Environmental Policies Chapter 11 Environmental Policies

What are trade-related environmental policies, their types and purpose? Environmental policies: aimed at addressing environmental concerns (air and water pollution, exhaustion of natural resources loss of biodiversity, global warming and so on); Trade and environment: evidence shows that along with trade liberalization urban environment has improved, while rural and global environment have worsened

Trade and environment: three issues The impact of trade policies on environment The impact of environmental policies on trade Is trade policy optimal in addressing environmental concerns? Trade and environment: the importance of the specific geographical scope (local, national, international) of the environmental issue

1. Effects of trade policy on environment Rather complex relationship. The overall impact is the result of four possible effects: Composition effect : specialization will locate dirty /clean industries in countries with comparative advantages. Dirty industries intensive in capital /natural resources; Clean industries intensive in human capital / knowledge. With trade liberalization countries abundant in capital/natural resources (human capital) will worsen (improve) their environment;

Growth effect: trade can promote growth. Rapid growth may damage environment Moderate growth can improve it (countries are able to adapt policies fast enough to protect environment from negative side effects of rapid growth) Scale effect : trade promote the expansion of production which can have negative side effects on environment; Technique effect: trade increases income; higher incomes imply an increase in the demand for environmental quality.

The impact of trade policies on environment is ambiguous Positive if a region: Has a comparative advantage in clean industries; There is a technique effect ; Policy-makers react to demand for environmental protection

The impact of trade policies on environment is ambiguous Negative if a region: Has a comparative advantage in dirty industries; Growth linked to trade is rapid; The impacts due to increased scale of production and increased transportation are large

The Kuznets curve: The effects of trade policy on the environment via income effects. From a to b, negative growth and scale effects dominate. From b to c: positive technique effects dominate

The effects of trade policy on the environment via changes in endowments The endowments of countries evolve over time: At earlier stages of development, they are abundant in capital and natural resources used in the dirty industries; trade liberalization at that stage increases pollution! At later stages of development, they are abundant in human capital and natural resources used in the clean industries. Trade liberalization reduce pollution!

2. What are the effects of environmental policy on trade? Differences in national environmental policies can affect (distort) trade. Two possible mechanisms: Pollution Haven Hypothesis: dirty (clean) industries relocate where environmental laws are less (more) stringent. Trade liberalization will improve (worsen) environment in high (low) environmental standard countries

What are the effects of environmental policy on trade? Factor Endowment Hypothesis (a variant): both policies and factor endowment contribute to relocate production. Dirty industries relocate in countries abundant of input used in these industries. If environmental policies are strong then trade liberalization will improve environment; if environmental policies are weak then trade liberalization will worsen environment;

Pollution haven and factor endowments implications If PH dominates then trade improves environment in the North (assuming they have stronger laws); If FE prevails then trade liberalization improves environment in countries abundant of human capital (presumably the North…); But if North has stronger laws and comparative advantages in dirty industries: the PH effect can even reverse the comparative advantage!

3. What are the implications of using trade policy to address environmental externalities? Externalities: when production or consumption result in side effects on external agents. Market fails to allocate efficiently resources. Externalities can be either positive or negative Negative production externality: production generates negative effects on other agents

Negative consumption externality: consumption generates negative environmental effects on others (for example: consuming goods packaged in non-recyclable materials…) Externalities are a typical case of market failure: markets do not allocate efficiently resources because production and consumption imply social costs (environmental damage) that agents do not consider in their decisions about production and consumption

Producers: will produce more dirty goods than the socially optimal level; Consumers will consume more than the socially optimal level Governments can use domestic or international policies to correct market failures due to externalities: policies that provide incentives for agents to produce /consume the optimal level (tax, regulations and so on) The Socially optimal policy depends upon the scope of the externality (local, national, international …)

First-best policies: correct market failure without introducing new distortions; typically the scope of the policy matches the scope of the externality (domestic policy to correct for domestic externality; internationally coordinated trade policy to correct for global externalities); Second-best policies: correct market failure but introduce new distortions; the scope of the policy does not match the scope of the externality (trade policy to correct for domestic externality);

Case 1: Can trade policy correct a negative production externality in a small exporter? Assume a small exporter producing a “dirty” good; the production of the good generates a negative externality (environmental damage); The social cost of producing that good is greater than the private cost: the difference is the environmental damage; Private supply curve reflects the private cost; social supply curve reflects the social cost;

Without policies producers overproduce the dirty good c+d = social welfare loss from overproducing

First best policy: a domestic tax equal to the difference between social and private cost; Private producer welfare: –(a+b+c+d+e); Tax revenue: a+b+c+d Social welfare: e + f Net welfare gain: f e: transfer from private producers to society

Second best policy: with an export tax also consumers face a lower price Private producer welfare: –(a+b+c+d+e+g); Tax revenue: c+d Social welfare: e + f Consumer welfare :a+b Net welfare gain: f - g g: deadweight loss consumption distortion introduced by the policy

Case 1: Can trade policy correct a negative production externality in a small exporter?

Case 2: Can trade policy correct a negative consumption externality in a small importer? Assume a small importer consuming a “dirty” good; the consumption of the good generates a negative externality (environmental damage); The social cost of consuming that good is greater than the private cost: the difference is the environmental damage; Private demand curve is higher than the social demand curve.

Without policies consumers overconsume the dirty good c+d = social welfare loss from overconsuming

First best policy: a consumption tax equal to the difference between the private and social demand; Private consumer welfare: –(c+d+g+h); Tax revenue: c + d + g Social welfare: h + i Net welfare gain: +i h: transfer from private consumers to society

Second best policy: with an import tax both consumers and producers face a higher price Private consumer welfare: –(c+k+d+g+h); Govt revenue: d+g Social welfare: h + i Producer welfare: +c Net welfare gain: i- k -k: deadweight loss: distortion introduced by the policy

Case 2: Can trade policy correct a negative consumption externality in a small importer?

What if the scope of externalities is global? National policies are ineffective i.e. they do not reduce the environmental damage; The first best policy in this case can be a “global” policy; Global policy means international coordination of policies: One example is the global warming and the Kyoto Protocol