Green, greener, greenest: Eco-label gradation and competition

Journal of Environmental Economics and Management 72 (2015) 164–176

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Green, greener, greenest: Eco-label gradation and competition Yuanhao Li, Klaas van 't Veld n Department of Economics & Finance, University of Wyoming, 1000 E. University Ave., Laramie, WY 82071, United States

a r t i c l e in f o

abstract

Article history: Received 7 February 2014 Available online 22 May 2015

This paper analyzes two common features of markets in which eco-label programs certify that products are “green”: gradation—single programs offering multiple certification standards (e.g., platinum, gold, silver)—and competition—multiple programs vying to certify to their respective standards. We find that, depending on whether programs are sponsored by industry, environmental groups, or a government, they have strikingly different incentives to grade or compete. Industry sponsors are indifferent about both; environmentalist sponsors optimally grade or compete with other environmentalist sponsors only if consumer preferences for green consumption are skewed in a specific way; and government sponsors' decisions depend on the relative importance of private vs. public benefits generated by the green market. We find also that it is no accident that green markets frequently have an environmentalist program competing with an industry one. For each of the cases examined, our analysis is consistent with casual empirical evidence. & 2015 Elsevier Inc. All rights reserved.

Keywords: Eco-labels Green markets

Introduction Because claims of environmental friendliness are often hard for individual consumers to verify, markets for many “green” products rely on eco-label programs to certify such claims. Typically, these programs certify—in exchange for a fee—that a firm's product meets a given environmental-performance standard determined by the program, and then allow the firm to feature the program's eco-label on its packaging or advertising materials. In some markets, a single program offers multiple, graded levels of certification, thereby offering green producers a choice of standards of environmental friendliness to try and meet. Hereafter, we refer to this as eco-label gradation. Examples are the four different certification levels of organic content offered by the US Department of Agriculture (USDA) Organic program; the Platinum, Gold, Silver, and Certified levels offered by the Leadership in Energy and Environmental Design (LEED) program; and the essentially continuous range of certified-forest content levels offered by the Sustainable Forestry Initiative (SFI) program. In other—and sometimes the same—markets, multiple programs offer to certify to their respective standards, thereby expanding green producers' options in a manner similar to gradation. Hereafter, we refer to this as eco-label competition.1 In a number of major markets, the competition is between a program sponsored by a non-profit organization—typically an environmentalist group—and a program sponsored by an industry association. Well-known examples are the forest-products market, in which the

n

Corresponding author. Fax: þ1 307 766 5090. E-mail address: [email protected] (K. van 't Veld). 1 Importantly, as we shall see, the existence of other programs in a market need not hurt, and may even help, a given sponsor's objective. In such cases, eco-label “competition” may exist only from the viewpoint of producers and consumers, since, just as in the case of graded eco-labels, they now face a choice between green options. http://dx.doi.org/10.1016/j.jeem.2015.05.003 0095-0696/& 2015 Elsevier Inc. All rights reserved.

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environmentalist Forest Stewardship Council (FSC) program competes with the industry SFI program; the building market, in which the environmentalist LEED program competes with the industry Green Globes program; and the ski-resort market, in which the environmentalist Ski Area Citizens' Coalition (SACC) program competes with the industry Sustainable Slopes program. In this paper, we investigate the implications of both eco-label gradation and competition. To do so, we modify and extend the “green clubs” model of van 't Veld and Kotchen (2011), which uses elements of club theory to examine how eco-label programs sponsored by industry, environmentalists, and government might be expected to differ. Whereas van 't Veld and Kotchen assume that both firms and consumers are homogeneous, however, which leaves no scope for eco-label gradation or competition, we make both sides of the market heterogeneous. Specifically, we assume that firms face differing costs of switching from conventional to green production, while consumers place differing weights on the private (e.g., “warm glow” or health) benefits of green consumption. On the demand side, this makes our model quite similar to standard models of vertical product differentiation. On the supply side, however, our model is quite distinct, both because individual consumers cannot easily verify environmental quality, so that firms have to rely on eco-label programs to set and certify the environmental quality standards to which they produce, and because green consumption gives rise to public environmental benefits, which different eco-label sponsors care about differently. Using this model, we first consider the three sponsor types separately. For each type, we compare a situation where the sponsor's program offers only a single certification standard and faces no competition (the “single-standard” case) to a situation where it either offers graded standards, or competes with other programs of the same sponsor type that offer different standards (the “multiple-standard” case). We find that industry sponsors are completely indifferent between these two cases. This is because, at any interior equilibrium with multiple standards, all firms are indifferent about which standard to adopt. All that matters to the firms, and thereby to any industry sponsor, is that at least one standard is set at the level that maximizes the green market's size, since that also maximizes firm profits. Environmentalist sponsors, on the other hand, may strictly prefer multiple standards to a single one. Whether they do depends on consumer preferences, and more specifically on how willingness to pay (WTP) for green goods is distributed across consumers. What matters thereby is the skew—not the variance or range—of the WTP distribution. If this distribution is either close to uniform or skewed towards high WTP, then having a single standard is optimal; if, however, the distribution is sufficiently skewed towards low WTP, then having multiple standards is preferable. Underlying this is a quantity–quality tradeoff. If relatively many consumers are “light green,” i.e., willing to pay only slightly more for environmentally friendly products, then drawing those consumers into the green market with a cheap, low-standard label may generate significant environmental benefits. It may do so, moreover, without inducing much defection by “deep green” consumers from a second, high-standard label. Lastly, although government sponsors rarely compete, they may prefer graded standards. The determining factor here is the relative importance of private (consumer surplus and profit) vs. public (environmental) benefits generated by the green market. If private benefits dominate, then graded standards are optimal; in the limit, welfare is maximized by offering each consumer a product tailored to her “ideal” standard. If public benefits dominate, then the government optimum in the limit approaches that of environmentalist sponsors. Graded standards then maximize welfare only if consumer preferences skew towards low WTP. We conclude our analysis by examining competition between environmentalist- and industry-sponsored programs. Consistent with the prevalence of such competition, our model predicts that the two programs will coexist, both if they set their standards simultaneously (i.e., in Nash equilibrium) and if one or the other program can commit to its standard first (i.e., in Stackelberg equilibrium). Each program prefers to enter a market in which the other program operates, but each finds it sub-optimal to drive the other program out. Literature review The theoretical literature on eco-labels has mostly ignored the phenomena of eco-label gradation and competition, by considering only situations in which a single eco-label program certifies to a single standard. The focus has thereby been on firm incentives to adopt an eco-label under different market structures (Bagnoli and Watts, 2003; Amacher et al., 2004); implications of imperfect monitoring of the standard (Kirchhoff, 2000; Hamilton and Zilberman, 2006; Ibanez and Grolleau, 2008; Mason, 2011); implications for international trade (Beaulieu and Gaisford, 2002; Tian, 2003; Basu et al., 2004; Greaker, 2006; Robertson, 2007); and potential perverse effects (Mattoo and Singh, 1994; Swallow and Sedjo, 2000; Dosi and Moretto, 2001; Sedjo and Swallow, 2002; Bougherara et al., 2005). Studies that do consider multiple standards have generally not modeled how eco-label sponsors choose the set of standards that they offer to certify. In Kirchhoff's (2000) terminology, the standards are either fully “endogenous,” i.e., left up to individual firms to choose2 (Conrad, 2005; Ben Youssef and Abderrazak, 2009), or fully “exogenous” and unexplained in the model (Harbaugh et al., 2011). We are aware of only three studies that do explicitly consider optimal standard setting by competing eco-label programs: Nimon and Beghin (1999) and Fischer and Lyon (2014a,b). Nimon and Beghin consider trade between two countries, each with its own, government-sponsored eco-label. They examine the welfare consequences of eco-label “harmonization,” i.e., a negotiated 2 Implicitly, firms either self-certify their chosen standard, or have access to an eco-label program that will certify whatever standard any given firm might choose.

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reduction in the difference between the two countries' standards. Fischer and Lyon's two studies are closest to our own, in that they, too, examine competition between environmentalist and industry labels. Fischer and Lyon's (2014a) framework in some ways complements ours: where we assume heterogeneity of consumer preferences and heterogeneity of firms' fixed, but not variable costs of green production, they assume the opposite, i.e., homogeneous consumer preferences and heterogeneity of only firms' variable costs. Their framework gives rise to complexities—including discontinuities in the environmentalist and industry programs' best-response functions to each other's standards—that make their model intractable analytically. Simulations show that counterintuitive equilibria are possible in which the environmentalist program sets a lower standard than the industry one; no such equilibria arise in our model. Additionally, they find that competition drives the two programs' standards apart; we find that it induces the environmentalist program to set a standard closer to the unchanged standard of the industry program. Fischer and Lyon's (2014b) framework adds consumer heterogeneity and the possibility of two-tier standards, but allows for just two firm types: those with high costs of meeting any given standard, and those with low costs. These assumptions again lead to very different results from ours. Whereas we find that environmentalist and industry programs coexist in equilibrium, Fischer and Lyon's framework permits coexistence only in the short run, or in the presence of some entry barrier. They again find also that, if the programs do coexist, the environmentalist program may set a lower standard than the industry one. In a sequel to this paper, we hope to integrate Fischer and Lyon's frameworks with our own. It should be noted that, although we state above that markets for many green products rely on eco-certification “because” claims of environmental friendliness are often hard for individual consumers to verify, certification is strictly speaking not necessary to overcome the asymmetric information problem. Sengupta (2012, 2015), building on earlier work in the industrial organization literature (Bagwell and Riordan, 1991; Daughety and Reinganum, 2007, 2008; Janssen and Roy, 2010), shows that firms may be able to signal their environmental quality through their prices if consumers (i) have sufficient information about firm costs and market demand conditions, and (ii) form particular beliefs if they observe nonequilibrium prices. The information and out-of-equilibrium beliefs are required to reduce the multiplicity of equilibria common in signaling games (Cho and Kreps, 1987). Model Consider a market with N firms that each produce a single unit of a consumption good, using either a conventional or a “green” production technology. Letting θ denote the level of environmental friendliness of the green technology, the cost of production using that technology is assumed to be higher by αθ for all firms, with α being a constant. For firms to be willing to adopt the green technology, the green version of the good must therefore fetch a price premium p over the conventional version. Because it is hard for individual consumers to verify claims of environmental friendliness, and because we assume that conditions for a signaling equilibrium are not in place, consumers are willing to pay that price premium only if the good is certified by an eco-label program.3 Certification is costly, however. To cover these costs, the program charges each firm it certifies a constant fee c.4 To introduce some degree of firm heterogeneity, we assume that when firms produce the green version of the good, they incur a firm-specific cost s over and above the additional production cost αθ and the certification fee c.5 Writing s as an increasing function of an index variable x on ½0; N makes it easy to think of ordering firms by increasing s, by lining them up in order of that index variable. Ordering firms by increasing x then also implies ordering them by increasing overall cost of producing the green good, αθ þ sðxÞ þc. In a situation where a single eco-label program certifies a single environmental 3 We do not explicitly model how eco-label programs overcome their own credibility problem, i.e., what incentives they have to properly monitor and enforce their standards. This problem is not unique to eco-label programs; it applies to all kinds of auditors, including for example accounting firms. Key to overcoming it is the observation, first made by Klein and Leffler (1981) in their seminal analysis of self-enforcing quality claims and by DeAngelo (1981) and Wilson (1983) in their analyses of the accounting industry, that establishing credibility is subject to economies of scale. Because of this, large auditors can essentially “rent out” their credibility to small firms. Auditors can play this role if evaluating the claims in question is not literally impossible (else auditing would be impossible too) but merely too costly for individual clients of the firm—consumers or investors—to bother with. Cheating will then come to light only if external agents (e.g., whistleblowers, investigative journalists, or watchdog groups) expose it. The probability of this happening may be low, however, for claims made by a single, small firm. Moreover, even if cheating is exposed, the probability may be low that word of it will spread to many of the firm's clients. Crucially, both probabilities are likely to be higher for claims made by a large auditor, both because it presents a larger “target” for investigations and because reports of it being found cheating are more likely to get media attention. Mathematically, cheating is suboptimal if qV 4ð1  qÞg, where q is the per-period probability of cheating being detected and word of it spreading, V is the present value of future profits then lost, and g is the one-period gain from cheating if it goes undetected. For a small firm, this condition may well fail, making its quality claims non-credible. A large auditor, however, can be thought of as a set of n firms that collectively make the same claim, and that stand to lose their collective profits if cheating on that claim is detected. Provided qV increases faster in n than ð1 qÞg, there will be some minimum n above which cheating becomes suboptimal and auditing self-enforcing. It is interesting to note in this regard that the eco-label industry features “auditors of auditors”: eco-label programs can themselves get certified by the ISO 14024 program or the ISEAL Alliance. Similarly, the American Institute of CPAs plays a role as auditor of US accounting firms. 4 By treating c as constant rather than eventually increasing in the number of firms certified by a program, we abstract from the congestion externality analyzed by van 't Veld and Kotchen (2011). 5 Various interpretations of s are possible. We think of it as a firm-specific switching cost, i.e., a cost of “retooling” to adopt the green production technology, which may depend on the firm's pre-existing physical or human capital.

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standard θ, this yields an ordinary, upward-sloping aggregate supply curve. Moreover, since each firm by assumption produces just one unit, the index of the last firm willing to produce the green good also equals the number of units of the green good supplied, denoted ns. The profit of this marginal firm is by definition

π ¼ p  αθ  sðns Þ  c ¼ 0:

ð1Þ

Demand for the good comes from N consumers, who each consume a single unit of the consumption good. If they choose to consume the green version of the good, they receive a private benefit f ðθÞ over and above whatever benefit they receive from the conventional version. In addition, all consumers, even those who do not themselves buy the green good, receive a public (environmental) benefit gðΘÞ, where Θ denotes the aggregate green consumption of all consumers combined. We assume f ðθÞ and gðΘÞ are both strictly increasing and strictly concave, with f ð0Þ ¼ gð0Þ ¼ 0. To introduce consumer heterogeneity, we assume that consumers place different weight γ on the private benefit f ðθÞ they receive from consuming the green good. Writing this γ weight as a declining function of an index variable y on ½0; N makes it easy to think of ordering consumers by declining γ, by lining them up in order of that index variable. Ordering consumers by increasing y then also implies ordering them by declining willingness to pay for the green good, γ ðyÞf ðθÞ. In a situation with a single certified standard θ, this yields an ordinary, downward-sloping aggregate demand curve. Moreover, since each consumer by assumption consumes just one unit, the index of the last consumer willing to purchase the green good also equals the number of units of the green good demanded, denoted nd. The consumer surplus of this marginal consumer is by definition CS ¼ γ ðnd Þf ðθÞ  p ¼ 0:

ð2Þ

Several of our results depend on the shape of the aggregate demand curve for the green good. This shape in turn depends on how the utility weight γ—hereafter referred to as the “warm-glow weight”—is distributed in the population. If the distribution of γ is uniform, then both the γ ðyÞ function and the aggregate demand curve are linear. If alternatively the distribution is skewed towards low (high) weights, implying that disproportionally many consumers care only a little (a lot) about green consumption, then both the γ ðyÞ function and the demand curve are convex (concave).6 Let n  ns ¼ nd denote the equilibrium quantity traded of the green good, at the market-clearing premium p. We then have from combining (1) and (2) that in market equilibrium

γ ðnÞf ðθÞ  αθ sðnÞ  c ¼ 0: This condition implicitly defines a relationship nðθÞ between the standard θ set by the eco-label program and the number of firms n that adopt its standard in equilibrium. Hereafter we refer to n or nðθÞ as the “size” of the label. Note for later reference that 0

dnðθÞ γ ðnÞf ðθÞ  α : ¼  γ 0 ðnÞf ðθÞ þs0 ðnÞ dθ

ð3Þ

Consider next a situation in which either a single program offers two standards, or two competing programs each offer a h ℓ single standard. Let θ denote the (weakly) higher standard and θ the lower one. Also, let ph and pℓ denote the h ℓ corresponding price premia, n and n the corresponding label sizes, and n ¼ nh þnℓ the aggregate size of the green market. Given our assumptions about firm heterogeneity, an equilibrium in which both nh and nℓ are positive then requires that ℓ

ph  αθ ¼ pℓ  αθ ; h

ð4Þ

making all firms indifferent about which label to adopt.7 In particular, the marginal, n-th firm to adopt either label gets profit

π h ¼ ph  αθh  sðnÞ c ¼ 0

ð5Þ

if it adopts the high-standard label, and profit

π ℓ ¼ pℓ  αθℓ  sðnÞ c ¼ 0

ð6Þ

if it adopts the low-standard one. The two conditions combined imply (4). On the demand side, a consumer with index y prefers the high-standard label over the low-standard one if her consumer surplus from the former: CSh ¼ γ ðyÞf ðθ Þ ph ¼ γ ðyÞf ðθ Þ  αθ sðnÞ  c; h

h

h

ℓ

ℓ

exceeds that from the latter: ℓ

CSℓ ¼ γ ðyÞf ðθ Þ pℓ ¼ γ ðyÞf ðθ Þ  αθ  sðnÞ c: 6 Let Hðγ Þ denote the distribution of γ, and hðγ Þ the associated density function, assumed to be monotonic. We then have y ¼ Nð1  Hðγ ÞÞ, which when inverted becomes the γ ðyÞ function. It follows that γ 0 ðyÞ ¼  1=ðNhðγ ÞÞ o 0, which makes the demand curve linear if H is uniform, since then h is a constant. 0 Also, γ ″ ðyÞ ¼  h ðγ Þ=ðN 2 hðγ Þ3 Þ, which makes the demand curve convex (concave) if H is skewed towards low (high) γ values, since then h declines (increases) with γ. h ℓ 7 If we had ph  αθ 4ð o Þ pℓ  αθ , then any firm, regardless of its index x, would prefer the label with the high (low) standard, implying that the other label would find no adopters.

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Fig. 1. Consumer surplus at an equilibrium with two labels.

As illustrated in Fig. 1, this is true of consumers with relatively high warm-glow weights. Specifically, since γ 0 ðyÞ o0, it is true ℓ h of consumers with index y less than or equal to nh ðθ ; θ Þ defined implicitly by CSh ¼ CSℓ , or equivalently by

γ ðnh Þf ðθh Þ  αθh ¼ γ ðnh Þf ðθℓ Þ  αθℓ :

ð7Þ

Consumers with lower weights buy the low-standard label, provided their surplus from doing so is positive. Using (6), we ℓ h ℓ find that this is true for all consumers with index y greater than nh ðθ ; θ Þ but less than or equal to nðθ Þ, defined implicitly by ℓ

ℓ

CSℓ ¼ γ ðnÞf ðθ Þ  αθ sðnÞ  c ¼ 0:

ð8Þ ℓ

As a result, the labels end up being of sizes n and n ¼ n  n . ℓ h Importantly, the two standards can coexist over only a limited range of ðθ ; θ Þ combinations, namely those for which h ℓ h ℓ h ℓ n ðθ ; θ Þ A ð0; nðθ ÞÞ. Only then is CS 4 CS for some strictly positive range of consumers, while CSℓ 4CSh for some other strictly positive range. In panel (a) of Fig. 2, these combinations fall in the white area above the 451 line. In the dark-shaded area, only the high-standard label survives, because CSh 4 CSℓ for all relevant consumers (namely all those willing to buy from at least one of the labels). Conversely, in the light-shaded area, CSℓ 4CSh for all relevant consumers, so only the lowstandard label survives.8 b , which play a key role in our analysis below. At standard θ
, the Also shown in panel (a) are critical standards θ
and θ horizontal intercept of any CS curve is maximized, and thereby the size of the green market. From (3), this is true when γ ðnðθÞÞf 0 ðθÞ  α ¼ 0. At standard θb , the vertical intercept of any CS curve is maximized. From expression 0 b. CSð0; θÞ  γ ð0Þf ðθÞ  αθ  sðnÞ  c for this intercept, this is true when γ ð0Þf ðθÞ  α ¼ 0. Since γ ðyÞ is decreasing, θ
o θ ℓ h h ℓ ~
Panels (b) through (d) show how CS compares to CS as θ is fixed at an arbitrary value θ below θ , while θ is gradually h ℓ h increased. At point 1 in panel (a), where θ ¼ θ ¼ θ~ , the CSh and CSℓ curves in panel (b) obviously coincide. When θ is ℓ h h
raised above θ , initially both intercepts of the CS curve shift out: the horizontal one because θ o θ and the vertical one h b . As a result, the high-standard label “dominates”: it is strictly preferred by all consumers who are willing to because θ o θ buy green in the first place. At point 3, the horizontal intercept reaches its maximum possible value nðθ
Þ. It starts to fall h h b , the vertical intercept still increases, however. At point 5, on the lower boundary when θ is raised further. As long as θ o θ of the blank region in panel (a), the horizontal intercept has fallen to where it now again coincides with the horizontal h h intercept nðθ~ Þ of the CSℓ curve. Further increases in θ cause nðθ Þ to drop below nðθ~ Þ, implying that some range of consumers with low warm-glow weights now strictly prefer buying from the low-standard label. At point 6, the vertical b Þ. Further increases in θh cause both intercepts to fall, until eventually at intercept reaches its maximum value CSh ð0; θ point 8, on the upper boundary of the blank region in panel (a), the vertical intercept again coincides with that of the h low-standard label. Yet further increases in θ cause the entire CSh curve to fall below the CSℓ one, implying that the low-standard label now dominates, even for the consumer with the highest warm-glow weight γ ð0Þ. Having laid out these general features of our model, we investigate in the next three sections what our model implies is the optimal standard, or set of standards, chosen by different eco-label sponsors. h

h

Industry sponsors We start with industry sponsors, whose objective we assume is to maximize the aggregate profits of firms that adopt their label(s).9 8

A mathematical appendix that formally delineates these regions is available upon request. Arguably, their objective could also be to maximize firms' average profits. This would generally yield the same results, except that we would have to rule out a perverse case where the sponsor might want to minimize adoption. 9

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Fig. 2. Different equilibria in ðθℓ ; θh Þ space (a) and in ðy; $Þ space (b)–(d)

Single industry label Consider first the case of a single industry label, with a single standard. The sponsor's optimization problem in this case is   Z 1 n max Π ¼ n p  αθ  sðxÞ dx  c ; n 0 θ;n;p subject to constraints (1) and (2). Substituting in these constraints yields the equivalent unconstrained problem max Π ¼ nðθÞsðnðθÞÞ  θ

Z

nðθ Þ

sðxÞ dx: 0

The first-order condition,     dnðθÞ dΠ ¼ n θ s0 n θ ¼ 0; dθ dθ shows that the industry sponsor's optimal standard θi is the standard that maximizes the green market's size nðθÞ. Above, we denoted this standard θ
. Intuitively, expanding the green market draws in marginal firms with progressively higher switching costs sðnÞ, which by condition (1) requires a higher equilibrium surplus p  αθ  c gross of these costs. But since all inframarginal firms, with switching costs sðxÞ o sðnÞ, receive that same higher surplus, expanding the market increases aggregate profits—the surplus net of switching costs for all firms combined.

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Graded industry label ℓ

If the industry sponsor offers a choice of two standards, θ and θ , its problem becomes     Z Z  1 n 1 n h ℓ sðxÞ dx c þ n nh pℓ  αθ  sðxÞ dx  c ; max Π ¼ nh ph  αθ  n 0 n 0 θh ;ph ;nh h

θℓ ;pℓ ;n

subject to constraints (5)–(8). Here we have used that, for the labels to end up with nh and nℓ ¼ n  nh firms even though all firms are in equilibrium indifferent about which label to adopt, a fraction nh =n of firms in any interval dx of the indexing variable must adopt the high-standard label, while the remaining fraction nℓ =n must adopt the low-standard one. As a result, both labels' average firm-specific cost (averaged over the firms adopting the label) ends up being identical, equal to Z Z 1 n ni 1 n dx ¼ s ð x Þ sðxÞ dx; i A fh; ℓg: n 0 n ni 0 Substituting in the constraints yields the equivalent unconstrained problem: Z nðθℓ Þ ℓ ℓ max Π ¼ nðθ Þsðnðθ ÞÞ  sðxÞ dx: θ h ;θ ℓ

0

Note that the sponsor's choice of θ has no effect on its objective function. If it introduces a high standard, then condition (7) ℓ h determines the number of firms nh ðθ ; θ Þ that adopt that standard; in equilibrium, however, the price ph will adjust to make h ℓ h each such firm's profit p  αθ  sðxÞ  c equal to the profit pℓ  αθ  sðxÞ  c from adopting the low standard. Aggregate ℓ profits for all firms combined therefore stay the same, and are affected only by the sponsor's choice of θ . Just as in the ℓ
single-label case, the sponsor maximizes those aggregate profits by setting θ ¼ θ , thereby maximizing the green market's ℓ size nðθ Þ. This analysis generalizes easily to the case of three or more standards: as long as one standard is at level θ
, the sponsor is indifferent about creating any number of higher standards. In fact, the sponsor could even introduce lower standards, except that those would fail to attract consumers: recall from panel (b) of Fig. 2 that those lower standards would be dominated by the θ
standard. One implication is that, if the industry sponsor is at all unsure about consumer preferences and hence about the value of θ
, it can simply certify a continuous range of standards that it thinks will contain θ
. It is interesting to note, in light of this, that the industry-sponsored SFI program allows firms to claim any percentage of certified forest content above 10%. h

Competing industry labels A further implication is that, if an industry label with standard θ
exists, no group of firms can benefit from sponsoring a competing label. A lower-standard label would attract no consumers, while a higher-standard one would leave the firms with the same equilibrium profit as they could get by adopting the existing label. Consistent with this, we know of no green market in which multiple industry-sponsored labels compete. We summarize the results of this section in the following proposition: Proposition 1. Industry sponsors of eco-label programs are indifferent about both grading and competition, provided at least one standard is set at the level that maximizes the green market's size. Environmentalist sponsors We next consider environmentalist sponsors, whose objective we assume is to maximize the aggregate environmental benefit Θ generated by green production. Single environmentalist label In the case of a single label, with a single standard, the aggregate environmental benefit is Θ ¼ nθ, and the sponsor's optimization problem is therefore max Θ ¼ nθ; θ;n;p

subject to constraints (1) and (2). The equivalent unconstrained problem is maxΘ ¼ nðθÞθ; θ

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with first-order condition10   dnðθÞ dΘ ¼n θ þ θ ¼ 0: dθ dθ The first term in this condition represents the marginal gain in environmental benefits from increasing the standard on the nðθÞ units of the green good bought by consumers. The higher standard also raises the good's production cost, however, and thereby its equilibrium price. At standards θ 4 θ
, the price rise starts to outweigh the higher warm-glow benefit for marginal consumers, causing nðθÞ to fall. The second term of the condition represents the resulting marginal loss in environmental benefits. The environmentalist sponsor's optimal standard θe balances the gain and the loss, and must therefore exceed the industry sponsor's optimal standard θi ¼ θ
.

Graded environmentalist label In the two-standard case, the sponsor's optimization problem reduces to ℓ

max Θ ¼ nh ðθ  θ Þ þnθ h

ℓ

θh ;nh ;θℓ ;n

subject to constraints (7) and (8). The solution turns out to depend on the shape of the γ ðyÞ function, and thereby on the distribution of warm-glow weights among consumers. If this distribution is close to uniform, so that γ ðyÞ is close to linear, then the solution is to set θh ¼ θℓ , i.e., stick with a single standard. To understand why, refer back to Fig. 1, in which n~ denotes the number of h consumers that would buy the green good if the sponsor stuck to a single standard θ rather than introducing a second, ℓ strictly lower standard θ . This number is implicitly defined by ~ ðθh Þ  αθh  sðnÞ ~ c ¼ 0: γ ðnÞf

ð9Þ

~ yields Substituting (8) and (9) into (7) and using that sðnÞ 4 sðnÞ

γ ðnh Þ  γ ðnÞ f ðθh Þ : o ℓ ~ γ ðnh Þ  γ ðnÞ f ðθ Þ ~ If now the γ ðyÞ function is linear, then ðγ ðnh Þ  γ ðnÞÞ=ðn  nh Þ ¼ ðγ ðnh Þ  γ ðnÞÞ=ð n~  nh Þ. This then allows us to rewrite the above expression as ðn nh Þθ

ℓ

ðn~  nh Þθ

h

o

f ðθ Þ=θ h

h

ℓ

ℓ

f ðθ Þ=θ

o1;

ð10Þ

where the second inequality follows from the concavity of f ðθÞ. But the first term of (10) is just the gain-to-loss ratio to the environmentalist sponsor from introducing a strictly lower standard. The numerator represents the environmental benefits gained from the n  nh consumers who end up buying the low-standard good. Without the low standard, however, n~  nh of those consumers would have bought the high-standard good. The denominator therefore represents the environmental benefits lost when those consumers switched. Since the gain-to-loss ratio is less than one, sticking with a single standard θh ¼ θe is optimal. ~ If, however, the γ ðyÞ function is convex, then ðγ ðnh Þ  γ ðnÞÞ=ðn  nh Þ 4 ðγ ðnh Þ  γ ðnÞÞ=ð n~  nh Þ, potentially reversing the first inequality in (10). It can be shown (by numerical example) that the sponsor may in this case prefer to introduce a second, h h strictly lower standard, while simultaneously adjusting θ (so that generally θ a θe ). Intuitively, a strongly convex γ ðyÞ function implies a long tail of “light green” consumers, whose WTP for green goods is positive but low. Few such consumers would buy the expensive, high-standard green good, even if it were the only green option available (in terms of (10), n~ is small). However, if offering a sufficiently cheap, low-standard second option entices enough of those consumers to go green and thereby generate some environmental benefits (in terms of (10), if n is sufficiently large), the environmental gain from the second standard will outweigh the loss. The same reasoning applies to additional, yet lower standards. Consistent with our analysis, some environmentalist programs (e.g., the Marine Stewardship Council program in the fish market) apply a single standard, while others (e.g., the LEED program in the building market) apply a graded standard. A testable prediction of our model is that the distribution of consumers' WTP drives this choice. In particular, it is the skew (not range or variance) of this distribution that matters: graded standards are optimal only in markets where WTP is sufficiently skewed towards low values. 10 The second-order condition is complex. It is satisfied when the γ ðyÞ and sðxÞ functions are linear, but more generally requires the γ ðyÞ function to be not “too convex” and the sðxÞ function not “too concave.”

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Competing environmental labels Our analysis is consistent also with the observation that in some markets multiple environmentalist programs “compete.” The coffee market, for example, features three major labels, with different levels of environmental stringency: Fairtrade, Rainforest Alliance/SAN, and UTZ Certified. We write “compete” in quotes, however, because our analysis suggests that these programs might better be viewed as complementing each other. That is, if a high-standard program cares about overall environmental benefits—whether generated by consumers of its own label or of other labels—then in markets with many light-green consumers, it should actively welcome entry by lower-standard programs. Interestingly, the three coffee programs issued a joint press release in 2011 stating that “We appreciate diversity in our approach, which enables producers, buyers and consumers to make a choice as to which certification best helps them meet their goals. We respect the complementary aspects of our work in moving towards sustainable agriculture and trade around the world.”11 The declaration rejected calls for “harmonization” of their respective standards.12 The following proposition summarizes this section's results: Proposition 2. Environmentalist sponsors of eco-label programs strictly prefer a single standard to multiple ones if WTP for a given level of environmental quality is either distributed uniformly across consumers or skewed to towards high values. They prefer the converse if WTP is sufficiently skewed towards low values. Government sponsors The final type of sponsor that we consider is a welfare-maximizing government. Since competition between government programs is rare, we consider only single programs, with either single or graded standards.13 Single government label In the case of a single label with a single standard, the government's problem reduces to Z nðθÞ Z nðθÞ max W ¼ γ ðyÞ dyf ðθÞ  nðθÞαθ  sðxÞ dx nðθÞc þBgðnðθÞθÞ; θ

0

0

where the parameter B  Nβ represents the welfare weight on public benefits gðΘÞ ¼ gðnðθÞθÞ, given that all N consumers each place utility weight β on those benefits. To understand the solution, it is useful to consider the extreme cases where B ¼ 0, so that only private (consumer surplus and profit) benefits matter to welfare, and B-1, so that only public (environmental) benefits matter. If B ¼ 0, the first-order condition determining the government's optimal standard is Z nðθÞ          dnðθÞ     dW ¼ γ n θ f θ  αθ  s n θ  c þ γ ðyÞ dyf 0 θ  n θ α ¼ 0; dθ dθ 0 0

where the first term is zero by the definition of nðθÞ. Since the second term is bounded between γ ð0ÞnðθÞf ðθÞ and γ ðnðθÞÞnðθÞf 0 ðθÞ, the solution θg lies strictly between θ
, defined implicitly by γ ðnðθÞÞf 0 ðθÞ  α ¼ 0, and θb , defined implicitly by γ ð0Þf 0 ðθÞ  α ¼ 0. The intuition for this result is easiest to grasp from panel (c) of Fig. 2. Recall that the horizontal intercept of any CS curve b . This implies that slightly is maximized at standard θ
, whereas the vertical intercept is maximized at the higher standard θ
raising the standard above θ has a second-order effect of reducing both aggregate profits (since these are maximized at nðθ
Þ) and consumer surplus for a few consumers with index y close to nðθ
Þ, but a first-order effect of increasing consumer surplus b for many more consumers with lower y (compare the CSh3 and CSh4 curves). Similarly, slightly lowering the standard below θ has a second-order effect of reducing consumer surplus for a few consumers with index y close to 0, but a first-order effect of increasing both aggregate profits and consumer surplus for consumers with higher y (compare the CSh5 and CSh6 curves). b. The private-benefit-maximizing standard therefore lies between θ
and θ When B 4 0, however, the effect of θ on public benefits must be taken into account as well. Since these benefits are just an increasing function of environmental benefits Θ ¼ nðθÞθ, accounting for them moves the government's optimal standard θg towards the environmentalists' optimal standard θe , until in the limit as B-1 the two standards coincide. 11

http://www.rainforest-alliance.org/newsroom/news/fairtrade-ra-san-utz-statement, February 14, 2011. Note that our model abstracts from the important reality that eco-label standards are multidimensional, whereby different labels emphasize different dimensions. For example, whereas Fairtrade's primary concern is to give farmers a “fair” price for their coffee, with environmental standards playing a secondary role, the reverse is arguably true for the Rainforest Alliance/SAN. 13 Competition might arise between programs sponsored by different levels of government, e.g., federal vs. state programs in the US, or EU-wide vs. country-specific programs in Europe. Such cases likely involve geographic differences in consumer preferences or firm costs, which are beyond the scope of this paper. 12

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Graded government label Going back to the extreme case where B ¼ 0, but now allowing for multiple standards, it is clear from panel (c) of Fig. 2 b cannot possibly maximize private benefits. The reason is that that having just a single standard θg between θ
and θ 0
b introducing a second standard θg , also between θ and θ , adds a consumer-surplus curve that crosses the first one, thereby 0 necessarily increasing private benefits. If θg is higher than θg , the second curve will have a higher vertical intercept but a 0 lower horizontal one. As a result, consumer surplus strictly increases for consumers with index y A ½0; nh ðθg ; θg ÞÞ, while 0 aggregate profits are unchanged (since they are determined by the horizontal intercept nðθg Þ of the first curve). If θg is lower than θg , the second curve will have a lower vertical intercept but a higher horizontal one. As a result, consumer surplus 0 0 strictly increases for consumers with index yA ðnh ðθg ; θg Þ; nðθg ÞÞ, while aggregate profits increase as well. Maximizing private benefits alone therefore always calls for graded standards; in fact, a continuum of standards is b . In contrast, a single standard may be optimal when maximizing public benefits alone: our optimal, ranging from θ
to θ analysis of environmentalist sponsors showed this to be optimal in markets where γ ðyÞ is concave or close to linear. Whether in such markets a government sponsor should grade its label therefore depends on the relative importance of private and public benefits. Only in markets with sufficiently convex γ ðyÞ does maximizing both types of benefits call for graded standards. Among government-sponsored programs in the US, the USDA's National Organic Program essentially uses a continuous standard for organically produced food. The program provides specific labels for products with 100% and at least 95% organic content, but also allows products with at least 70% organic content to state that percentage on their package (together with a seal or other identifying mark of an USDA-accredited certifying agent). Our model suggests that this arrangement is optimal if consumers mainly buy organic to obtain health or other private benefits, and place relatively low weight on environmental benefits. The EPA/DOE's Energy Star program, on the other hand, uses only a single standard for energy-efficient appliances of any particular type. Our model suggests that this is optimal if consumers place relatively high weight on the environmental benefits of such appliances (so B is high), and more or less uniform weight on the private benefits (so γ ðyÞ is close to linear).14 Summarizing this section's results, we have the following: Proposition 3. Government sponsors of eco-label programs strictly prefer multiple standards to a single one if the welfare weight on public benefits is sufficiently small. Conversely, as the weight increases, the government sponsors' optimum approaches that of environmentalist sponsors, as characterized in Proposition 2.

Competition between industry and environmentalist labels Although government labels sometimes compete with non-government ones, we focus here on the more prevalent and interesting case of competition between industry and environmentalist labels. An important question that arises is to what extent industry and environmentalist sponsors care about their own label's size. Arguably, label adoption is for neither type of sponsor a goal in itself; rather, it is just a means towards the end of promoting, respectively, aggregate industry profits or aggregate environmental benefits. Note in this regard that industry labels are typically sponsored by trade associations: the SFI label is sponsored by the American Forest & Paper Association, for example, and the Sustainable Slopes label by the National Ski Areas Association. Given the mandate of these associations to represent the entire industry in their lobbying and other activities, it seems reasonable to assume that they care about firm profits regardless of what eco-label firms adopt. Similarly, as we already suggested when discussing the coffee market, it seems reasonable to assume that environmentalist sponsors care about environmental benefits regardless of what ecolabel gives rise to those benefits. Given these assumptions, and focusing on the analytically tractable case where γ ðyÞ is linear, consider a market in which an industry sponsor sets a single standard θi and an environmentalist sponsor sets a single standard θe . Panel (a) of Fig. 3 plots the different possible outcomes in ðθi ; θe Þ space. The light- and dark-shaded areas represent combinations at which, respectively, the industry and the environmentalist standard dominate; in the white area, both standards coexist.15 Also n n shown are both sponsors' optimal single standards in the absence of competition, namely θi ¼ θ
and θe .16 14 Note that private benefits in this case refer only to warm-glow benefits; lower energy bills should be thought of as reducing the appliances' effective price premium. 15 Fig. 3 differs from Fig. 2 in that points ðθi ; θe Þ below the 451 line must be considered as well. But since coexistence is a symmetric property (if h ℓ h ℓ standard θe ¼ θ coexists with standard θi ¼ θ , then standard θi ¼ θ coexists with standard θe ¼ θ ), the coexistence region simply reflects in the 451 line. h ℓ h ℓ Since in contrast dominance is antisymmetric (if standard θe ¼ θ dominates standard θi ¼ θ , then standard θi ¼ θ is dominated by standard θe ¼ θ and vice versa), the dominance region for θi is the reflection in the 451 line of the dominance region for θe and vice versa. n 16 b . As panel (d) of Fig. 2 indicates, this implies, somewhat counterintuitively, that if a competing Note that in our baseline case with linear γ ðyÞ; θe 4 θ b , all consumers—even the “darkest green” ones, with the highest warm-glow weights—would switch to that label were to enter with a standard closer to θ lower-standard label, away from the environmentalist one. Underlying this is the classic public-goods externality: because individual consumers take the public benefit gðΘÞ as given, they would compare only their private, consumer-surplus benefit from the two standards, which for all consumers is higher at θb . In a referendum vote on θne vs. θb , however, some consumers might well choose the former.

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The environmentalist sponsor's reaction correspondence Re is quite complex. When faced with either a very low θi n standard or a very high one (above θe ), its optimal response is to drive the industry label out of the market, by choosing a n b and θn , its optimal response is to do dominating standard at or slightly below θe . When faced with a θi standard between θ e the exact opposite: cede the market to the industry label, by choosing either a low or high domina ted standard. And when faced with a θi standard in the remaining, intermediate range, its optimal response is to share the market, by choosing a standard in the coexistence region somewhat above θi . Much of this complexity is moot, however, because the industry sponsor's reaction correspondence Ri is very simple: it consists of a vertical line at θi ¼ θ
together with a horizontal line at θe ¼ θ
. that the industry's aggregate profits are maximized if at least one standard in the market is at level θ
. It follows that, when faced with any θe a θ
, the industry sponsor's optimal response is to set θi ¼ θ
. When faced with θe ¼ θ
, however, the industry sponsor becomes indifferent about choosing any θi , including values θi o θ
that are dominated and therefore imply ceding the market to the environmental label. The two correspondences combined yield a simple, unique Nash equilibrium if the two sponsors set their standards NE NE b ; θn Þ simultaneously: the industry sponsor chooses θi ¼ θ
, while the environmentalist sponsor chooses a standard θe A ðθ e 17 that is higher, but not so high as to be dominated. The equilibrium, in other words, always has both programs coexisting. Two facts underly this result. First, given that the industry sponsor chooses θ
, the environmentalist sponsor cannot dominate; the best it can do is offer a somewhat higher standard, to increase aggregate environmental benefits. Second, the industry sponsor does not care to dominate; it just wants some standard in the market to equal θ
. Both facts combined imply that even if the sponsors do not set their standards simultaneously, i.e., if either sponsor can commit to a standard anticipating entry by the other sponsor, the resulting sequential Stackelberg equilibrium outcome features the same combination of standards as the simultaneous-move Nash equilibrium outcome does. NE n Note also that θe is below the environmentalist sponsor's optimal standard θe without competition. Intuitively, competition induces consumers with low warm-glow weights to “defect” to the industry standard. The resulting loss in environmental benefits can be mitigated by lowering θe , thereby luring some of these consumers back. Once again, our model appears consistent with casual empirical evidence—in this case, with the very prevalence of competing industry and environmentalist labels. Although one might expect to see instances where an environmentalist label drives out an industry one or vice versa, we know of no examples where this has in fact occurred. Instead, the two labels appear to always coexist, each taking a segment of the market.18 Summarizing: Proposition 4. Environmentalist and industry sponsors of eco-label programs coexist in equilibrium: each program prefers to enter a market in which the other program operates, but each finds it suboptimal to drive the other out.

Welfare implications Our discussion of welfare implications can be brief. This is because, apart from the unsurprising result that a welfaremaximizing government is generally best off sponsoring its own label rather than leaving label sponsorship to private initiative, our model offers few sharp predictions about welfare. Much depends on model parameters, and in particular on the welfare weight B on public benefits. Consider for example the question whether competition between industry and environmentalist labels should be welcomed—does such competition improve welfare? To examine this question, panel (b) of Fig. 3 adds welfare-indifference ℓn hn curves to panel (a), and indicates the welfare-maximizing pair of standards ðθg ; θg Þ when B ¼ 0. In section “Government ℓn hn
b welfare-dominates any single sponsors” we explained, referring to panel (c) of Fig. 2, why this pair with θ o θg o θg o θ NE NE standard. The same explanation implies also that the competitive outcome ðθi ; θe Þ shown in Fig. 3 welfare-dominates n “monopoly” outcomes along the 451 line, with either an industry label setting single standard θi ¼ θ
or an environmentalist n NE b label setting single standard θe 4 θ . In the former case, entry by the environmentalist label at standard θe keeps producer NE profits unchanged, while increasing consumer surplus. In the latter case, entry by the industry label at standard θi n NE increases both aggregate profits and consumer surplus, and the induced lowering of standard θe to θe increases consumer surplus further.19 Panel (b) of Fig. 3 can be used also to illustrate how a government sponsor might increase welfare indirectly, by committing to a standard anticipating how a private sponsor—either industry or environmentalist—will react. The optimal such standard is that at which the private sponsor's reaction function is tangent to the highest welfare indifference curve. In hn ℓn the case shown, this standard lies slightly below θg when faced with an industry sponsor and slightly above θg when faced 17

A mathematical appendix that formally proves this result is available upon request. This is not to say that the coexistence is amicable. See, for example, the competing complaints filed with the US Federal Trade Commission by groups allied with the FSC and SFI, accusing the other program of unfair and deceptive trade practices (Vestel, 2009; Broder, 2013). See also the SACC website's prominent reference to studies by Rivera and de Leon (2004) and Rivera et al. (2006) questioning the environmental effectiveness of the rival Sustainable Slopes program (http://www.skiareacitizens.com). n NE 19 b ; see footnote 16. This follows because θe 4 θe 4 θ 18

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Fig. 3. Nash equilibrium when an industry and environmentalist program compete (a), and comparison of this equilibrium to the welfare optimum (b).

with an environmentalist sponsor. Note that, although the industry sponsor's optimal response is just the same standard θ
n that it would choose if it had the market to itself, the environmentalist sponsor is induced to choose a standard below θe . Recall also from section “Government sponsors”, however, that the true welfare optimum at B ¼ 0 involves not just a pair, b . And recall from section “Industry sponsors” that an industry program might but a continuum of standards between θ
and θ optimally introduce such a continuum if it is unsure about consumer preferences, and would more generally be indifferent b additional to θn ¼ θ
. If it does, then competition by either an about introducing any number of standards between θ
and θ i environmentalist or government sponsor need not increase welfare after all (although it will not reduce welfare either). But all this is for the case where B ¼ 0. Recall from section “Government sponsors” that in the limit as B-1, the welfare n optimum coincides with that of the environmentalist program, and therefore involves a single standard at θe . By continuity, there must be an intermediate value of B above which competition by an industry sponsor reduces welfare. Beyond these broad-brush statements based on what is true at B extremes, little can be said about welfare in general.

Conclusion In this paper, we have examined two common features of green markets in which eco-label programs operate, namely eco-label gradation and competition. We find that different program sponsors—industry associations, environmental groups, or government agencies—face strikingly different incentives to either grade or compete. Industry sponsors, for example, are indifferent about both; their only concern is to maximize consumer participation in the green market, which is achieved if at least one program, which need not be their own, offers the participation-maximizing standard. Environmentalist sponsors, on the other hand, optimally grade or compete with other environmentalist sponsors only if relatively many consumers are “light green,” i.e., care only a little about environmental friendliness; if consumer preferences are more uniform, or relatively many consumers are “deep green,” then a single standard is optimal. Lastly, a government sponsor's optimal decision depends on the relative welfare weight on private and public benefits generated by the green market. If private benefits dominate, the sponsor may optimally offer a continuum of standards and welcome any amount of competition; but if public benefits dominate, its decision depends on consumer preferences in a manner similar to that of an environmentalist sponsor. We find also that it is no accident that green markets frequently have an industry sponsor competing with an environmentalist one. Our analysis suggests that, at least in markets where consumer preferences for environmental friendliness are relatively uniform, neither sponsor can improve on the competitive outcome by setting a standard that would drive out or deter entry by the other sponsor. For each of the cases examined, our model appears consistent with casual empirical evidence, while also generating testable predictions. One such prediction is that industry sponsors will never restrict adoption of their label, or resist entry by a rival label. A second prediction is that environmentalist sponsors will never respond to an increase in “deep green” consumers by switching from a single to a graded label (or vice versa). A third is that whether government sponsors grade their label or not will depend on how consumers value private vs. public benefits of the green market. Two features of green markets that we recognize are important, but have abstracted from in this paper are fixed costs of establishing eco-label programs and consumer confusion about standards. Since fixed costs imply that eco-label programs need a minimum size to be viable, their presence is likely to shrink the coexistence region in standard space, and make entry deterrence easier. An environmentalist program may, for example, lower its standard to a point where too few consumers would prefer an even lower industry standard. Consumer confusion, on the other hand, likely has the opposite effects: low-

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