This paper explores the relationship between environmental subsidies, the diffusion of a clean technology, and the degree of product differentiation in an imperfectly competitive market. Like others, we show that the subsidy succeeds in reducing environmental damage only when the substitution effect (the reduction in pollution associated with the clean technology) exceeds the output effect (the extent that the subsidy increases output). Here, we add product differentiation and diffusion dynamics. When the substitution effect dominates, environmental damage decreases monotonically during the diffusion process. The extent of technology diffusion (the degree to which clean technology replaces dirty) is decreasing in the degree of product differentiation. Further, as products become closer substitutes, it is more likely that the subsidy will reduce environmental damage. Finally, the subsidy for clean technology will spill over to the remaining dirty producers, increasing their profit as well. In a free-entry equilibrium, the subsidy decreases pollution when product differentiation is low compared to the relative pollution intensity of the clean technology.
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