Can Trade Be Good for the Environment?

• Date: 01 April 2017
• Published date: 01 April 2017
• DOI: http://doi.org/10.1111/jpet.12176

CAN TRADE BEGOOD FOR THE ENVIRONMENT?

HARVEY E. LAPAN

Iowa State University

SHIVA SIKDAR

Keele University

Abstract

We analyze the impact of trade in a differentiated good on environmen-

tal policy when there is local and transboundary pollution. In autarky,

the (equivalent) pollution tax is set equal to the marginal damage from

own emissions. If the strategic policy instrument is a tax, leakage occurs

under trade and tends to lower the tax. The net terms of trade effect,

due to the exportable and importable varieties of the differentiated

good, tends to increase the tax. We derive conditions under which pol-

lution taxes under trade are higher than the marginal damage from

own emissions, i.e., higher than the Pigouvian tax and than that un-

der autarky. Then, pollution falls under trade relative to autarky. When

countries use quotas/permits to regulate pollution, there is no leak-

age, while the net terms of trade effect tends to make pollution policy

stricter. The equivalent tax is always higher than the marginal damage

from own emissions, i.e., always higher than the Pigouvian tax and than

that under autarky; hence, pollution always falls under trade. Our anal-

ysis provides some insight into the findings in the empirical literature

that trade might be good for the environment.

1. Introduction

The relation between trade and environmental policy has received extensive cover-

age due to the concern about the detrimental effect of trade on the environment.1

Large countries can use weaker environmental regulation as a second-best method of

pursuing terms of trade goals. Also, leakage effects (which occur when strict domestic

1See, for instance, Environment and Trade, A Handbook, 2005, published by the United Nations En-

vironment Programme and the International Institute for Sustainable Development (available at

http://www.iisd.org/sites/default/files/pdf/2005/envirotrade handbook 2005.pdf).

Harvey E. Lapan, Department of Economics, Iowa State University, 283 Heady Hall, Ames, IA 50011

(hlapan@iastate.edu). Shiva Sikdar, Keele Management School, Keele University, Darwin Building,

Keele ST5 5BG, UK (shivasikdar@gmail.com).

We are thankful to an Associate Editor and an anonymous referee for their comments and sugges-

tions, which significantly improved the paper. The usual disclaimer applies.

Received June 28, 2013; Accepted December 1, 2014.

C2016 Wiley Periodicals, Inc.

Journal of Public Economic Theory, 19 (2), 2017, pp. 267–288.

267

268 Journal of Public Economic Theory

pollution policy leads to increased foreign pollution through changes in the world price

of pollution-intensive goods) tend to make environmental policy weaker under trade.2

Empirical studies, in contrast to the aforementioned concerns, indicate that the

impact of trade on the environment is not necessarily negative. Grossman and Krueger

(1993), for instance, find that the North American Free Trade Agreement (NAFTA)

would have had a positive impact on the global environment. Strutt and Anderson

(2000) analyzed the case of Indonesia, which was undertaking trade liberalization, and

showed that trade reforms would improve the environment.3Using global environmen-

tal monitoring system (GEMS) data on SO2concentrations from 43 countries between

1971 and 1996, Antweiler, Copeland, and Taylor (2001) conclude that free trade ap-

pears to be good for the environment. Our theoretical analysis seeks to identify condi-

tions under which trade can be good for the environment in line with these empirical

findings.

The effect of trade on environmental policy has been extensively analyzed theo-

retically in both strategic and nonstrategic settings.4Most of the theoretical literature

focuses on interindustry trade; however, it is well known that a significant proportion of

trade is intraindustry trade in similar goods between similar countries.5This paper ana-

lyzes the effect of intraindustry trade on environmental policies in the presence of local

and transboundary pollution when countries set their policies strategically. Weshow that

trade can lead to stricter environmental policies and consequently lower pollution than

under autarky. While these results are in keeping with the empirical findings that trade

can be beneficial for the environment,6they arise not because of the assumption that

higher incomes lead to greater demand for cleaner environment, and hence decreased

pollution, but rather because of the strategic effects associated with policy setting.

Leakage effects in the context of intraindustry trade have been analyzed in Rauscher

(1997), chapter 6, and G¨

urtzgen and Rauscher (2000) using the Dixit–Stiglitz frame-

work of monopolistic competition. Also, Fung and Maechler (2007) use a two-country

“price-setting duopoly model” along the lines of Brander and Krugman (1983) to ex-

amine the effect of trade liberalization on the environment. However, these papers an-

alyze the effect of a change in the policy of one of the two countries, while the other

country holds its policy fixed. Although the strategic (Nash) equilibrium where both

countries choose policies noncooperatively would be of interest, given their framework,

as G¨

urtzgen and Rauscher (2000) point out, “this is an intractable problem.” In contrast

to these papers, which consider unilateral policy, we analyze the strategic game between

two policy-active countries when environmental policy is the strategic variable in each

country and also compare outcomes under different policy instruments. To maintain

tractability, we use a perfectly competitive framework of intraindustry trade rather than

the monopolistic competition framework.

2See, for instance, Rauscher (1997), Yanase (2007), and Lapan and Sikdar (2011). G¨

urtzgen and

Rauscher (2000) discuss other mechanisms through which leakage occurs.

3See also Lee and Roland-Holst (1997) for a two-country computable general equilibrium (CGE)

model calibrated to Indonesia and Japan which finds that trade liberalization can lower emissions and

raise welfare simultaneously.

4See, for instance, Copeland and Taylor (2004) for a comprehensive and critical review of the issues.

5See Grubel and Lloyd (1975) for one of the earliest analyses. Other empirical studies on intraindustry

trade include Tharakan (1984), which points out the increase in intraindustry trade between OECD and

developing countries, and Bernhofen (1999), which examines intraindustry trade in petrochemicals

between Germany and the United States.

6Karp, Sacheti, and Zhao (2001) show that, when property rights for renewable resources are imper-

fect, trade can make the property rights regime stricter.