Free-Market Incentives for Innovation: A Closer Look at the Case of Pollution Control

Dynamic considerations are often advanced as an important reason to prefer free markets to command-and-control policies. This paper takes a closer look at the theoretical support for this claim in the area of pollution control in competitive markets, where market-based instruments such as Pigovian taxes are argued to provide stronger incentives for innovation than direct controls. Counter to established theory, we find that commonly used forms of direct control—such as limits on emissions per unit output—can provide greater incentives for innovation than Pigovian taxes. After providing a numerical example of this result, we identify general conditions under which dynamic considerations do favor market-based instruments for environmental protection.