Optimal regulation and sustainable product design under uncertainties

Abstract This paper studies the impact of environmental regulations on the design decisions of auto manufacturers. In a duopolistic setting, each manufacturer determines the price as well as the level of fuel economy and acceleration capability of its vehicle. The manufacturers are subject to environmental regulations, and the government determines the level of greenhouse gas emissions each vehicle is allowed to produce. Depending on the realization of the uncertainties during the design phase, if the emission level of a vehicle exceeds the emission standard, the manufacturer also incurs an additional retrofitting cost. We find that when the customers are less price-sensitive, then high intensity of competition on vehicle acceleration induces the regulator to impose strict emission norms. Therefore, firms design low acceleration, low power vehicles. However, if customers are price-sensitive, then high vehicle acceleration competition leads to relaxed emission norms. Here, firms design high acceleration, low mileage vehicles.