The merits of new pollutants and how to get them when patents are granted

The performance of market based environmental regulation is affected by patents and vice versa. This interaction is studied for a type of innovation where a new technology reduces emissions of a specific pollutant but at the same time causes a new type of damage. If the new pollutant associated with this technology is sufficiently different from existing ones such that marginal damage is increasing in each of them but additive across pollutants, a diversification of the pollution portfolio is socially desirable. In a situation where the incentives to develop such a technology are created by patents, the efficiency of permits is affected by monopoly pricing of the patent-holding firm. This result carries over to other types of innovation. The performance of taxes is limited by either the inability to implement specific pollution mixes or monopoly pricing. For constant returns to scale at the industry level the combined use of taxes and permits ensures the first best mix of technologies and provides positive research incentives.