Prices vs. Quantities for Self-enforcing Agreements

We study the optimal self-enforcing agreement based on quantity mandates and price instruments in a repeated game between countries, whose domestic firms invest in green technology before consumers emit. We find that technology must be regulated in addition to emissions, even in the absence of technological spillovers. Under a quantity agreement, emission is capped and countries must either overinvest in technology—to weaken the temptation to emit—or they must be punished unless they invest less—to maintain their willingness to retaliate on others. Under a price agreement, emission is taxed and investments subsidized. The price agreement dominates the quantity agreement because when firms are free to modify investment levels if another government defects, the punishment for defection is stronger.