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This paper constructs a stylized model of firm output and emissions that accounts for the two externalities that characterize environmental markets when technological change is endogenous. The first externality concerns emissions, the external damages of which are not accounted for by the firm, and the second concerns knowledge spillovers, which increase the social return to innovation above the private return. We show that when firms can reduce emissions separately through both output and abatement, the existence of knowledge spillovers implies that a single tax on emissions is no longer capable of inducing the firm to emit at the socially optimal level. This is due to the different effects that spillovers have on the firm output and abatement decisions. We then derive the output tax and abatement subsidy required to correct the emissions externality and the investment subsidy required to correct the spillovers externality. When spillovers exist, the output tax should be set below marginal external damages and the abatement subsidy above marginal external damages.



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