An Alternative Base Case for Modeling Trade and the Global Environment

Abstract

The trade-and-environment literature often begins with a generic base case. Sectors differ in pollution intensities and countries have sectoral comparative advantage. Pollution comes from production, not consumption, and consumers have identical, homothetic preferences over goods and environmental quality. Policy instruments are Pigouvian taxes and tariffs. I argue that this model is counter-empirical in some ways and assumes away other crucial features. I offer a simple alternative base case, in which global pollution is proportional to all economic activity, and where environmental quality has an income elasticity of demand exceeding one. An income tax can fund an abatement activity, diverting resource from production and creating a terms-oftrade externality that passes some costs of abatement to the other country. I contrast cooperative and non-cooperative outcomes between governments of two countries differing in per-capita incomes. Free trade is good for the environment because (a) gains from trade increase resources devoted to abatement and (b) countries can pass more of their abatement costs to the other country in the non-cooperative case. Leakage takes a very different form called “policy leakage” and border taxes are counter-productive. When per-capita income differences are large, a poor country may be worse off when the large country abates (reversing the usual argument on free riding) and cooperative bargaining over abatement levels may offer no gains. Finally, I examine “issue linking” in bargaining when one country is both large and rich, and hence has both a high tariff and a high abatement effort in a non-cooperative equilibrium.