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Working Paper 93.2010, Sustainable Development Series, Fondazione Eni Enrico Mattei, Milan Acemoglu, Daron, Philippe Aghion, Leonardo Bursztyn, and David Hemous, 2010

A theoretical framework of economic growth is derived to study the response of technology to environmental degradation and environmental policy, finding long-run growth to be achievable using clean technology provided that inputs are substitutable, policy involves taxes and subsidies, and action is immediate and decisive.

The concern over climate change is growing, sparking debate and critical analysis of technological alternatives. Economic analysis of the potential of these alternatives usually takes the level of technology as given. This paper identifies a shortcoming in economic research and fills the gap in the literature by building a framework wherein technological change is a response to environmental policy.

The authors are motivated by a better understanding of how environmental policy can trigger changes in technology to end or reverse environmental degradation. This theoretical framework is meant to guide future quantitative research.

Consider an economy of two sectors, each producing an input for a final good. One sector uses clean technology while the other uses ‘dirty’ technology, which leads to environmental degradation. Initially, the dirty sector is more technologically advanced. Researchers earn profits by developing better quality technologies for one sector or the other. Two effects govern technological change. First, the market effect which pulls innovation towards the sector which uses the most inputs. Secondly, the price effect which pulls innovation towards the sector with the highest prices. The influence of these effects will depend on how developed each sector’s technology is, whether it uses an exhaustible resource, and how easily the sectors’ inputs can be substituted for one another.

The framework predicts that an absence of policy intervention will lead to environment disaster. If inputs are easily substituted for each other, market effects would draw innovation and production to the dirty sector, and degradation would ensue. Conversely, even modest changes in environmental policy could redirect research towards clean technology. Since research builds on the findings of prior research, innovation in clean technology need only be sufficiently advanced for market effects to kick in and draw in further innovation into the clean sector. The change in policy could, therefore, be temporary. While the solution seems straightforward, there are costs in delaying implementation. Delays “widen the gap between dirty and clean technologies, thereby inducing a longer period of catch-up with slower growth”, not to mention the cost of environmental degradation in the meantime.

Government policy could manifest itself as either a carbon tax or subsidization of research, but the optimal policy is found to be a mix of both taxes and subsidies. The notable exception is when the dirty sector uses an exhaustible resource in its production. The resource will become more expensive as it becomes scarce, motivating the sector to invest in the research and development of clean technologies. Dubbed the ‘laissez-faire’ approach, the optimal solution of long-term economic growth without environmental degradation is achieved without policy intervention.

The framework demonstrates that the transition to clean technology can lead to sustainable long-run growth. However, this result has hinged on the ability to substitute goods from one sector for another. If goods are complementary rather than substitutable, then the market for ‘dirty’ inputs will persist and environment disaster can be avoided only by stopping long-run growth. Finally, the authors remark that although the framework is optimistic about clean technology, policy-directed technological change requires immediate and decisive action.