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Environmentally-friendly (“green”) products face a unique set of market barriers. I develop a dynamic model of observational learning and costly search wherein a green consumer product enters a market to challenge an established “dirty” product. Purchase decisions depend on price and quality differences, consumers’ willingness-to-pay to protect the environment, and the cost of obtaining information. Using both theoretical analyses and simulations, I solve for the long-term market performance of the green product. Conditions are provided for when it is socially optimal to encourage green purchases with public policy. Comparative statics predict the effectiveness of various policy tools used to improve market performance. Permanent financial incentives are shown to be more effective than informational campaigns at encouraging green purchases if the green product is inferior to the dirty substitute. Temporary financial incentives are shown to be an ineffective tool to encourage the long-term market success of any green product. Numerical market simulations are used to test and supplement the theory.

Traditional economic analysis predicts that rational consumers will not voluntarily contribute to the provision of public goods such as environmental protection. However, recent studies have shown that, in fact, consumers display a willingness to pay significant premiums for products that benefit the environment (Camacho-Cuena et al., 2004, Brecard et al., 2009 and Garcia-Gallego and Georgantzis, 2009). This trend in consumer preferences has spurred the entrance of an increasing number of environmentally-friendly (“green”) alternatives to established products in consumer goods markets. Energy-efficient light bulbs, recycled paper and biodegradable cleaning products are just a few examples of the types of green products this paper will discuss. Green products gain a competitive advantage from offering environmental benefits, but they also face a unique set of barriers when entering a market to compete with established “dirty” products (Bonini and Oppenheim, 2008). For instance, they are often priced significantly higher due to the higher costs of production. Consumers are also relatively uninformed about both the existence and the characteristics of entrant green products. All new products face this information barrier, but it is particularly problematic for green products. First, green products carry a stigma of lower quality with some consumers. This stigma is sometimes well deserved – the early versions of green products often perform worse than their “dirty” counterparts. Second, corporations often make misleading claims of environmental benefits. Consumers have therefore become hesitant to believe such claims. A final barrier is the high degree of consumer heterogeneity in their willingness-to-pay to protect the environment (GfK Roper Consulting, 2007, Loureiro and Lotade, 2005 and Garcia-Gallego and Georgantzis, 2009), which forces green producers to target a subset of the full population. It is often beneficial to society for green products to overcome these barriers and succeed in their markets because widespread green consumption is a substitute for costly (and politically contentious) government spending on environmental protection. It is therefore crucial that we understand what causes green consumer goods to achieve success in their markets. For instance, are financial incentives or informational campaigns more effective at encouraging green product purchases? Economists have said surprisingly little on the issue, outside of certain studies of the moral motivations or social norms that lead to green purchasing behavior (Clark et al., 2002, Nyborg et al., 2006 and Stern, 1999). In this paper, I begin to fill that void by developing a simple economic model that predicts the effectiveness of various public policy options of encouraging the long-term market performance of green products. The premise of the model is that a green consumer good enters a market to challenge an established “dirty” good. The characteristics of the established dirty product are well known, while the entrant green product's characteristics are uncertain. A dynamic model of observational learning is used to predict the long-term market performance of the green product. Observational learning models (also known as “social learning” or “Bayesian learning” models) are often used to depict environments in which a large number of consumers sequentially make decisions whether to purchase a product with uncertain characteristics, and consumers update their perceptions of the product based on the purchase decisions of others.1 In such situations, it has been shown that consumers will engage in inefficient “herd” behavior in which they simply copy the purchase decisions of others (Banerjee, 1992), and that this conformity of actions can occur based on a very small amount of information (Bikhchandani et al., 1992). The practical consequence of such behavior is that a large number of consumers can collectively arrive at incorrect conclusions about product characteristics, which explains why high quality products can fail and low quality products can succeed. The critical assumption in these models is that consumers are aware and responsive to the actions of others, and various empirical studies and experiments have confirmed that this type of learning does occur in a variety of situations (Munshi, 2004, Cai et al., 2009 and Anderson and Holt, 1997). The market performance of green products is an important new application to the literature on observational learning because consumers pay particularly close attention to the prevailing social norms in these markets. Indeed, a primary motivating factor of consumers’ willingness-to-pay to protect the environment is their desire to be seen either publicly or introspectively as conscientious citizens (Clark et al., 2002). Buenstorf et al. (2008) describe green purchasing behavior as a dynamic process in which consumers make choices based not on utility maximization but instead on the gradual cultural transmission of information and social norms (Buenstorf et al., 2008). A dynamic model in which consumers can be influenced by the actions of others is therefore appropriate for this setting. The basic observational learning model has been generalized in a number of ways, and this paper's model, presented in Section 2, will build upon elements of various extensions. For instance, consumers are given the option of removing the uncertainty in the model by undertaking costly search instead of relying on public perception alone (Burguet and Vives, 2000 and Hendricks et al., 2010). Heterogeneity across consumers is also included (Smith and Sorensen, 2000 and Goeree et al., 2006) to represent the wide range of willingness-to-pay to protect the environment. Compared to the Hendricks et al. model, the key differences are that consumers are heterogeneous ex-ante (as opposed to learning of idiosyncratic preference shocks via search), and, importantly, all consumers are aware of how their preferences relate to those of all other consumers. The implication of these differences compared to the earlier literature is that in this new model of observational learning, an entrant green product can “succeed” or “fail” with positive probability once consumers are sufficiently convinced of the products characteristics and thus stop paying the search cost. In Section 3, I explicitly solve for the green product's long-run market performance, in terms of the probability that it succeeds or fails and its long-run market shares at both outcomes. The model describes a green good but it could apply certain green services as well. In addition, the model is sufficient generally that it may be applied to other traits besides the preference for environmentally-friendly attributes. This paper concentrates on this particular preference trait because of the importance of encouraging the success of green products. Inefficient herds always decrease social welfare, but green products failing due to herds on dirty product purchases can be especially harmful. Not only may consumers lose the opportunity to consume a high quality product, but unnecessary environmental damage will occur as well. It is therefore particularly important that we understand how to avoid inefficient herds in markets with green alternatives. Public policy can be used to remove the inefficiencies in the market, and in Section 4, I provide explicit conditions for when it is welfare improving to use public policy to encourage green purchases. In Section 5, comparative statics are used to predict the relative effectiveness of commonly used public policy tools such as financial incentives and informational campaigns. Among other results, I show that financial incentives are more effective than informational campaigns at encouraging green purchases if the green product is inferior to its dirty substitute. On the other hand, if short-term policies are used to promote a high quality green product, informational campaigns are more effective tools than financial incentives. I also show that public policy cannot have a substantial impact on the transition dynamics of the model, since the long-run outcome is determined very rapidly following a green product's introduction to the market. The final section summarizes the results and discusses various important extensions to the model, such as additional sources of uncertainty and frictions in consumer awareness and product availability. These extensions include uncertainty in price, wherein consumers are unable to precisely compare the life-cycle costs of a green product versus a dirty alternative product, and consumer skepticism of corporations’ claims of environmental benefits. With a few notable exceptions, comparative statics on these more complex models result in straightforward generalizations of the results found using the base model.2

In the previous sections I presented a dynamic model of observational learning and costly search in which a green consumer good enters a market to challenge an established dirty product. I showed that as long as it is relatively inexpensive for consumers to determine a green good's quality type, multiple long-run outcomes are possible, and green products can “succeed” or “fail” with positive probability. Using both theoretical analyses and model simulations, I solved for the long-term performance of the green good in the market, in terms of its probability of success and its market share, and arrived at the following conclusions. Under certain conditions, it is welfare improving to use public policy to encourage green good purchases. Both financial incentives and informational campaigns can be effective tools to improve the performance of a green consumer good as long as its quality is comparable to a dirty substitute good. To encourage the performance of a lower quality green good, financial incentives may be the only effective policy tool. However, if only short-term policies are feasible, temporary informational campaigns will be more effective than temporary price discounts at encouraging the long-term performance of a high quality green good. Additionally, the long-run performance of a green product is determined relative rapidly and by a very small percentage of consumers. Firms and policymakers should be aware of these factors when deciding whether and when to bring a product to market and which consumers to initially target. In a companion paper (Kaufman, 2011), the results of the basic model are extended to add complexity and applicability to real world situations. The following are brief descriptions of three important model extensions: (1) energy efficiency products; (2) consumer skepticism of environmental claims; (3) limitations of consumer awareness and product availability.