Environmental policy and trade under non-competitive markets: Directions for developing economies

Abstract

This paper is only a first step towards an understanding of the effects of strategic environmental policy. Even the simple framework developed here provides interesting insights. As the precedent analysis has made clear, the optimal pollution policy under domestic distortions can be decomposed into a "domestic output effect", a "trade effect", and a "pollution effect". The "domestic output effect" captures the change in welfare coming from a change in domestic firms sale, the "trade effect" captures the change in welfare coming from a change in the level of imports, while the "pollution effect" captures the negative effect on welfare of domestic emissions. Then, the optimal pollution policy can imply a tax or subsidy for the domestic industry, which will depend on the specific characteristics of a given economy. This result emphasizes the idea, as is well known, that the outcomes for the case of one distortion do not hold in an optimal-second best pollution policy. With respect to the issues of international trade, we showed that international trade unambiguously increases social welfare and that the effect of an increase in the level of the domestic tariff is uncertain on optimal pollution tax. The analysis presented appears robust to other specifications of functional forms; the use of specific and relatively simple functional forms allowed calculation of closed-form solutions for variables of interest and allowed a clear understanding of the underlying economic principles at work in the analysis. There are many additional of research that could be pursued. A natural extension is to consider a simple two-country model with endogenous world prices.