Role of labor intensity interaction in the relation between abatement expenditure and production

Polluting industries are characterized by different levels of abatement expenditure. In countries such as the US with relatively strict environmental standards, theoretical models and intuition predict that industries that are forced to undertake greater abatement expenditure would have lower production. However this negative relation between abatement expenditure and production has been elusive in existing empirical research. The current paper starts from a standard theoretical model of production in the short run and incorporates abatement expenditure into it. This leads to an interaction term, that has been absent in existing empirical literature, which reflects that the effect of increased abatement expenditure increases the shadow price of the inputs that are immobile across industries. For the same abatement expenditure, industries more intensive in mobile labor can absorb the abatement expenditure more easily resulting in a smaller reduction in production. The empirical analysis based on the specification stemming from the theoretical model finds the coefficient of the interaction of labor intensity and abatement expenditure to be significant. Also the pure Pollution Haven effect that predicts a negative effect of abatement expenditure on production emerges to be stronger with this specification compared to the more common formulation where the interaction term is absent. Alternate specifications find the results to be robust and significant.