Achieving Environmental Goals in a World of Trade and Hidden Action: The Role of Trade Policies and Eco-labeling

Abstract

Consumers, mainly in Europe and North America, frequently express concerns about the environmental, social or health impacts of the products they purchase. When these products are produced abroad, consuming countries often resort to using trade policies and consumer actions targeting imported products in order to reduce negative environmental or social impacts. Traditionally, these policies were non-discriminatory, i.e., they treated all imports equally, without considering the actual damages caused by the product. More recently, there is a trend towards process-discriminatory policies which attempt to discriminate against imports from environmentally or socially unsound production processes while encouraging environmentally or socially sound alternatives. Such policies often rely on eco-labeling and costly monitoring of the producers' claims. This paper develops a theoretical model of the consuming country's optimal trade policy, allowing for asymmetric information and costly monitoring. I analyze what type of policy is preferable under what conditions, and how the optimal policy depends on the target country's alternative markets and the type of consumer concern. It is shown that imperfect information reduces the optimal level of sound and total imports while raising the level of unsound imports. It is generally optimal to monitor imperfectly, and non-discriminatory policies can be interpreted as corner solutions to the optimal process-discriminatory policy. The observed shift from non-discriminatory policies to process-discriminatory policies over time might be explained by a reduction in monitoring costs. The target country always at least weakly prefers process-discriminatory policies over non-discriminatory policies, possibly explaining why producing countries establish their own labeling systems when faced with the threat of non-discriminatory policies. The optimal tariff on unsound imports is shown to be generally less than the Pigouvian tariff and is less for consumption pollution, health and safety effects, and moral concerns than for production pollution. Implementation of the optimal policy through consumer action rather than trade policy is also discussed.