Environmental policies in a Stackelberg differential game

We develop a Stackelberg differential game to analyze the economic effects of the reduction plan through two policy instruments, tradable permits and taxes on emissions. Emissions are a by‐product of firm output. The authority acts as a Stackelberg leader, able to set the optimal instrument's level in the light of a finite‐horizon environmental target. We show that the optimal solution of the game is dynamically consistent. Moreover, optimal environmental policies substantially impact the level and composition of economic activity. The differentiation between “clean” and “dirty” firms allows us to assess distributional effects and how environmental technology may influence the game's outcome. Results are shown to be robust under different parameterizations.