendliness of the production: they consist in current expenditure onabatement devices ("leasing filters").

• the firm acts so as to maximize the present value of its stream of cash-flow profits plusthe capital value of its assets, i.e. its green reputation.

Strategic interaction is ignored: each firm makes its own decisions in isolation. This is notconsistent with Paba's emphasis on oligopolistic interaction, and investments in qualitymanufacturing and signalling through brand name promotion decided in response tocompetitor's moves8.

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3.3. Green Watch

Assume there exist an environmentalist group, Green Watch, that has among its aims thatof discovering firm's frauds on environmental friendliness. Green Watch behaves atfollows:

• it checks a number of firms randomly chosen, each period. The probability for eachfirm to be checked during any one period, , is common knowledge.

• the probability for any one firm to be checked in period t is independent of whether itwas checked in period t-1 or not9.

• it evaluates the amount of their unit expenditure on environmental protection EP; onthose grounds, it gives firms a "mark". Marks are given according to a function GWof EP, the shape of which is known, and are expressed in the same unit of measure asgreen reputation itself10 . The function GW is, realistically, assumed to displaydecreasing returns. GW is therefore expected to take a shape of the following kind:

FIGURE 1: The GW function

• the assessment process affects the firm insofar it increases or decreases the value ofits green reputation, and by that token the value of future sales. It behaves as anindependent evaluation of the firm's green reputation: at the end of each period, if the greenreputation has been found overestimated, a share 1− of its customers will accept GreenWatch's evaluation, and consequently reduce their demand for the firm's product. Thereason why the firm does not lose all its customers has been clarified in chapter two: green

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reputation commands brand loyalty. , the share of consumers who do not alter theiropinion of the firm's environmental friendliness, can be interpreted as the degree of brandloyalty.

3.4. The Model.

We are now in a position to write the three basic equations of the model.

[1] Π t t tp S R C= ⋅ −( )

Where Π denotes profit, S sales, p the quality-signalling price and C costs.

[2] C pe EP St t t= ⋅ ⋅

Where EP (for environmental protection) denotes the quantity of "leased filters" per unitproduced and pe the lease price. Finally,

[3] R R GW EP Rt t t+ = + − ⋅ + −1 1 1( ) ( ) ( )

where, as we have seen, is the probability of a Green Watch inspection in any givenperiod, brand loyalty as defined above, GW the evaluation made by Green Watch as afunction of EP. The first part of the RHS describes what happens if Green Watch doescheck the firm: the second one what happens if it doesn't.

The maximization problem can be written as follows [Neher, 1990]:

[4] MAX /( )V r Rtt

t tt= + + ⋅+=

∞∑ Π ∆1 10

Or, in its more familiar continuous-time form,

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Clearly, EP acts as control variable and R as state variable.

The expression for ∆R can be obtained by [3], subtracting Rt from each side:

R R R GW EP R Rt t t t t+ − = + − ⋅ + − −1 1 1( ) ( ) ( )

∆R R GW EP Rt t t+ = + − ⋅ −1 1( ) ( )

[5] ∆R GW EP Rt t+ = − ⋅ −1 1( ) ( )

What follows deals with the continuous-time form, assuming continuity in R and piecewisecontinuity in EP. The current value Hamiltonian is

[6] H qRt= +Π

Where q ert≡ . Substituting [1], [2] and [5] into [6] yields:

[7] H p pe EP S R q GW EP R= − ⋅ ⋅ + − ⋅ −( ) ( ) ( ) ( )1

FOCs can be derived from [7]. We start from the maximum principle (subscripts denotepartial derivatives):

H

EPpe S q

GW

EP= − ⋅ + ⋅ − ⋅( )1

[8]pe

q SGWEP=

⋅ −⋅

( )1

Portfolio balance condition:

H

Rrq q=− = −

p pe EP S q rq qR− ⋅ ⋅ − ⋅ − = −( )1

[9]q

qr

p pe EP S

qR= + ⋅ − −

− ⋅ ⋅( )1

Dynamic constraint:

H

qR=

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[10] ⋅ − ⋅ − =( ) ( )1 GW EP R R

Equation [8] means that production will be "greened" up to the point where the marginalcapital gain resulting from Green Watch's evaluation (filtered through brand loyalty andGreen Watch's probability of checking this particular firm) equals the marginal cost. ofdoing so. pe/q represents the price of "leasing filters" in terms of reputation. This situationcan be represented by the following diagram:

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FIGURE 2: The maximum principle

ks in the diagram are equal to ⋅ −( )/1 S , and k1<k2. Notice that, in equilibrium, EPdepends on the value of the constant k and on the position of the straight line pe/q. Inparticular, EP will be higher:

• the lower the price of "leasing filters" in in relation to that of green reputation;

• the higher the probability of being checked by Green Watch;

• the lower the degree of brand loyalty;

• the smaller the firm is.

The first three results are hardly surprising. The fourth one, which seems to contrast withthe intuition that firms need to be visible to enjoy exploit their green reputation, and need tobe large to be visible, is a byproduct of the specification of the model: Green Watch isinterested in unit expenditure on environmental protection, whereas its contribution tobuilding up green reputation is scale-independent. This means that the incentive to complywith Green Watch's standards increases as firm size decreases11 . This effect disappears ifthe EP on which Green Watch's evaluation is based is let to be a fixed cost rather than avariable one, as the appendix to this chapter demonstrates.

Equation 9 has a structure similar to that of Hotelling's rule. It implies that, for portfoliobalance, the rate of growth of the price of reputation must equal the rate of interest minus a

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factor accounting for the sales- (and therefore, in our model, profit-) generating power ofinvestments in green reputation. This factor, in its turn, is taken net of the factors limitingit, namely the uncertainty surrounding Green Watch's monitoring activity and brandloyalty.

More analitycally, on an equilibrium path, q must grow faster:

• the higher the rate of interest r;

• the lower the price-cost margin (p-pe.EP);

• the lower the sales-generating power of green reputation SR;

• the higher the probability of being checked by Green Watch;

• the lower the degree of brand loyalty.

The analogy with Hotelling's rule can be carried one step further. r + −( )1 can bethought of as a risk-adjusted rate of interest. In this interpretation, the (marginal) capitalgain on reputation plus the marginal cash-flow profit gain deriving from a higher "stock" ofgreen reputation must, for equilibrium, equal the risk-adjusted rate of interest.

Finally, equation [10] simply recovers the dynamic constraint.

3.4. The model in steady state

It is interesting to look at the long-run evolution of the system described by theseequations. Recall first order conditions:

[8a] qpe S R

GWEP

=−

⋅( )

( )

1

[9]q

qr

p pe EP S

qR= + ⋅ − −

− ⋅ ⋅( )1

[10] ⋅ − ⋅ − =( ) ( )1 GW EP R R

Equation [8a] is simply equation [8] solved by the price of reputation q. To depict themotions of the control variable, the environmental protection expenditure EP, and of thestate variable, the green reputation R, begin by considering [10]. Firstly, it isstraightforward to check that the steady state version of [10] has the same shape of theGW(EP) function:

[10a] R°= 0 hence GW EP R( )=

22

FIGURE 3: The R°=0 condition

Consider a point such as A in the graph. It is characterized by a higher R than the steadystate requires; a glance at [10] shows that this implies R°<0. So, first order conditionsrequire that R decrease when above the steady state level and vice versa.

The motion of EP is less intuitive, and requires a little manipulation. Begin bydifferentiating [8a] with respect to time:

[11] qpe S

GWR

pe S R GW

GWEPR

EP

EP

EP

°=−

⋅ ⋅ °−−

⋅⋅ ′′ ⋅ °

( ) ( )

( )

1 1 2

From [11] and [9]:

r q p pe EP Spe S

GWR

pe S R GW

GWEPR

R

EP

EP

EP

+ − ⋅ − − ⋅ ⋅ =−

⋅ ⋅ °−−

⋅⋅ ′′ ⋅ °( )

( ) ( )

( )1

1 1 2

Substitute for q from [8a]:

rpe S R

GWp pe EP S

pe S

GWR

pe S R GW

GWEP

EPR

R

EP

EP

EP

+ − ⋅−

⋅ − − ⋅ ⋅ =−

⋅ ⋅ °−−

⋅⋅ ′′ ⋅ °( )

( )

( )

( ) ( )

( )1

1 1 1 2

Substitute for R° from [10] and simplify:

23

rpe S R

GWp pe EP S pe

S

GWGW EP R

pe S R GW

GWEP

EP

RR

EP

EP

EP

+ − ⋅−

⋅ − − ⋅ ⋅ = ⋅ ⋅ − −−

⋅⋅ ′′ ⋅ °( )

( )

( )( )

( )

( )1

1 1 2

Multiply each term in the equation by GW

SEP

R

:

rpe S R

Sp pe EP GW pe GW EP R

pe S R

S

GW

GWEP

REP

R

EP

EP

+ − ⋅−

⋅ − − ⋅ ⋅ = ⋅ − −−

⋅ ⋅⋅ ′′ ⋅ °( )

( )

( )( )

( )

( )1

1 1

Rearrange

[12]pe S R

S

GW

GWEP pe GW EP R p pe EP GW r

pe S R

SR

EP

EPEP

R( )

( )( ) ( )

( )

( )

11

1−⋅ ⋅

⋅ ′′ ⋅ °= ⋅ − + − ⋅ ⋅ − + − ⋅−

⋅

[12] describes the motion over time of EP as a function of the absolute values of EP itselfand R. Together with [10], it constitutes a system of two differential equations in twounknowns, EP° and R°, which, at each point in time, can be solved given the values of EPand and R and of the relevant parameters.

At the expense of some loss of generality, it is possible to proceed further. Assume

[13] S R R( ) = hence S RR = −1

and

[14] GW EP EP( ) = −1 with 0 1< <

Hence GW EPEP = − −( )1 and GW EPEP′′ = − − − −( )1 1

Substitute in [12] to yield

pe R

EPEP pe EP R p pe EP EP r

pe R

( )( ) ( )

( )11 1

11

−⋅ ⋅

−⋅ °= ⋅ − + − ⋅ ⋅ − ⋅ − + − ⋅

−⋅− −

Rearrange as

• ⋅ °= ⋅ + − ⋅ ⋅ − ⋅ − + − ⋅−

⋅ − ⋅− − −EP pe EP p EP pe EP rpe

R pe R1 11 11

( ) ( )( )

[15] • ⋅ °= ⋅ ⋅ + − ⋅ ⋅ − ⋅+ −

−+ ⋅− −EP pe EP p EP pe

rR1 1

1

11( )

( )

( )

Let K per

≡ ⋅+ −

−+

( )

( )

1

11

24

In steady state, since EP°=0, the LHS of [15] must also be zero. The steady state version of[15] is therefore reduced to

[16] K R pe EP p EP⋅ = ⋅ ⋅ + − ⋅ ⋅− −1 1( )

To compute the slope of [16] take its total differential:

K dR pe EP dEP p EP dEP⋅ = − ⋅ ⋅ ⋅ − − ⋅ ⋅ ⋅− − −( ) ( )1 1 1

K dR EP p pe EP dEP⋅ = − ⋅ − ⋅ − ⋅− −( )1 1

[17]dR

dEP

EP

Kp pe EP= −

− ⋅ ⋅⋅ − ⋅

− −( )1 1

K is clearly positive; so is the numerator of the term multiplying the profit marginp pe EP− ⋅ . The sign of dR/dEP will then be the inverse of the sign of the profit margin

term.

dR

dEPEP

p

pe

dR

dEPEP

p

pe

dR

dEPEP

p

pe

< ⇒ > ⇒ <

= ⇒ = ⇒ =

> ⇒ < ⇒ >

0 0

0 0

0 0

Π

Π

Π

Of course, the last case does not make economic sense; there cannot exist a steady state inwhich the firm makes a loss. [16] must then be negatively sloped over the relevant range.

25

FIGURE 4: The EP°=0 condition

It is now possible to depict the motion of EP outside the steady state. The term betweensquare brackets multiplying EP° in [15] is always negative; this implies that

[15] EP K R pe EP p EP°> ⇒ ⋅ − ⋅ ⋅ + − ⋅ ⋅ >− −0 1 01 ( )

Consider a point such as C in the diagram. It displays a lower R than the steady state wouldrequire. A glance at [17] shows that EP in C must grow to satisy first order conditions. Thevice versa holds for a point such as D.

Over the economically relevant range, the two curves [10a] and [16] will only intersectonce, giving rise to a unique steady state equilibrium.

26

FIGURE 5: The steady state equilibrium and equilibrium paths of EP and R

The model predicts that, along "stable arms" equilibrium paths, firm starting from a lowlevel of green reputation will begin the program with a high level of (unit) environmentalprotection expenditure. This will cause its green reputation to increase; as the equilibriumpoint is approached, the per period EP will decrease. The opposite happens when the firmstarts off from a high level of green reputation. This will cause it to spend comparativelylittle in environmental protection, letting its green reputation lower to its equilibrium level.As the equilibrium level is approached, EP grows.

Notice that Green Watch can always shift the steady state equilibrium point towards theright (towards an environmentally friendlier equilibrium) by "rising its standards", i.e.flattening and shifting to the right the R°=0 curve. However, this move is constrained bythe requirement that the firm make a profit in the steady state.

Appendix: a Fixed Costs Model

An alternative way to think about environmental protection expenditure is as a fixed cost.Assume, for example, production is "greened" via research and development, which leadsto an environment-saving innovation, like a new, easier to recycle plastic. The obvious wayto think about environmental protection expenditure as a variable cost, as is donethroughout chapter 3, is waste generation, which is linked to the amount of outputproduced. Equations in this version of the model will be marked with an f, standing for"fixed cost".

27

The cost function becomes:

[2f] C pe EPt t t= ⋅

So the current value Hamiltonian for the problem is

[7f] H p S R pe EP q GW EP R= ⋅ − ⋅ + − ⋅ −( ) ( ) ( )1

F.o.c.s differ in the maximum principle and in the portfolio balance condition, whereas thedynamic constraint is still equation [10] of the variable cost model.

[8f]pe

qGWEP= ⋅ − ⋅( )1

Equation [8f] does not display the scale diseconomy of equation [8].

[9f]q

qr

p S

qR= + ⋅ − −

⋅( )1

Equation [9f] is less restrictive than its variable cost counterpart, in the sense that it requiresa slower growth of the price of reputation for equilibrium. This is because the marginalcash-flow profit of investment in reputation is higher in this model, as it amounts to theentire value of the marginal increase in sales.

A steady state for this model can be characterized proceeding as in section 3.5, but is not asclear-cut as that of the variable cost model. Equation [12f] reads

[12f] −−

⋅⋅ ′′

⋅⋅ °= + − ⋅

−⋅ − ⋅

pe GW

GW SEP r

pe

Sp GWEP

EP R REP( )

( )( )1

11

1

Assuming the same functional forms for GW(EP) and S(R) as in [13] and [14], one gets

[15f] −−

⋅−

⋅ ⋅ °=+ −

−⋅ − − ⋅− −

−pe

EP REP pe

r

Rp EP

( )

( )

( )( )

1

1 1

1

11

1 1

In the steady state [15f] reduces to

[16f]′−

⋅ = −K

pEP R

( )11

Where ′ ≡+ −

−K pe

r ( )

( )

1

1

The slope of [16f] is

28

[17f]dR

dEP

K EP

p R= ′ ⋅ ⋅

− ⋅ − ⋅

−

−

1

21 1( ) ( )

K' is clearly positive. In order for the RHS of [17f] to be negative, an additional restrictionmust be imposed that <1.

29

Chapter 4

Information-Based Environmental Policy


This chapter looks at the policy implication of the theory of green consumerism. Section4.2 makes a case for government intervention to reduce the information asymmetriesdiscussed in chapter 1. Section 4.3 proposes a range of "information-based" environmentalpolicy instruments, classified according to the allocation of consumers' trust. Section 4.4,4.5, and 4.6 discuss the policy instruments included in the range so far; they are,respectively, green consumerism, voluntary agreements and eco-labeling. Finally, section4.7 discusses briefly the possibility that information-based environmental policy be used asa nontariff barrier to trade.

4.2. Environmental Policy by Circulating Information

Environmental economics was born with the idea of internalizing environmentalexternalities using fiscal instruments [Pigou, 1938]. Although it has gone a long way fromThe Economics of Welfare, tackling more and more problems and developing newanalytical tools, the state of the art in environmental policy seems to have kept faithful tothis public finance matrix [Baumol and Oates, 1989]. Indeed, the prescription of "market-based instruments", i.e. mechanism whereby the marginal external damage to theenvironment of human activities is equalled to the marginal cost of preventing it, seems tobe the ubi consistam of the discipline12 .

This approach to environmental policy has had a tremendous cultural impact on policymakers, and, where put into practice, has performed reasonably well, or even very well.However, one cannot help noticing that it rests on a simplistic, ultra-orthodox view of firmbehaviour; firms are perfectly rational black boxes that equal marginal costs to marginalrevenue. Consumers, by definition, are not involved in externalities until they are pricedand passed on to consumer goods' prices; then they individually maximize their utility.Consumers as economic agents capable of taking collective action and possessing a certaindegree of autonomy are simply absent from the model. Environmental economists canclaim credit for raising a number of objections, but the response to these objections in termsof policy prescriptions has so far been quite weak.

The main point of this chapter is that some of these objections can be dealt with byborrowing from more recent developments in firm and consumer theories. This will beargued by considering how well environmental policy based on the theory of greenconsumerism performs in the face of two of the main arguments against more traditionaleconomic instruments; organizational failure and regulatory capture.

Eco-taxes (à la Baumol and Oates, 1989) have been criticized on the basis that they aresubject to organizational failure [Veljanowsky, 1983], especially if the marginal external

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30

cost of the polluting activity happens to be low. If, within a firm, managers who pay taxesare physically and "organizationally" separated from engineers in charge of technicalchoice, the incentive to pollution abatement may get lost in the meanders of the firm'sheadquarters. More generally, in a bounded rationality framework a firm may simply notbother reducing its discharge of polluting substances into the environment if the charge theypay for it is low. The decision-making power of managers, itself a costly resource, may bebetter allocated to "strategic" activities.

Regulatory capture is also a danger for the policy maker; on this ground, the greenmovement has often asserted its dissatisfaction about the introduction of eco-taxes. Thedanger consists in the bargaining process that precedes the introduction of any regulatorymeasure; industry can, and often does, blunt the edge of market-based instruments bylobbying and using occupational blackmail to lower the rate of eco-taxes. The talks aboutthe introduction of a carbon tax at the 1992 Earth Summit make an illuminating example.

Suppose, however, that the government, by a mix of measures including environmentaleducation campaigns and giving easy access to the media to environmentalist, could raisethe effectiveness of environmentalist groups in spotting and reporting environment-unfriendly firm behaviour. In terms of the model of chapter 3, this means

• increasing the opportunity cost of not investing in green reputation, by increasing theeffect on sales of an increase in green reputation

• increasing the probability of a check by Green Watch. The model predicts aconsequent increase in the unit expenditure on environmental protection.

It is reasonable to expect firms with very high marginal costs of abatement to stay out of the"green" market; by this token, at least some degree of static efficiency is ensured. Dynamicefficiency follows from the arguments developed in chapter 2.

This way of doing environmental policy enjoys two advantages over traditional market-based instruments. Firstly, it seems reasonably robust to organizational failure objections.Environmental friendliness is here one of the grounds for competition; even in the presenceof bounded rationality, it is plausible to expect firms to react to a change in consumerpreferences towards it as they would if consumers changed, say, their taste for productdesign.

Secondly, it seems less subject to regulatory capture than other available policy measures.Regulatory capture involves bargaining and a high degree of sharing the same values andcultural background between firms and regulators; what's more, it implies that, to someextent, the latter rely on the direct knowledge of the former to understand the problems theyare trying to regulate. This is very much more likely to take place with government officialsthan with environmentalists13 .

Of course, green consumerism as environmental policy also has two major disadvantagesover eco-taxes. The first is that it makes it impossible (save by chance) to drive theeconomy to the optimal amount of pollution emission, as market-based instruments do.This may be a less serious limitation than it seems: environmental economists have knownfor a long time [Baumol and Oates, 1971] that it is virtually impossible to compute theposition of the optimum. Eco-taxes are now being marketed as second-best efficient, least-cost policy instruments.

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31

The second disadvantage is obvious: it only works for industries where the environment is,or can be made, an important differentiation factor.

Notice that no mention is being made of what goes under the heading of "environmentaleducation". The reason for this is that the understanding of environmentalinterdependencies belongs to the first of the two kinds of information described in section1.2, with which this study is not concerned. However, it may be useful to keep some ofthe relevant issues in the background of what follows.

Firstly, it should be noted that environmental education policies are being implemented.Italian schoolchildren in the majority of primary schools are taught that life forms are linkedto each other in non obvious ways; they are taught how to plant trees and, in the mostadvanced cases, even that only indigenous species of trees should be planted in any givenplace. Most interestingly, an environmentally friendly detergent producer, Atlas, financesthe education program of the Italian environmentalist group Legambiente [Cantoni, 1993].

Secondly, environmental education tends to shape preferences. Environmental awarenesstends to be keener among the young than among their parents: exposure to theenvironmental issues from an early age seems to be one of the causes behind this pattern. Itis not totally clear how the notion of optimality applies to a context of endogenouslydetermined preferences: does teaching schoolchildren that extinction of species is "bad"lead to "too much" conservation? It may be so from the point of view of people who wentto school before environmental education was introduced, but not from that of theschoolchildren themselves. Brusco [1993] has noted that teaching moral values meansrunning the risk of a confessional state; for this reason, public schools should limitthemselves to pointing out the inherent interdependency of species from one another.

4.3. Information-Based Environmental Policy Instruments: A Proposed Taxonomy

Environmental policy by "making information circulate", then, appears to enjoy desirableproperties. The purpose of this section is to discuss and evaluate the technical means bywhich information-based environmental policy, as we shall label it, can be done.

We propose to distinguish information-based environmental policy instruments accordingto where the trust of the "green" consumers is allocated. By this criterion, it is possible tolist three of them, each one characterized by a different allocation of consumers' trust.

• green consumerism itself; trust lies with firms

• firm-government agreements; trust lies with the government

• eco-labeling: trust lies with the eco-label awarding agency

Notice how environmental groups themselves are not mentioned among the possibleallocations of trust. As is made clear by the model presented in chapter 3, they play a majorrole in the case of green consumerism: by providing an independent source of informationabout firms' environmental performances, they ultimately allow green reputations to bemeaningful to consumers. Without Green Watch acting as a committment device, a firm'ssignaling "I am environment-friendly" would have no information content [Milgrom andRoberts, 1986]14 . The other two policy instruments can be implemented even without

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32

strong and informed environmentalist groups at the price, as will be discussed, ofincreased risks of regulatory capture.

4.4. Green Consumerism

The desirable properties of green consumerism as the archetypal information-based policytool have been discussed in section 4.2. We are here concerned with the technical means ofputting it into practice.

Government intervention on information asymmetries is by no means new. Theconsumers' movement, started off in the U.S.A. well before the Second World War, wasactively encouraged in its development by in European governments in the late sixties[Shonfield, 1984]. Most active in this process were the Scandinavian countries and theUnited Kingdom. The measures put in place by those governments were chiefly aimed atreducing the time, transaction and monetary costs to consumers of claiming reimbursementfor purchases whose quality was less than contracted for. Consumers' advisory officeswere set up; Sweden, in a typically corporatist arrangement, formed a "consumers'tribunal" with no cohercitive power, but the recommendations of which no Swedishcompany would defy; Britain set up its Fair Trade Office, and for a while Small ClaimsCourts, much swifter and less costly to set in motion than the ordinary justice machine,functioned.

All of these measures were inspired by the idea that information asymmetries are all to thefirms' advantage; to counterbalance that, these tribunal-like structures should have a biastowards consumer protection. In the case of green consumerism, the availability of free orcheap laboratory facilities where environmentalists could bring sample of industrialeffluents or waste to analyze would have, in countries with a reasonably strong greenmovement, an impressive impact.

On the diffusion of information side, another possible policy measure is subsidizing greenconsumerist media. Tirole [1988] provides an argument for such an action15 .

It is our belief that the history of the consumer movement has much to teach togovernments interested in green consumerism. Further investigation into it isrecommended.

4.5. Voluntary Agreements

A possible path to building consumers' goodwill lies in asking governmental bodies tomonitor one's environmental performance. Firms can sign agreements whereby theycommit themselves to improving their environmental records, in return for the possibility touse the government as a guarantee of environmental friendliness. Such voluntaryagreements (accordi di programma) are part of the Italian law, and are increasingly seen asa useful policy-making tool. The new waste disposal plan of the Lombardia region, forinstance, includes a series of agreements with such major waste producers as hotel andsupermarket chains, whereby the latter agree to source separate all their waste for recycling.These agreements are being much promoted on local media, and they are thought to helpbuild up the involved companies' green reputation [Cantoni, 1993].

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33

On a larger scale, in autumn 1991, the Italian car manufacturer Fiat signed anotheragreement with the Ministry of the Environment, committing itself to spending 23 billionlire (£10 million) on environmental improvements. The Italian government promisedincentives to the use of catalytic converter equipped-cars, which were launched a fewmonths later. This move by Fiat may be interpreted as an attempt to restore itsenvironmental credibility by a company to which green activists are becoming a nuisance16 .

It is very difficult to draw conclusions about the allocative efficiency of voluntaryagreements. Static efficiency, which could stem from Coasian bargaining, is endangered byinformation asymmetries on firms' marginal abatement costs; once agreements are reached,if many firms are involved there is a risk of free riding. However, as has been noted, thebargaining process itself helps build a consensus between firms and the government, sothat voluntary agreements end up "building trust" as a desirable side effect [Glachant,1993]. Like green consumerism, such agreements are relatively robust to organizationalfailure objections; on the other hand, they are inherently subject to regulatory capture17 .

4.6. Eco-Labeling

Eco-labeling involves an agency, often governmental, carrying out the environmentalfriendliness assessment and awarding a "green label" to the friendliest products. Thispolicy tool, intuitively appealing, appears to be flawed by a number of practical problems.The progress of the European eco-labeling scheme, officially approved in December 1991,provides some insights about the nature of these problems.

The first issue confronting eco-labeling schemes is that of defining the borders of productgroups. It is a relevant one: often, products that are (imperfect) substitutes differsignificantly in their degree of environmental friendliness. When carpets become waste,they leave behind synthetic fibres that must be burned, which is costly and can causepollution; ceramic tiles, by contrast, are simply inert baked clay and pose only an aestheticproblem. Clearly, if flooring materials are grouped within an eco-labeling scheme, eco-labels will tend to be awarded to ceramic tiles and not to carpets. This will give rise to inter-industry competition on environmental grounds. If, on the other hand, tiles and carpets areseparated, the competition will be of the intra-industry kind: consumers will be able to tell,say, lead-free glazed tiles from ordinary tiles, but will have no information as to theenvironmental impacts of alternative flooring solutions.

Assuming products can be sensibly grouped, the problem arises of selecting the criteria bywhich products can be assessed. The ideal instrument would be, of course, a cradle-to-grave cost-benefit analysis of each product; since this is, obviously, a very costly solution,existing schemes have taken shortcuts, with some paradoxical results. Under the German"Blue Angel" scheme lawnmowers and vacuum cleaners, the only criterion for theawarding of the label was noisiness, which is obviously an unsatisfactory definition ofenvironmental impact18 .

Once found, the criteria have to be weighed against each other, and in the case of multiplecriteria, a decision has to be made as to whether a product that falls short of the standard setfor one criterion should be denied the eco-label, regardless of a better-than-averageperformance under the other criteria. This is known as the "hurdle vs. decathlon" problem.

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34

Finally, a cutoff point has to be set to divide "green" products from other products. In thecase of the European scheme, industry lobbying resulted in an unofficial 10-20% target ofeco-labeled existing products; criteria will be set in such a way that 10 to 20% of existingproducts qualify for the eco-label.

It can be reasonably concluded that eco-labeling suffers from an inherent difficulty tocommunicate in an exceedingly simple way (a logic variable like the presence or absence ofa label on the package) to consumers complex information about the product'senvironmental impact. It also seems to be extremely vulnerable to regulatory capture19 .

4.7. Possible Consequences on Foreign Trade

An unrestricted foreign trade and global environmental protection are, traditionally,conflicting policy objectives. Banning or taxing polluting production processes in onecountry may simply lead to their relocation to other countries, with less strict environmentalpolicies. This move then only leads to a loss of competitiveness of the "environmentalist"country, with no reduction of the overall amount of pollution. Policy makers at the nationallevel are then confronted with international prisoner's dilemmas [Gatsios and Seabright,1989]; the political debate on many environmental issues, from the biodiversity conventionto European Community carbon and energy tax, has been characterized by such aprisoner's dilemma structure.

In principle, a tariff on environmentally unfriendly import could correct for the problem;but, as is well known, for the monitoring authority to distinguish between eco-tariffs andprotectionist tariff may get very difficult if such a principle were to be accepted. Inrecognition of such problems, GATT does not permit tariffs on environmental grounds.So, when American environmentalists tried to ban Mexican dolphin unfriendly tuna fish,they were denied the right to do so.

However, there is nothing stopping American environmentalists from boycotting Mexicantuna fish, or even lobbying their retail chains to cancel their contracts with Mexican fishingcompanies. A very similar operation was organized in 1992 against Norwegian products,to protest against the killing of 100 whales by Norwegian fishermen, exploiting loopholesin the International Whaling Convention. Campaigners organized a boycott of allNorwegian products, which resulted in the cancellation of several contracts. The siglelargest one was that between the American fast food restoration chain Burger King and theNorwegian fishing company Frioner, which used to supply Burger King its cod fingers.The move cost Frioner £5 million [Brown, 1993].

One hardly needs to point out that there is absolutely nothing GATT can do if consumers orretailers in one country refuse to buy foreign environmentally unfriendly products. In thissense, a well-led information based environmental policy may act as a nontariff barrier totrade, leading to a gain, rather than a loss, of competitiveness of the country in question.

Similar forces seem to be at work in the case of the Packaging Ordinance in Germany. TheGerman government introduced in 1991 the duty for retailers to withdraw the emptypackages of the goods they sell and for manufacturers to recycle them or, alternatively, toset up a collection and recycling system of packaging materials. German industry haschosen the second option; collection, sorting and recycling costs are now pre-paid to acompany called DSD (Duales System Deutschland); packages taking part in the circuit are

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35

recognizable by a Green Dot printed on them. However, it is still possible for any oneproducer to stay out of the DSD circuit, as long as they agree to recycle their packages.

The barrier to trade part of the story is that all German retail chains refuse to distributeproducts wihthout the Green Dot. A Green Dot must be applied for, and the package musthave certain technical characteristics (i.e. must be easy to recycle) in order to obtain it. So,German controlled DSD regulates, an in important sense , access of foreign goods to theGerman market by setting standards that they must meet in order to compete [Southern,1993]. One cannot help being reminded of the history of the powerful Deutsche Institutfuer Normung (DIN), which has admittedly been setting its standards in order to make theGerman market more difficult to access [Gatsios and Seabright, 1989].

36

Chapter 5

Conclusions And Indications For Further Research

5.1. Concluding Remarks

The idea that information plays an important role in determining the environmentalstrategies of firms seems to be a promising one. If it is accepted that beliefs regarding theenvironmental friendliness of certain substances and production processes form amongconsumers, for green consumerism to work it is no longer necessary that each consumercan carry out an environmental impact analisys of each product he or she buys: it is enoughthat the content of the product and its production technology are known. Environmentalistgroups are increasingly collecting and diffusing this kind of information in order to drivefirms to an environmentally friendlier behaviour. In turn, this pattern of behaviour maybear consequences for market structure; a very important one is that firms with a reputationfor environmental friendliness may enjoy an advantage over their competitors. This seemsto imply at least the possibility for environmentally aware firms to be as profitable, if notmore profitable, than their less careful competitors.

To a certain extent, this intuition seems to lend itself to some kind of formalization. Themodel developed in chapter 3 captures some of the features of this process: greeningproduction as an investment in "green reputation" is undoubtedly the most important ofthem. On the other hand, the model is wanting from many points of view: its most seriousshortcoming is its inability to take oligopolistic interaction into account.

If the theory of green consumerism is found to be useful to understand firm behaviour, andif the analitycal instruments to model it can be perfected, it follows that one of the ways todo environmental policy is by collecting and circulating information, and letting marketforces drive firms to an environmentally friendlier behaviour. For a number of reasons thathave to do with industry structure and firm visibility, it is unlikely that this model ofintervention can be applied to all industries, but it does not seem unreasonable that it couldplay a role in some.

5.2. Directions for Further Research

There is obviously a lot of work to be carried out if one wants the theory of greenconsumerism to develop into an useful tool for policy makers. However, the most urgentlines of research to add to it seem to four.

The first one concerns the development of a model which takes into account oligopolisticcompetition. Paba [1989] makes his (unformalized, although consistent with his empiricaldata) prediction of long-run efficiency rest on market share competition between firms. Theoptimal control model presented in chapter 3 can be extended in this direction only at theexpense of a sharp increase in its mathematical tractability. A more interesting approach, onwhich we have carried out some preliminary work, seems to be that of building a game in

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which "green" firms compete for market share with one another, and at the same time the"green" product competes with its nongreen counterpart. Such a model would helpunderstand under what conditions competition on environmental grounds is triggered; bycontrast, the model in chapter 3 depicts a stationary environment, in which the greenproduct is basically established.

The second line of research concerns the refinement of the policy instruments rangepresented in chapter 4. A careful investigation would certainly bring to light moreinstruments, as well as implementation problems and informational requirements of theexisting ones. A particularly promising approach seems to be that of reconstructing thehistory of consumer movements in the developed countries, and especially of the policymeasures taken by European governments in the sixties to encourage their development.

The third one concerns the "barrier to trade" features of information based environmentalpolicy. If the reasons of international competitiveness can really be partially reconciled withthose of environmental quality, new, politically acceptable ways of tackling old problemsmay be found. The strategies of environmentalist groups and their capability of buildingtemporary alliances with firms, especially retail firms, should be studied carefully.

Finally, some light should be cast over the cases in which solving information asymmetriesdoes not, in itself, drive the system towards an efficient solution. The theory of industrialorganization is full of perfect information models that display welfare losses of variouskinds, due to the structure of incentives facing agents. An analisys of these cases couldprove itself useful to the policy maker by providing him or her with a number of situationsin which information-based environmental policy cannot be expected to work, andtherefore a more conventional approach is recommended.

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Klein, B., and K. Leffler, 1981, "The Role of Market Forces in Assuring ContractualPerformance", Journal of Political Economy

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1A NBC Christmas show has recently asserted that Wal-Mart, America's largest clothingretailer, buys from Bangladeshi sweatshops where children as young as 9 are employed.This matter is causing vast embarassment to the company, and has already pushed toolsand building materials retailer Home Depot to take immediate action to spare itself similarproblems [Mc Cormick and Levinson, 1993]. The research work that led to the show hadbeen carried out by a trade union leader.

2"Two fiddles don't make a Stradivarius" [Rosen, 1974]

3Darby and Karni's implicit assumption is that consumers don't object to being cheated, aslong as the expected loss due to the fraud does not exceed the costs of preventing it. Thiscould be criticized on the grounds of the recent game theoretical developments on humanbehaviour, whereby individuals with a reputation for retaliation at all costs are neverwronged, and therefore never have to incur into the costs of retaliation [Frank, 1989].

4In the seventies, the Italian electric appliances manufacturer Zanussi built refrigerators andwashing machines. Part of the production was sold to consumers with the firm's ownbrand; another part, consisting of physically identical machines, was commissioned by theGerman firm AEG, which commercialized it with its own brand. The AEG-brandedappliances commanded, on the German market, a substantially higher price than theirZanussi-branded identical twins [Paba, 1989]. This can be explained in the light of thebrand name promotion approach: AEG, through higher level of sunk costs, was signallingmore credibly for high quality than Zanussi.

5The embryo of this idea can actually be traced back to Kaldor's [1950-51] work about thetransition of the American capitalism from a "wholesaler dominated" phase to a"manufacturer dominated" one.

6Much of the literature about business management practices, with its emphasis on qualitycontrol and corporate identity, seems to be in line with this intuition. See for exampleWaterman and Peters [1981?]

7"Reputation is a word that denotes the persistence of quality" [Stigler, 1961]

8Some preliminary work has been carried out to extend the model presented in this chapterto the symmetric duopoly case. The "open-loop" [Fudenberg and Tirole, 1986]precommitment Nash equilibrium conditions could not be solved without specifyingfunctional forms; the ideal choice of functional forms is, turns out to be quite a difficultproblem. We have chosen not to follow this line of research for the time being.

9This assumption is obviously unrealistic. Notorious polluters tend to stay in the crosshairof environmentalists: the Italian group Legambiente has even bought shares of some of thebiggest, most polluting companies in the country (including the car manufacturer Fiat); itcarries out monitoring of their environmental performance on a regular basis, and itsrepresentative turn up the each shareholders' meeting to demand a more careful

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environmental policy. Italian media such events sexy, and give them good coverage,causing major embarassment to the companies involved if their environmentalperformances are particularly poor.

10An evaluation of green reputation may be thought of as an assessment of the discountedflow of profits that will accrue to the firm from competing on environmental friendlinessgrounds.

11In the detergent market, the Belgian firm Ecover, mentioned in the introduction, providesan interesting example of firm response to such an incentive structure. Its much biggercompetitors would need an enormous financial effort to get the same environmentalistsimpathy and media coverage that Ecover gets with a 45-employees plant. In this sense,greening production seems to display true scale diseconomies as well as profiting from theabsence of sunk costs (noted in chapter 2).

12Baumol and Oates [1989] supply a clear and exhaustive discussion of market-basedinstruments, which include taxes, subsidies, tradeable permits, and their variouscombinations. In what follows, the terms "market-based instruments" and "eco-taxes" willbe used indifferently to signify the whole range of market-based instruments.

13Interestingly, this suggests that the much-criticized anticapitalism of environmentalistleaders may play a positive role: it could be a committment device against collusion witheither big business or government. As Frank [1989] has suggested, the best way toperform credibly an independent role is to be independent; lack of self-interest, then,brings about personal advantages. When we asked a Friends of the Earth spokesman if hedidn't think that the mahogany campaign implied that big firms are good for theenvironment (for they obviuosly couldn't target small firms), he answered "Oh, no, theyaren't. But we can use the bastards". It is straightforward that the answer translates as"yes"; our hypothesis is that admitting the positive role of big business in the greening ofindustry he would weaken the set of committment devices that make him a tough bargainerand a credible environmentalist leader. See Frank [1989] for a fascinating treatment of thecommitment problem.

14Coherently with Nelson [1974], Klein and Leffler [1981] and much of the tradition ineconomics, we assume that consumers are rational, and that their preferences cannot beshaped by advertising.

15The idea is that a fraction of consumers have read Consumer Report and know inadvance if the product is high quality or not. The (monopolistic) firm has to choosewhether to cater only for uninformed consumers, supplying low quality, or to cater for allconsumers, supplying high quality. It will decide for high quality if

p c p c− ≥ − −1 01( )( )

Where p is the price of the good, c0 and c1 denote the average cost of, respectively, lowand high quality and is the share of informed consumers. Clearly, the higher the morelikely to be satisfied this conditrion is. So, informed consumers should be subsidized forwhat they do.

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16The Fiat case also shows signs of heavy lobbying behind curtains. The company hadlong been opposing the introduction of compulsory catalytic converters on all cars in Italy,on the grounds that that would benefit European competitors and affect the trade balance. In1991 it was ready; government measures triggered a mini-boom of catalysed automobilesales in the spring of 1992, and Fiat, who had been building up stocks, could offercustomers shorter waiting lags than its competitors. Despite this, we believe that theagreement was also, and mainly, a signal to environmentally aware consumers.

17Regulatory capture is the other side of the "trust building" coin. Glachant's "French bias"is obvious in stressing the benefits of businessmen being close to government officials andnot its risks.

18In other examples, shortcuts work better. Under the European scheme, dishwashers andwashing machines are ranked on the basis of water consumption, energy consumption anddetergent dispersion. Experts stated that these three parameters summarize theenvironmental impact of this group of products during the use phase of the life-cycle,which accounts for more than 90% of the total environmental impact.

19Perhaps the most apparent sign of regulatory capture under the European scheme tookplace in the fields of detergents. In September 1992, twenty small producers, led by the"radical green" Belgian firm Ecover, left the European association of detergentmanufactures and associated in the Environmental Detergent Manufacturers Association(EDMA). They contend that major producers are unduly influencing the development ofecolabelling criteria, biasing them towards packaging and turning the attention away fromthe products themselves..

The Economics of Green consumerism (1993)

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