Does air pollution change a firm's business strategy for employing capital and labor?

We examine the impact of air pollution on a firm's capital‐labor ratio. We propose the hypothesis that, in dealing with air pollution, a firm responds strategically by using relatively more capital and less labor to contain labor costs and remain competitive in the market. Using a sample of Chinese firms and a satellite‐based air pollution metric, we test this hypothesis, and our results confirm it. In addition, we document that the impact of air pollution on the capital‐labor ratio is more salient for firms with high economic incentives and close monitoring. Further, we report that to respond to worsening air pollution, a firm uses more capital and substitutes lower‐quality labor with more high‐quality labor. Finally, after increasing the capital‐labor ratio, a firm's value increases, in terms of Tobin's Q, suggesting that the adoption of a higher capital‐labor ratio, due to air pollution, is a sound business strategy.