The controversy that followed when Porter and van der Linde first presented their hypothesis some 25 years ago has given rise to several different theoretical approaches to explain the Porter hypothesis. These theories include behavioral arguments, market failures (market power, asymmetric information, research and development spillovers), and organizational
145 Porter and van der Linde, 1995, p. 100
146 Porter and van der Linde, 1995, p. 101
147 Porter and van der Linde, 1995, p. 101
87 failure148. The different theories will briefly be presented before we present the one in which will be the basis for further analysis.
6.4.1 Behavioral arguments
The theory that supports behavioral arguments stems from behavioral economics literature.
This theory rests on the assumption that the rationality, and thus the decision making, of the firm are controlled by the manager(s), which have motives and goals that does not necessarily coincide with profit maximization149. The reasons for this behavioral difference may be that managers are risk averse, resistant to costly change, or simply rationally bounded to choose the profit maximizing option (e.g. lacking information or the ability to take the optimal action)150. All of these deviations will result in missed investment opportunities due to risk, cost, or simply that it is outside the manager’s rationality.
6.4.2 Market Failures
The second way of providing a theoretical basis for the Porter Hypothesis is to assume the existence of market failure. By introducing market failure, one can still proceed with the notion that the firm is profit maximizing in addition to the environmental externality problem.
The market failure theory, unlike the behavioral argument presented in the previous section, allows the firm to be profit maximizing. Thus, it is market failure that prevents the firm from pursuing all profitable opportunities. In such a case, environmental regulation can, at least partially, help firms to overcome this. Market failure can arise in different forms which will be presented in this section.
The first form of market failure is market power. Imperfect competition among firms may distort the function of the market. In 1996, Simpson and Bradford showed that when there is imperfect competition among firms, the state could provide a strategic advantage to domestic firms vis-à-vis international competitors by introducing stringent environmental regulation151.
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151 Simpson & Bradford, 1996, p. 284
88 The result popularized the idea that a country (or a firm) can benefit from being a first-mover in becoming green152.
The second form of market failure is asymmetric information. The main emphasis is on asymmetric information regarding the environmental quality of products, which can create a
“market for lemons” where dirty (bad) products phase out clean (good) products due to lack of information. George Akerlof proposed this theory in 1970 where he exemplified the problem with the used car market. A similar example can be made of the salmon market and the toxic level of salmon. A buyer of salmon will not be able to know the difference between a clean salmon (with low levels of toxins) and a dirty salmon (with high levels of toxins).
Suppose further that buyers generally are willing to pay a higher price for the clean salmon.
The problem arises because the seller knows whether or not the salmon is clean, and thus worth more. The buyer, however, cannot distinguish between a clean and dirty salmon, and will therefore only be willing to pay the average price of a clean and dirty salmon. The result is that sellers will stop producing clean salmon because 𝑃𝑐𝑙𝑒𝑎𝑛 > 𝑃𝑎𝑣𝑒𝑟𝑎𝑔𝑒. Thus, only “dirty”
salmon is produced in such a situation. Regulations such as putting green labels on clean products can help consumer awareness and at least partially fix the asymmetric information problem.
Another type of asymmetric information problem is when there is a lag between the time firms invests in green products and the time where consumers recognize that the product is in fact green153. According to Constantatos and Herrmann, a firm that unilaterally adopts the green product loose profits due to a) increased cost and b) reduced market share. The authors argue that the government by imposing simultaneous adoption eliminates b), thus increasing long-run profitability of the adoption. Thus, regulations can correct that there exists a first-mover disadvantage.
The third type of market failure is R&D spillovers. This theory relates to the public good nature of knowledge154, which R&D in many instances is. Mohr set up a model in which each
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153 Constantatos and Herrmann, 2011
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89 agent (firm) in the industry would like to apply the new technology, given that enough other firms did it first155. The reason is that the new technology imposes short-term costs, consistent with the Porter Hypothesis156. Thus, there exists a second-mover advantage because the first-movers incur the short-term costs of adopting the technology. That is, the knowledge
accumulated by the first-movers is a public good which decreases the cost for second-movers.
Thus, Mohr found that when the return on a firm’s R&D investments is partly captured by competitors, firms generally underinvest in environmentally friendly technology157. In addition, Mohr argues that environmental policy which favors or requires the use of new
“cleaner technology” can improve environmental quality and perhaps increase the long-run productivity158.
6.4.3 Organizational Failure
Part of the literature on the subject has theorized that so called “organizational failure” can reconcile the Porter Hypothesis and the assumption that firms are profit maximizing
entities159. Porter and van der Linde did themselves argue that the process of dynamic competition contains highly incomplete information, organizational inertia and control
problems160. Thus, the literature helped formalize the argument that environmental regulation may help overcome organizational inertia. An example of organizational failure is when managers have private information about the cost of new technologies that might enhance both productivity and environmental performance161. Managers can then use this information opportunistically to extract some rent from the firm. Regulation will in this instance be beneficial for the firm if the rent saved exceeds the cost of complying with regulations.
Therefore, regulation can help the firm overcome the informational disadvantage vis-à-vis the manager.
155 Mohr, 2002, p. 160
156 Mohr, 2002, p. 162
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158 Mohr, 2002, p. 162
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160 Porter and van der Linde, 1995, p. 99
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