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Environmental regulation and innovation

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The paper considers a case in which the threat of environmental regulation can be used by a government to induce a domestic firm to engage in a socially desirable product-development effort. We use a stochastic game to show that even if the government is restricted to Markov strategies, a non-trivial, self-enforcing incentive scheme can be devised. More efficient outcomes can be implemented by equilibria using strategies that condition on the payoff-irrelevant history. An example of such an equilibrium is given.

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