The Impact of Innovation on a Polluting Firm's Regulation Driven Decision to Upgrade its Capital Stock

The extant literature has paid scant theoretical attention to the tripartite interaction between increasing environmental regulations, the resulting decision by a polluting firm to upgrade its capital stock, and the impact of innovation on this capital stock improvement decision. Hence, we theoretically analyze this tripartite interaction when the polluting firm faces adjustment costs to upgrade its capital stock. First, we construct a dynamic model of regulation driven investment by a polluting firm. Second, we specify the conditions characterizing efficient investment. Third, we study the impact of an unanticipated increase in innovation on the polluting firm's steady state capital stock. Fourth, we analyze the impact of an anticipated increase in innovation on the polluting firm's steady state capital stock. Finally, we discuss the relationship between the polluting firm's internal shadow price of capital and the stock market value of a unit of this firm's capital