Regulation, innovation, and firm selection: The porter hypothesis under monopolistic competition

Abstract

The Porter Hypothesis (PH) posits that well-designed environmental regulations can stimulate innovation, which may lead to efficiency gains or even profit increase in regulated firms. In this study, we revisit the PH under monopolistic competition by incorporating two important features in our model and analysis, namely, firm heterogeneity and general equilibrium. We show that the PH holds for high-capability firms, but not for low-capability firms. Heterogeneous responses exist in innovation investment, but the average industry productivity increases. We obtain an interesting finding that adds a new feature to the PH. This finding indicates that strict environmental regulations can encourage firm entry and exit, thereby improving the composition of firms in the regulated industry.