Does a Stricter Environmental Policy Discourage Foreign Direct Investment

Abstract

We set up a two-country model in which a foreign firm chooses FDI or exporting to enter the host market, and plays a Cournot competition game with 11 host firms. Facing the host country's emission tax policy, all firms located in the host country use the same abatement technology to abate emissions. The major findings are as follows. When the trade cost is high and the abatement technology is efficient, a higher emission tax rate may encourage FDI. Moreover, under plausible parameters, raising the emission tax to drive the foreign firm out of the host country will be detrimental to environmental quality but raise consumer surplus in the host country. The interaction of the abatement technological efficiency and trade cost with emission tax plays a key role in the entry mode of the foreign firm and the associate welfare of the host country.