Environmental policy in a linear city model of product differentiation

This paper analyzes how a tax/subsidy policy affects consumers' behavior when choosing between green (pollution-free goods) and conventional products, and its effects on welfare when a proportion of consumers have strong preferences for green goods. We analyze a Hotelling's linear city model where final products by two firms are symmetric in all dimensions except for the externality their production process generates. Our efficiency comparisons suggest that, under a setting of horizontal product differentiation, an environmental regulation (either on polluting firms or consumers buying their products) yields higher social welfare than the absence of policy. Moreover, the proportion of consumers who prefer green products affects the welfare gains from a subsidy or tax policy.