Trade Liberalisation and Environmental Regulation in Developing Economy

Abstract

The article develops a static three-sector, specific-factor, competitive general equilibrium model of a small open developing economy highlighting the role of environmental pollution in the determination of the skilled–unskilled wage inequality and the extent of urban unemployment as a result of different economic policies. Production of the urban unskilled sector generates pollution in this model. It is shown that inflow of FDI, in the basic model where only two urban sectors use capital, exerts a favourable impact on average low-skilled wage as well as on the relative wage inequality although the unemployment situation of urban unskilled workers may worsen. Trade liberalisation, on the other hand, aggravates wage inequality but improves the urban unemployment problem unconditionally. However, Stringent environmental regulation is likely to produce an adverse impact on skilled–unskilled wage inequality though the impact on urban unemployment is ambiguous. These results do not hinge on the nature of capital mobility between different sectors and, therefore, are robust. In the second part of the analysis, where capital is mobile between all three sectors, inflows of FDI have no impact on relative wage inequality though unemployment problem worsens unquestionably. Urban unemployment situation, however, improves following a reduction in import tariff or increase in pollution tax though relative wage inequality worsens under a reasonable factor intensity condition.