A paler shade of green: Environmental policy under induced technical change

Conventional wisdom argues that environmental policy is less costly if it induces the development of cleaner technologies. In contrast to this argument, we show that once the second-best nature of actual economies is taken into account, the cost of environmental policy may well be larger with induced technical change (ITC) than without. Thus, ITC may lower both the emissions reductions and the welfare gains associated with environmental policy. In an endogenous policy framework, ITC may reduce the desired stringency of the policy.