The effects of environmental quality misperception on investments and regulation

This paper analyzes whether consumers' misperception on the quality of the product influences firms' investment choices. We examine a setup with horizontal and vertical (green) differentiation, where consumers are heterogeneous in the exogenous perception of environmental quality. Demands, true qualifies and profits are increasing in the perception of higher quality, while the investment in green quality is high for high and low degrees of product substitutability. We further consider the introduction of either an emission tax or an environmental standard. Both interventions increase the investment in green quality. We show that for low marginal damages, the environmental standard increases quality, while taxation is more effective when the environmental damage is large.