Free Trade and Strategic Environmental Policy Huei-Chin Lin National Dong-Hwa University

Introduction Eco-dumping and free trade  Rent-shifting effect, e.g. Brander and Spencer (1985)  Burden-shifting effect, or pollution-shifting effect, e.g. Markusen et al.(1992)  Terms of trade effect and general equilibrium effect, e.g. Krutilla (1991), Rauscher (1994)  Inferior factor effect, e.g. Greaker (2003)  Bertrand vs. Cournot competition, e.g. Eaton and Grossman (1986), Barrett (1994)

The Model Two-stage, two-country model Government sets the emission tax in the first stage Firms choose their output level in the second stage Firms from different countries have different abatement/transitional cost

Notation θi is the marginal costs of abatement. ei = e(θi ) is the emission level per unit of output,, and suppose e' 0. di = d( ) denotes damages from local, global, and transboundary pollution, suppose d' > 0, d" > 0, n: # of firms in each country

Notation (cont.) denotes the share of country i ’ s total environmental damage caused by country j ’ s production. : purely rivalry case (in externality) : purely non-rivalry case

2nd Stage: Industry Equilibrium A representative firm solves where : total production in country i, : total consumption in country i,

First order condition: Let |e'|= k = - e'.

The second-order condition 3p'+p"y < 0

Symmetry case: Equilibrium output:

Learning-By-Doing Capability Differentiate (4) with respect to y and k yields If dθ/dk<0, and by definition e'= - k, then dy/dk > 0.

Learning-By-Doing Capability (cont.) k = -e '=−(∂e/∂θ) can be treated as a “learning by doing” capability, it shows the effect of the abatement spending on the reduction of emission. Suppose the size of k is affected by transitional costs of adopting /managing/developing abatement technology. The lower the transitional costs the higher the size of k. m = ∂k/∂θ = −e" can be treated as “marginal learning by doing capability”. ∂k/∂θ< 0, which means “learning-by-doing” effect increases with a decreasing rate when firm increases its abatement experiences.

Learning-By-Doing Capability (cont.) Hence, higher k means a more effective learning-by-doing capability. dy/dk > 0, i.e., higher k induces higher y. Countries with lower transitional costs of adopting new abatement technology will have higher k, and consequently, it would be able to produce more output.

Learning-By-Doing Capability (cont.) Differentiate equation (3) with respect to θi and ti yields > 0

1st stage: Efficient Emission Taxes The joint welfare function is 

1st stage: Efficient Emission Taxes (cont.) First-order condition:

Symmetry case The efficient tax is

1st stage: Nash Equilibrium Taxes Government chooses ti to maximize

1st stage: Nash Equilibrium Taxes (cont.) First-order condition:

1st stage: Nash Equilibrium Taxes (cont.) The symmetric Nash equilibrium tax is Compared with the efficient tax

Nash Equilibrium Tax vs. Efficiency Tax under the symmetric case > 0 and  t(NE) > t* < 0 and  t(NE) < t*

Conclusion Higher technological capability (i.e. k ) on abatement induces higher equilibrium output. when emission taxes can yield more welfare benefit from reduced pollution damages than the welfare loss of profit reduction, if the country’s additional pollution caused by home production (i.e. ) is greater/less than the cost of domestic firms’ effort on abatement innovation (i.e. ), then government will have the incentive to set a low/high emission tax rate (lower/higher than the efficient level).

Conclusion (cont.) when emission taxes yield less welfare benefit from reduced pollution damages than the welfare loss of profit reduction, if the country’s additional pollution caused by home production (i.e. ) is less than the cost of domestic firms’ effort on abatement innovation (i.e. ), then government will have the incentive to set a low emission tax rate (lower than the efficient level).

Conclusion (cont.) And when the country’s additional pollution caused by home production is equal to the cost of domestic firms’ effort on abatement innovation, (i.e. ) Nash equilibrium emission tax is equal to the efficient tax level.