Absorptive Capacity, R&D Spillovers, Emissions Taxes and R&D Subsidies^* Available to Purchase

In this paper, we consider a duopoly competing on quantity, where firms can invest in R8D to control their emissions. We distinguish between efforts carried out to acquire first-hand knowledge (inventive R8D) and efforts made to develop an absorptive capacity to be able to capture part of the knowledge developed by the rival. There are also free R8D spillovers between firms. To reach the first best outcome, the regulator uses three instruments, namely, a per-unit emissions tax, a per-unit inventive-research subsidy, and a per-unit absorptive-research subsidy. The socially optimal investment cost in inventive R8D is always higher than that in absorptive R8D. Interestingly, when the free spillover is high enough, the regulator gives a greater per-unit subsidy for inventive research, and when it is low enough and the marginal damage cost of pollution is sufficiently high, the regulator supports absorptive research to strengthen R8D spillovers. Moreover, inventive research is actually taxed when the free spillover is low and the marginal damage cost of pollution is high.