The Inefficiency of Private Adaptation to Pollution in the Presence of Endogeneous Market Structure

The paper considers an industry where the effects of pollution can be off-set by investing in adaptation as a private good. The focus is not on external effects, but on economies of scale that are introduced when the costs of adapting to pollution are independent from the quantity produced. The structure of the resulting oligopolistic market is endogenous in the model, since adaptation expenditures are like fixed costs in production, but the amount of these expenditures is itself a choice variable for the firms. The analysis of externalities usually disregards defensive or adaptation measures, with a few exceptions that indicate considerable complications. The present debate on adaptation to climate change yet shows the importance of understanding defensive measures. Is there a case for governmental action in private adaptation? It is shown that market failure caused by private adaptation leads to production costs above the social optimum, i.e. to under-adaptation. When pollution increases, adaptation only increases if demand is inelastic. Only then welfare loss from market failure increases. Total welfare loss from pollution is only convex if demand is inelastic and the influence of pollution on production costs is stronger than the influence of adaptation.