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The Impact of Intra-Industry Trade on the Environment

Abstract

Empirical evidence suggests that international trade ‡ows take increasingly the form of intra- ratherthan inter-industry trade. So far, however, the literature has not addressed the environmental impactof trade liberalization in the context of two-way trade. The purpose of this paper is to …ll this gap andto show that under oligopolistic competition, the environmental e¤ects of trade di¤er signi…cantly fromthose predicted under standard inter-industry trade models. We show that environmental deteriorationis determined largely by which country liberalizes trade and by the nature of pollution. Implications forFDI and anti-trust policies are also discussed.

JEL classi…cation : F12, F18, F23

Keywords : Environment; Intra-industry trade; Foreign direct investment; Trade liberalization.

We are grateful to Brian Copeland for detailed comments on an earlier draft. Comments from Kar-Yiu Wong, Keith Markusen and Larry Goulder as well as from participants at the ”World Trade and theWTO Conference”, University of Washington, and at the ”SCCIE Workshop on Emerging Trade Issuesat the WTO”, University of California at Santa Cruz, greatly improved the quality of the present paper.Funding from the UCSC Social Science Division Research Grant is gratefully acknowledged. Any errorsand omissions are of course our own.

K.C. FungUniversity of CaliforniaEconomics Department217A Social Sciences 1Santa Cruz, CA 95064USAEmail: [email protected]

Andréa M. MaechlerSwiss National BankBörsenstrasse 15P.O. BoxCH - 8022 ZurichSwitzerlandEmail: [email protected]

1 Introduction

Recent years have witnessed two interesting developments in trade theory, namely, the emergence

of intra-industry trade as a widespread phenomenon and a revitalization of the concern about

the environmental consequences of international trade.1 By providing a link between these

two strands of the literature, the present paper departs from the standard inter-industry trade

approaches used in the trade-environment debate and o¤ers new perspective to revisit this issue

in the context of intra-industry trade.

The concept of intra-industry trade emerged when it became apparent that much of the trade

growth experienced over the last …fty years is attributable to an increase in two-way trade within

the same industry. This is particularly true for the manufacturing sector, among which rank some

of the most pollution-intensive industries, including chemicals, metallurgy, mining, and paper

and pulp. Bernhofen (1999), for example, has tested and supported the statistical evidence that

a signi…cant share of international trade in certain highly polluting industries, such as the coal

market, takes the form of two-way trade.

For illustration, Table 1 presents indexes of intra-industry trade for selected industries in 1998.

While the …rst column presents intra-industry trade indexes for the U.S., the second column

presents those for Western Europe. These two sets of data allow to illustrate the extent to which

intra-industry trade is not a U.S.-speci…c phenomenon but rather a widespread characteristic of

international trade. An index close to one (such as 0.98 for machinery and transport equipment

in Western Europe) indicates that for this industry Western Europe imports almost as much as

it exports, while an index close to zero (such as 0.30 for clothing in the U.S.) indicates that for

1 For excellent surveys on the environment-trade nexus, see Anderson and Blackhurst (1992), Beghin and Potier(1997), Beghin, Roland-Holst and van der Mensbrugghe (1995) and Low (1992). See Bhagwati and Srinivasan (1997)for critical discussions on the international harmonization of environmental standards. Finally, Rauscher (1997)o¤ers an insightful chapter on the interlinkages between trade and the environment in an imperfect competitionframework. Although the main focus of his work considers how environmental policies can be used to achievetrade-related policy objectives, he introduces a monopolistic competition model to sketch some of the environmentalconsequences of intra-industry trade.

1

this industry, the U.S. is only an exporter or an importer.2 Overall, although the average intra-

industry trade indexes are high in both regions, it is higher in Western Europe than in the U.S.

(respectively, 0.96 and 0.85). While earlier empirical work focuses on industrial countries, more

recent studies suggest that this phenomenon is not limited to industrialized countries and can be

signi…cant in developing countries.3 In fact, a new consensus is emerging from recent experience

suggesting that trade liberalization has been a powerful vehicle for the growth of intra-industry

trade in a wide range of countries.4

The observation that an increasing share of trade expansion is taking the form of intra- rather

than inter-industry trade is of particular importance when examining the far-reaching environmen-

tal consequences of trade liberalization. For example, the literature recognizes that the adjustment

costs associated with shifting resources across industries (i.e., from import-competing industries

to export-competing industries) are generally much larger than those associated with switching

resources across di¤erent product lines within the same industry.5 Following the same argument,

trade liberalization is also likely to yield very di¤erent e¤ects on the environment depending on

whether the underlying structure of trade leads to inter- or intra-industry trade expansion. This

suggests that, in the presence of intra-industry factor movements, the interactions between inter-

national trade and the quality of the environment need to be analyzed in their own right, that is,

independently of what occurs in the presence of inter-industry factor movements.

So far, however, the question of international trade and the environment has not been addressed

in the context of intra-industry trade. Thus, the purpose of this paper is to …ll this gap in the

2 For a recent empirical study of intra-industry trade in pollution-intensive homogeneous products, see therecent work by Bernhofen (1999). This paper uses the Brander (1981) model of intra-industry trade in identicalcommodities to conduct an empirical investigation in the context of the petrochemical industry in Germany andthe United States.

3 For a comprehensive survey of the literature on intra-industry trade, see Greenaway and Milner (1986),Greenaway and Torstensson (1997) and Helpman (1987). Tharakan (1984) provides evidence on intra-industrytrade between OECD countries and the developing world.

4 For example, Hoekman and Djankov (1996) presents evidence for trade liberalization-induced intra-industrytrade expansion in Eastern Europe, Lee and Lee (1993) in Korea and Menon (1994) in Australia.

5 Krugman (1981), for example, shows that in the context of intra-industry trade it is possible for all factors ofproduction to gain, which can alleviate adjustment costs. See Menon and Dixon (1996, 1997) for a general discussionon factor market disruption under inter- versus intra-industry trade.

2

literature and to add elements of intra-industry trade to the current debate on trade and the

environment.

[Table 1]

Broadly, the literature on the environmental consequences of international trade distinguishes

between three e¤ects, namely, the scale e¤ect that always increases pollution (trade induces more

output, which means more pollution); the technique e¤ect that always decreases pollution (trade

makes cleaner technologies available, which reduces pollution) and the composition e¤ect (trade

alters the pattern of production).6 To isolate the link between intra-industry factor relocation

and environmental damage, we put aside both, the technique and the scale e¤ects and focus on

the third and largely contentious e¤ect, that is, the composition e¤ect of trade.7

The composition e¤ect of trade relies on the theory of comparative advantage to predict how

trade alters the composition of national output and thereby, the quality of the environment.8

For example, trade may deteriorate the quality of the environment if it causes, say, the relatively

capital-abundant countries to specialize in the (dirty) capital-intensive goods.9 Trade may also

deteriorate the quality of the environment if it induces the dirty industries to relocate away from

the industrialized countries imposing tougher environmental standards towards the lower-income

countries requiring lower environmental standards.10 According to these arguments, global trends

6 This decomposition is …rst introduced in Grossman and Krueger (1993, 1995), elaborated in Copeland andTaylor (1994, 1995a, 1995b) and then tested in Antweiler, Copeland and Taylor (1998). Note that the scale and thetechnique e¤ects can incorporate the income e¤ect, which is discussed in Copeland (1996), Copeland and Taylor(1999) and Grossman and Krueger (1993).

7 The technique e¤ect relies on a very di¤erent set of theoretical premises dealing with the role of technologicalprogress. The scale e¤ect requires a general equilibrium analysis, while our model, which follows the tradition ofthe new oligopoly literature, is set in a partial equilibrium framework. It is important to keep in mind, however,that whatever the environmental consequences of trade via the composition e¤ect are (which Antweiler, Copelandand Taylor (1998) …nds to be only slightly negative), the full impact of trade may be either positive or negative,depending on the relative strength of the (positive) technique and the (negative) scale e¤ects.

8 The theory of comparative advantage predicts that a country tends to export products that use intensivelythe factors of production with which it is relatively well endowed, and import those that use intensively its scarcefactors. With respect to the environment, the e¤ects of trade depend on whether a country becomes an exporteror an importer of pollution-intensive goods in the post-liberalization situation. In the absence of transboundarypollution, trade is good for the domestic environment in the former case, while it is bad in the latter case.

9 This hypothesis, which is refered to as the ”simple factor endowment” hypothesis, relies on factor-abundanceto explain the link between trade and the environment.

10 The literature refers to this hypothesis as to the ”pollution-haven” or ”dirty industry migration”.

3

in environmental degradation are explained by inter-industry factor relocation.

The present paper, however, o¤ers a very di¤erent approach to address the trade-environment

nexus. It focuses on intra-industry trade as the main culprit of environmental degradation. In this

context, the composition e¤ect of trade generates a very di¤erent kind of change in the pattern

of production, namely, one that alters an industry’s output mix across international oligopolies

rather than modifying a country’s commodity mix across industries. In particular, we …nd that

global trends in environmental deterioration are determined largely by two factors, namely: (i) by

which trading partner liberalizes trade, and (ii) by the nature of pollution (i.e., whether pollution

is local, transboundary or global). For example, our model predicts that the global environment

can bene…t from trade liberalization, provided that the most pollution-intensive country liberalizes

trade.

By restricting our analysis to the context of oligopolistic intra-industry trade, our model iso-

lates the source of trade to be determined solely by the strategic interactions of oligopolistic

polluting …rms and not by cost di¤erences and/or by economies of scale.11 In reality, of course,

the determinants of trade are manifold, including di¤erences in factor endowments, income lev-

els, technological capabilities and regulatory and institutional frameworks. But given the strong

empirical evidence in support of a substantial and ever-growing volume of intra-industry trade, it

remains useful to analyze the likely impact of international trade on the quality of the environment

in this limited context.

This paper is organized as follows. Section 2 presents our basic duopoly model of intra-

industry trade and derives the environmental consequences of trade liberalization under local,

transboundary and global pollution. Section 3 extends the basic model to verify the validity of

our results in the presence of multiple …rms. In Section 4, we examine how trade collusion alters

our basic results. In Section 4, we introduce foreign direct investment (FDI) to discuss the impact

11 Note, however, economies of scale would be a key determinant of environmental deterioration in the contextof monopolistic competition.

4

of trade liberalization on the quality of the environment when one of the trading partner engages

in FDI activities. Finally, concluding comments are provided in Section 5.

2 Basic Model

2.1 Framework

We develop a standard intra-industry trade model in the tradition of Brander (1981) and Brander

and Krugman (1983). There are two countries, a home country and a foreign country, each

holding one polluting …rm. Consumers consume goods which are produced both at home and

abroad. Because most intra-industry trade occurs between similar economies, it is safe to assume

that the two countries have similar tastes and endowments. The home (foreign) country produces

a pollution-intensive good which is sold in the home (foreign) market and which can also be

exported to the foreign (home) market. The pro…t function of, respectively, the home and the

foreign …rm is written as:

¼x = x1px1 + x2px2 ¡ ex(x1 + x2) ¡ txx2 (1)

¼y = y1py1 + y2py2 ¡ ey(y1 + y2) ¡ tyy1 (2)

where xi (i = 1; 2) represents a pollution-intensive good that is produced in the home country and

yi (i = 1; 2) represents a pollution-intensive good that is produced in the foreign country. The

subscripts indicate whether a good is sold in the home market (1) or in the foreign market (2).

For example, while the …rst term in equation (1) represents the domestic sales of the home

…rm, the second term represents its export sales. The third term represents the home pollution tax

ex; which the home country imposes on all home-produced pollution-intensive goods, regardless

of whether they are sold at home or abroad. Finally, the fourth term represents the foreign

import tari¤ tx; which the home country faces when exporting its pollution-intensive production

abroad. Similarly for the foreign pro…t function in equation (2), where the …rst term represents

its export sales to the home country, the second term represents its domestic sales to the foreign

5

market, the third term represents the foreign pollution tax ey imposed on the foreign-produced

pollution-intensive good and the fourth term represents the home import tari¤ ty imposed on

foreign exports.

To highlight the environmental e¤ects of trade liberalization, we assume zero production and

transportation costs and focus solely on pollution taxes and/or trade protection. While the as-

sumption of zero production and transportation costs greatly simpli…es the interpretation of the

results, it does not a¤ect its general conclusions.

We assume a symmetric linear demand structure and allow for di¤erentiated goods (that is,

we assume ¯1 = ¯2 6= °)12 :

pxi = ®1 ¡ ¯xi ¡ °yi

pyi = ®2 ¡ ¯yi ¡ °xi

where ®i (i = 1; 2) > 0, ¯ > 0, and ° > 0. Assuming that the …rms are Cournot-Nash players,

the …rst-order pro…t maximization conditions yield the following outputs:

xCN1 =

2¯(®1 ¡ ex) ¡ °(®2 ¡ ey ¡ ty)D

(3)

xCN2 =

2¯(®1 ¡ ex ¡ tx) ¡ °(®2 ¡ ey)D

(4)

yCN1 =

2¯(®2 ¡ ey ¡ ty) ¡ °(®1 ¡ ex)D

(5)

yCN2 =

2¯(®2 ¡ ey) ¡ °(®1 ¡ ex ¡ tx)D

(6)

where D =¡4¯2 ¡ °2

¢: Note that the concavity assumption of the aggregate utility function

Ui associated with the above demand functions implies that (¯2 ¡ °2) > 0. Furthermore, we

assume that the own-price e¤ects are greater than the cross-price e¤ects, that is, ¯ > °.

12 This demand structure is associated with the following aggregate utility function: Ui = wi + mi wherewi =

©®1xi + ®2yi ¡ 1

2

£¯(x2i + y

2i ) + 2°xiyi

¤ªrepresents the expenditure on xi and yi and mi the expenditures

on all other goods in country i.

6

2.2 Conditions for Intra-Industry Trade

The existence of intra-industry trade requires that xCN2 > 0 and yCN

1 > 0. Thus, the conditions

for intra-industry trade can be expressed as:

xCN2 > 0 iff

2¯°

>(®2 ¡ ey)

(®1 ¡ ex ¡ tx)

yCN1 > 0 iff

2¯°

>(®1 ¡ ex)

(®2 ¡ ey ¡ ty)

According to the above conditions, intra-industry trade is more likely to occur in the presence

of: (i) greater product di¤erential (high ¯=°); (ii) low import tari¤s, ti; and (iii) lower envi-

ronmental standards imposed on the exporting country i (high ®i ¡ ei), where i represents the

non-liberalizing country.13

2.3 Unilateral Trade Liberalization

Assume that the home (foreign) country implements a unilateral trade liberalization, such that

dty < 0 (dtx < 0): The impact of such a trade policy on the demand for pollution-intensive goods

is given in the following equations:

@xCN1

@ty=

°D

> 0 (7)

@yCN1

@ty= ¡2¯

D< 0 (8)

For example, by unilaterally liberalizing trade, the home country facilitates the access of foreign

pollution-intensive goods into the home market. Given our earlier assumption that the own-price

e¤ects exceed the cross-price e¤ects (i.e., ¯ > °), the increase in imports exceeds the fall in the

demand for the domestically produced good (i.e.,¯̄@yCN

1 =@ty¯̄>

¯̄@xCN

1 =@ty¯̄). Thus, on aggregate,

13 The results in the present paper are derived under the assumption that the pollution-intensive goods aredi¤erentiated goods (i.e., ¯1 = ¯2 6= °): Assuming homogenous goods (i.e., ¯1 = ¯ = °); however, would not altersigni…cantly our results, except that the conditions for intra-industry trade become stricter, requiring an even lowerimport tari¤ and/or an even higher environmental di¤erential between the two countries for our results to hold.

7

a unilateral trade always increases the domestic consumption of the pollution-intensive good and

reduces its domestic production.

Similarly for a foreign trade liberalization, which increases the demand for the imported good

by more than it decreases the demand for the domestically-produced polluting good, raising the

aggregate foreign consumption of the pollution-intensive good and reducing its foreign production.

@yCN2

@tx=

°D

> 0 (9)

@xCN2

@tx= ¡2¯

D< 0 (10)

In summary, a unilateral trade liberalization (dti < 0) raises the pollution-intensive output in

the non-liberalizing country and lowers it in the liberalizing country. Furthermore, the liberalizing

country increases its aggregate consumption of the pollution-intensive good.

Although these results set the stage for our analysis, we need to go one step further and to

model how the volume e¤ects of trade liberalization presented in equation (7)-(10) above translate

into the environmental impact of trade liberalization. This is what we do next.

2.4 Environmental Damage

In this section, we focus on how a unilateral trade liberalization a¤ects the environment in a world

where the quality of the environment is a by-product of the production of pollution-intensive

goods.14 To tackle this question, we assume that pollution harms consumers without a¤ecting

the production possibility frontier and that the source of pollution may lie outside of national

boundaries. We di¤erentiate between three types of pollution, namely: (i) local pollution; (ii)

transboundary pollution; and (iii) global pollution.15

14 Although most of the existing theoretical work focuses on production-generated pollution, Copeland andTaylor (1995, 1999) examine, respectively, pollution as a by-product of consumption and pollution as it a¤ectsproductivity.

15 Although there is an extensive literature on transboundary pollution (see Dean 1992 for a survey), there islittle work examining the environmental consequences of trade in an imperfect competitive framework and evenless in an intra-industry setting (see Rauscher 1997).

8

Although there exists no strict line delimiting local pollution from transboundary or even

global pollution, the impact of various types of production-generated pollutions on the environ-

mental quality may be very di¤erent in scope. When pollution is local, a country’s environmental

damage is determined entirely by its domestic polluting production. Examples of local pollution

abound and include urban air pollution, local soil erosion and local contamination of water, air

and land. When pollution is transboundary, environmental damage spills across national bound-

aries and the quality of a country’s environment is determined by the sum of two components,

namely, the pollution generated by its own domestic polluting production and a fraction of the

pollution generated during the polluting production abroad. Acid rain, for example, is often cited

as an illustration of transboundary pollution. The production of certain pollution-intensive goods

releases pollutants in the air, which are then carried by winds hundreds of miles away from their

production site before being deposited again in the atmosphere through rain, fog or snow. In

this situation, a country cares about the type and the quantity of pollution generated abroad.

Finally, when pollution is global, a country’s environmental damage is determined by the aggre-

gate pollution-intensive production, regardless of the country of production. Examples of global

pollution include the deterioration of the ecosystem, the depletion of the ozone layer and global

warming.

The environmental damage of, respectively, the home and the foreign country, can be written

as:

Edx = dx(x1 + x2) + ´ydy(y1 + y2)

Edy = dy(y1 + y2) + ´xdx(x1 + x2)

where di (i = x; y) represents the environmental damage associated with the pollution-intensive

goods produced, respectively, in the home (x) country and in the foreign (y) country. ´i represents

the pollution spillover parameter and illustrates the extent to which pollution generated in one

9

country damages the environment in the other country.16 At one extreme, í is zero and one

country’s pollution does not a¤ect the quality of the environment in the other country. This is the

case of local pollution. At the other extreme, í is equal to one and pollution produced in either

country a¤ects both countries equally. This is when pollution is global. Finally, if í lies somewhere

between zero and one, pollution is transboundary. In this case, no country is completely insulated

from the other country’s pollution and pollution incurred in one country spills over to the other

country. Since the pollution parameter is between zero and one, the damage that a country incurs

from its own pollution is greater than the damage it incurs from the pollution generated abroad.

To clarify our analysis, we assume that the home country is the ’clean’ country, in the sense

that it imposes a higher pollution tax than the foreign country, or, ex > ey. Furthermore,

we also assume that the stricter environmental standards induce the clean country to generates

less pollution than the foreign country or, dx < dy. These assumptions allow us to focus on a

particular scenario, without compromising the generality of our results. Henceforth, we will use

interchangeably the terms of home and clean country on the one hand, and of foreign and dirty

country on the other hand.

We can turn now to the e¤ects of a unilateral trade liberalization on the environment.

2.4.1 Local Pollution

When pollution is local, the environmental damage of, respectively, the home and the foreign

country, is given by:

Edlx = dx(x1 + x2)

Edly = dy(y1 + y2)

16 While there is an extensive literature on transboundary pollution, it is mostly concerned with how environmen-tal regulations a¤ect trade, rather than how trade a¤ects the quality of the environment (Siebert, 1977 and Baumoland Oates, 1988). See Copeland and Taylor (1993, 1995a, 1995b) for a discussion on the role of transboundarypollution in the debate over trade and the environment.

10

Clearly, under local pollution, there is a direct link between a country’s level of polluting pro-

duction and the quality of its environment: a country raises (lowers) the quality of its environment

if it decreases (increases) its pollution-intensive production. The e¤ects of a unilateral trade lib-

eralization by the clean country on the environmental damage of, respectively, the clean and the

dirty country, are given by:

@Edlx

@ty=

°dx

D> 0

@Edly

@ty= ¡2¯dy

D< 0

We have seen above that a unilateral trade liberalization raises the polluting output in the

non-liberalizing country and reduces it in the liberalizing country. Thus, a trade liberalization by

the clean country transfers the production of the pollution-intensive good away from the clean

country towards the dirty country. This lowers the environmental damage in the clean country

and raises it in the dirty country, or, put di¤erently, this raises the quality of the environment in

the clean country and deteriorates in the dirty country.

Similarly, if the dirty country liberalizes trade, the production of the pollution-intensive good is

shifted away from the dirty country towards the clean country. Thus, a unilateral trade liberaliza-

tion by the dirty country lowers the environmental damage in the dirty country (which produces

now less of the pollution-intensive good) and raises it in the clean country (which produces now

more of the pollution-intensive good). This can be seen in the following equations:

@Edlx

@tx= ¡2¯dx

D< 0

@Edly

@tx=

°dy

D> 0

These equations highlight one very interesting point, namely, that a unilateral trade liberal-

ization actually improves the quality of the environment in the country that liberalizes trade,

regardless of which country is liberalizing. This is a very di¤erent outcome than the one generally

11

predicted under standard inter-industry trade models, where comparative advantage generally

drives the economic consequences of trade liberalization. This result can be formalized in the

following terms.

Proposition 1 Assuming that pollution is local, a unilateral trade liberalization improves thequality of the environment in the liberalizing country and deteriorates it in the non-liberalizingcountry. This proposition holds regardless of whether the clean country or the dirty country isliberalizing trade in the pollution-intensive goods.

2.4.2 Transboundary Pollution

In the presence of transboundary pollution, the environmental damage of, respectively, the home

and the foreign country, can be written as:

Edtx = dx(x1 + x2) + ýdy(y1 + y2) (11)

Edty = dy(y1 + y2) + ´xdx(x1 + x2) (12)

where 0 < í < 1 (for i = x; y): Because now pollution produces in one country spills over to

the other country, the e¤ects of a unilateral trade liberalization by the home country on the

environmental damage of, respectively, the home and the foreign country, are given by:

µ@Edt

x

@ty

¶CN

=1D

©°dx ¡ 2¯ýdy

ª(13)

µ@Edt

y

@ty

¶CN

=1D

f°´xdx ¡ 2¯dyg (14)

To simplify their interpretation, these equations can be re-written in the following conditional

expressions:

@Edtx

@ty> 0 iff

dx

ýdy>

2¯°

(15)

@Edty

@ty> 0 iff

dy

´xdx<

°2¯

(16)

For notational purposes, we refer to the left-hand side of the above conditional statements as

country i’s ”relative pollution di¤erential” e¤ect. This e¤ect is measured by the pollution borne

12

by country i due to its own pollution damage over the pollution it bears due to the pollution

spillover from country j. On the right-hand side, we de…ne 2¯=° as the ”product di¤erential”

e¤ect, which is always positive according to our earlier assumption regarding the magnitude of

the own- and cross-price e¤ects.

We have seen that a unilateral trade liberalization by the clean country shifts the pollution-

intensive production away from the clean country towards the dirty country. As long as the home

country does not bear a large fraction of the foreign pollution (i.e., as long as the pollution spillover

from abroad, ´y; is not too large), the clean country (which bene…ts from lower production and

hence, lower domestic pollution) improves the quality of its environment by unilaterally liberal-

izing trade. The quality of the environment in the foreign country, however, always deteriorates

following a unilateral trade liberalization by the home country. This can be seen from equation

(16), where the conditional statement never holds.

Assuming that the home relative pollution di¤erential exceeds the product di¤erential, we can

summarize the results as follows:

Proposition 2 Assuming that pollution is transboundary, the clean country can improve its en-vironment by unilaterally liberalizing trade. But the higher environmental quality in the cleancountry is always achieved at the expense of a deterioration in the environmental quality of thedirty country.

So far, we have considered the case where the clean country liberalizes trade. However, once

pollution is no longer local, the e¤ects of a trade liberalization on the quality of the environment

are sensitive to which country is liberalizing trade. Thus, we turn now to the case where the dirty

country is liberalizing trade.

@Edtx

@tx> 0 iff

´ydy

dx>

2¯°

@Edty

@tx> 0 iff

dy

´xdx>

2¯°

A foreign unilateral trade liberalization shifts the pollution-intensive production away from

the dirty country towards the clean country. Again, as long as the foreign country does not bear

13

a large fraction of the home pollution (i.e., as long as the pollution spillover parameter from

home, ´x; is su¢ciently small), the dirty country can improve the quality of its environment by

unilaterally liberalizing trade.

The interesting point here is that when the foreign country liberalizes trade, the clean country

does not necessarily su¤er from higher pollution in the post-liberalization equilibrium. Indeed,

the quality of its environment can improve, even though it ends up producing a greater quantity

of the polluting good. This is possible if its new level of clean production generates less pollution

than that borne previously under the foreign pollution spillover. For this to be true, dx must be

relatively low and ´ydy relatively large.

Again, provided that the foreign relative pollution di¤erential exceeds the product di¤erential,

we can summarize these results as follows:

Proposition 3 Assuming that pollution is transboundary, the dirty country can improve simul-taneously its own environment and that of the clean country by imposing a unilateral trade liber-alization in the pollution-intensive goods. This proposition holds when the production process inthe dirty (clean) country generates a su¢ciently large (small) amount of pollution spillover.

2.4.3 Global Pollution

When pollution is global, the environmental damage is determined by the aggregate production

of pollution-intensive good (regardless of whether it is produced at home or abroad) and it is

identical in both countries. This global environmental damage can be expressed as:

Edg = dx(x1 + x2) + dy(y1 + y2)

According to this expression, the e¤ects of, respectively, a home and a foreign trade liberaliza-

tion on the global environmental damage are given by:

@Edg

@ty> 0 iff

dx

dy>

2¯°

(17)

@Edg

@tx> 0 iff

dy

dx>

2¯°

(18)

14

As before, we refer to the right-hand side of these conditional statements as the product

di¤erential e¤ect. But in the presence of global pollution, we refer to the left-hand side as the

”absolute pollution di¤erential” (equation (17) refers to the home absolute pollution di¤erential,

while equation (18) refers to the foreign absolute pollution di¤erential).

By unilaterally liberalizing trade, the clean country transfers the production of the pollution-

intensive good away from the clean country towards the dirty country. Since the rise in dirty

production exceeds the reduction in clean production, the unilateral trade liberalization by the

clean country always raises the global environmental damage. This is expressed in equation (18),

where the conditional statement never holds and hence, @Edg=@ty < 0.

This result may be reversed if the dirty country reduces its trade barriers, in which case a

unilateral trade liberalization shifts the pollution-intensive production away from the dirty country

towards the clean country, possibly raising the quality of the environment. While the aggregate

production is higher in the post-liberalization equilibrium (which tends to support higher global

pollution), the rise in the clean production exceeds the reduction in the dirty production. Thus,

with a su¢ciently large pollution di¤erential, the dirty country can still improve the quality of

the environment by unilaterally liberalizing trade.

Assuming that the foreign relative pollution di¤erential exceeds the product di¤erential, these

results can be summarized as follows.

Proposition 4 Assuming that pollution is global, a unilateral trade liberalization by the cleancountry deteriorates unambiguously the global environment. But a unilateral trade liberalizationby the dirty country can still improve the quality of the global environment, provided that thepollution di¤erential is large.

In this section, we show that when the driving forces of the environmental damage associ-

ated with trade expansion are fueled by oligopolistic competition, there is no justi…cation for the

traditional inter-industry factor-relocation hypotheses. Indeed, according to our model, the envi-

ronmental consequences of trade liberalization depend largely on two factors, namely, on which

country initiates trade liberalization and on the nature of pollution (as opposed to comparative

15

advantage). For example, under local pollution, the liberalizing country always bene…ts from trade

liberalization, while the non-liberalizing country always su¤ers from it, regardless of whether it

is the clean country or the dirty country that liberalizes trade. This result, however, depends

strongly on the nature of pollution. As pollution crosses borders, the global economy is better-o¤

when the dirty country liberalizes trade than when the clean country does so. These results sup-

port the inconclusive empirical evidence found in support of the inter-industry e¤ects of trade.17

2.5 Multilateral Trade Liberalization

So far, we have discussed the e¤ects of a unilateral trade liberalization on the quality of the

environment. Assume now that the home and the foreign countries implement a multilateral

trade liberalization, such that dtx = dty = d¿ < 0: Under this scenario, it is easy to show that a

trade liberalization always a¤ects negatively the quality of the environment, regardless of whether

pollution is local, transboundary or global. The main reason for this results is that a multilateral

trade liberalization raises the domestic production geared towards exports by more than it reduces

the domestic production geared towards domestic consumption. This is illustrated in the following

expressions:

@xMTL1

@¿+

@xMTL2

@¿=

° ¡ 2¯D

< 0

@yMTL1

@¿+

@yMTL2

@¿=

° ¡ 2¯D

< 0

Thus, a multilateral trade liberalization raises each country’s overall pollution-intensive pro-

duction, and hence, deteriorates each country’s environmental quality. This is shown in the

following equations:

@Edx

@¿=

1D

£(dx + ´ydy)(° ¡ 2¯)

¤< 0 (19)

17 For a recent survey on the empirical literature, see Rauscher (1997). An excellent collection of papers isprovided in Low (1992), where various aspects of this issue are discussed and reviewed.

16

@Edy

@¿=

1D

[(´xdx + dy)(° ¡ 2¯)] < 0 (20)

According to equations (19) and (20), a multilateral trade liberalization always deteriorates

the quality of the environment, regardless of wether pollution is local (í = 0), transboundary

(0 < í < 1) or global (í = 1). But the magnitude of this deterioration, however, depends

positively on the size of the pollution spillover parameter, í.

These results can be summarized in the following terms:

Proposition 5 A multilateral trade liberalization always deteriorates the quality of the environ-ment in both, the clean and the dirty country. This proposition holds regardless of whether pollutionis local, transboundary or global, although its detrimental environmental e¤ects are smallest whenpollution is local.

Note, however, that although a multilateral trade liberalization raises the aggregate level of

pollution, it is important to keep in mind that the literature has long argued that di¤erent countries

have di¤erent pollution assimilation capacities. Thus, as long as the environmental degradation

borne by each country does not exceed its absorptive capacity, the positive variety and pro-

competition e¤ects of freer intra-industry trade may well outweigh the negative environmental

e¤ect.18

So far, we make the assumption that the polluting …rms are quantity-setting oligopolists. How-

ever, we know from standard textbooks of industrial organization that this is not the only possible

mode of competition. To test the robustness of our previous results, we have also considered the

case where the polluting …rms are price-setting producers, rather than quantity-setting producers.

It is easy to show that under standard assumptions, the presence of a price-setting competition

does not alter the results derived under a quantity-setting competition and all of the propositions

derived in Section 2.4 carry over to the case of Bertrand-Nash competition.

18 Excellent discussions on countries’ di¤erent pollution absorptive capacities can be found in Bhagwati andSrinivasan (1997) and Low and Safadi (1992). Note that while the authors highlight countries’ variable capacitiesto assimilate pollution in defense against an international harmonization of environmental regulations, they bothrecognize that not all pollution is unacceptably bad for the environment.

17

3 Multiple Firms

In this section, we extend the previous analysis and examine how our earlier results change when

each country holds a number of …rms producing the pollution-intensive good, as opposed of having

a single polluting …rm. In particular, we allow for m (n) …rms to produce good x (y), where

(m;n) > 1: Under this new speci…cation, the pro…t function of, respectively, the home and the

foreign …rm needs to be modi…ed as follows:

¼ix = x1px1(X1; Y1) + x2px2(X2; Y2) ¡ ex(x1 + x2) ¡ txx2

¼iy = y1py1(X1; Y1) + y2py2(X2; Y2) ¡ ey(y1 + y2) ¡ tyy1

where Xi = xi + (m ¡ 1)vi and Yi = yi + (n ¡ 1)zi (for i = 1; 2): While both x and v are

produced in the home country, good x is produced by a single oligopolistic …rm and good v is

produced by the remaining (m ¡ 1) oligopolistic …rms in the domestic industry: Similarly for the

foreign country, where good y is produced by a single foreign …rm, while good z is produced by

the remaining (n ¡ 1) foreign …rms in the industry: If we assume now that all the …rms in a given

country produce a homogenous good, we can now drop the inter-…rm product di¤erential and focus

on the international product di¤erential, such that xi = vi and yi = zi: As before, the subscripts

indicate whether a polluting good is sold in the home market (1) or in the foreign market (2).

In the presence of multiple …rms, the optimal outputs require:

xCN1 =

(n + 1)¯(®1 ¡ ex) ¡ n°(®2 ¡ ey ¡ ty)E

xCN2 =

(n + 1)¯(®1 ¡ ex ¡ tx) ¡ n°(®2 ¡ ey)E

yCN1 =

(m + 1)¯(®2 ¡ ey ¡ ty) ¡ m°(®1 ¡ ex)E

yCN2 =

(m + 1)¯(®2 ¡ ey) ¡ m°(®1 ¡ ex ¡ tx)E

18

where E =£(m + 1)(n + 1)¯2 ¡ mn°2

¤, which is assumed to be positive.19

3.1 Conditions for Intra-Industry Trade

The existence of two-way trade requires that xCN2 > 0 and yCN

1 > 0. Thus, the conditions for

intra-industry trade can be expressed as:

x2 > 0 iffµ

n + 1n

¶¯°

>(®2 ¡ ey)

(®1 ¡ ex ¡ tx)

y1 > 0 iffµ

m + 1m

¶¯°

>(®1 ¡ ex)

(®2 ¡ ey ¡ ty)

Similar to the conditions derived under the basic case in Section 2, intra-industry trade is more

likely to occur in the presence of: (i) greater product di¤erential (high ¯=°); (ii) low import tari¤s,

ti; and (iii) lower environmental standards imposed on the exporting country i (high ®i¡ei). Note,

however, that since (q + 1) =q < 2 (for q = m;n) the conditions for intra-industry trade are more

binding in the m £ n case than under the basic case. Thus, when the polluting good is produced

by multiple …rms rather than by a single …rm in each country, at least one of the three conditions

stated above must be stronger for intra-industry trade to occur and hence, for our analysis to be

relevant.


The impacts of a trade liberalization on the demand for pollution-intensive goods are given by the

following equations:

@xCN1

@ty=

n°E

> 0 (21)

@yCN1

@ty= ¡(m + 1)¯

E< 0 (22)

19 When comparing the optimal outputs derived in the presence of a single …rm (equations (7)-(10) in Section2.3) with those presented here in the presence of multiple …rms, we note that the denominator in the former issmaller the denominator in the latter, or, E > D for (m;n) > 1.

19

@xCN2

@tx= ¡(n + 1)¯

E< 0 (23)

@yCN2

@tx=

m°E

> 0 (24)

Clearly, the presence of multiple …rms does not alter the proposition stated in Section 2.3.

It is interesting to point out, however, that it is not clear whether the e¤ects of a unilateral

liberalization on the environment will be larger or smaller (in absolute value) in the presence of

multiple …rms than in the presence of a single domestic …rm. This will depend on the respective

magnitude of two con‡icting e¤ects. While, on the one hand, the determinant in the single …rm

case is smaller than the determinant in the multiple …rm case (E > D), on the other hand, the

numerator increases with the number of …rms (m;n). This can be seen by comparing equations

(7)-(9) with equations (21)-(24).

3.3 Environmental Damage

Assuming that each country has multiple …rms producing the pollution-intensive good, the impact

of a unilateral trade liberalization by the home country on the quality of the environment can be

summarized in the following expressions:

µ@Edx

@ty

¶m£n

=mnE

½°dx ¡

µm + 1

m

¶¯ýdy

¾(25)

µ@Edy

@ty

¶m£n

=mnE

½°´xdx ¡

µm + 1

m

¶¯dy

¾(26)

The various scenarios under local, transboundary or global pollution can be represented by sub-

stituting í with the relevant pollution spillover parameter (í = 0 for local pollution, 0 < í < 1

for transboundary pollution and í = 1 for global pollution): Similarly in the case of a foreign

trade liberalization,

µ@Edx

@tx

¶m£n

=mnE

½°ýdy ¡

µn + 1

n

¶¯dx

¾(27)

20

µ@Edy

@tx

¶m£n

=mnE

½°dy ¡

µn + 1

n

¶¯´xdy

¾(28)

While the presence of multiple …rms does not alter signi…cantly the general conclusions derived

in Section 2.4, both the direction and the magnitude of the environmental e¤ects of a trade

liberalization can be di¤erent in the m £ n case than in the basic case, depending on the speci…c

parameter values of the model. In particular, the overall e¤ect will depend on the relative size of

two e¤ects:

(i) First, the second term in the brackets of equations (25)-(28) is smaller in the m £ n case

than in the basic case, because (q + 1)=q < 2 (for q = m;n): This means that, in the presence of

transboundary pollution, a trade liberalization is more likely to be good for the environment in

the presence of a large number of …rms than in the presence of a single …rm in the liberalizing

country. Note that the direction of the environmental impacts of a trade liberalization depends

only on the number of …rms in the liberalizing country and not on the number of …rms in the

non-liberalizing country.20

(ii) Second, the multiplier in front of the brackets in equations (21)-(24) is larger in the m £n

case than in the basic case (mn=E > 1=D). According to this e¤ect, whatever the direction of

the environmental e¤ects of a trade liberalization, these e¤ects are magni…ed in the presence of

multiple …rms. Thus, the presence of multiple …rms magni…es the impact of a trade liberalization

on the quality of the environment: If a trade liberalization is good (bad) for the environment, its

impact on the environment will be better (worse) under the m£n case than under the basic case.

These results can be summarized in the following proposition:

Proposition 6 Generally, the presence of multiple polluting …rms does not alter the direction ofthe environmental e¤ects of trade liberalization, although it magni…es their impact. Nevertheless,if pollution is transboundary, there exists a range of parameter for which a trade liberalization ismore likely to be good for the environment when a large number of polluting …rms (as opposed toa single …rm) are located in the liberalizing country.

20 This is because following, say, a home trade liberalization, the foreign country produces a higher level of thepollution-intensive production. In equilibrium, the extent to which the foreign country increases its productiondepends on the number of …rms in the home country. This is shown in equations (21)-(24).

21

Note the interesting implication of this observation in the context of competition policy. Ac-

cording to our model, anti-trust policies can be pro-environment. This statement is particularly

true for the non-liberalizing country and in the case of global pollution.


In the presence of multiple …rms, the e¤ect of a multilateral trade liberalization on the environ-

mental damage of country i is given by:

@Edx

@¿=

mnE

½µ° ¡

µn + 1

n

¶¯¶

dx +µ

° ¡µ

m + 1m

¶¯¶

´ydy

¾< 0

@Edy

@¿=

mnE

½µ° ¡

µn + 1

n

¶¯¶

´xdx +µ

° ¡µ

m + 1m

¶¯¶

dy

¾< 0

where ´i; the degree of pollution spillover, can be substituted with the appropriate parameter

value to illustrate the environmental damage under local, transboundary, and global pollution.

As in Section 2.5, a multilateral trade liberalization always raises the overall level of polluting

production, which necessarily deteriorates the quality of the environment. The number of …rms,

however, magni…es the detrimental environmental e¤ect of trade liberalization.

Proposition 7 As in the basic case presented in Section 2.5, a multilateral trade liberalizationalways deteriorates the quality of the environment in both, the clean and the dirty country. Thenumber of oligopolistic …rms, however, magni…es the detrimental environmental e¤ects of a mul-tilateral trade liberalization. This proposition holds regardless of whether pollution is local, trans-boundary or global, although the degradation of the environment is smallest when pollution is local.

4 In the Presence of Tari¤-Jumping FDI

4.1 Framework

When tari¤ barriers are high, rather than producing the pollution-intensive good at home and

exporting it abroad, a …rm may choose to serve the foreign market by engaging in foreign direct

investment (FDI) and setting up production plants abroad. This is often referred to as ’tari¤-

jumping’ FDI because it allows …rms to jump high trade barriers abroad. In this section, we

present the case where the home …rm engages in FDI activities in the foreign country, while

22

the foreign …rm continues to produce the pollution-intensive good at home and to export part

of its production to the home market. We have chosen this scenario because it illustrates an

interesting counter-example to the common ”dirty-industry migration” hypothesis, according to

which trade liberalization deteriorates the quality of the environment. This result is driven by the

assumption that trade liberalization induces the pollution-intensive industries to relocate away

from the industrialized countries with higher environmental standards towards the lower-income

countries with lower environment standards and hence, causing a convergence towards the lowest

common environmental standards. In our model, however, we show that in the presence of tari¤-

jumping FDI activities, trade liberalization may not necessarily deteriorate the quality of the

environment.

To duplicate the ”dirty-industry migration” hypothesis, we assume that the …rm that engages

in FDI adopts the production technology of the host country. For example, when the clean

country engages in FDI activities in the dirty country, it adopts the environmental standards

imposed by the dirty country for its FDI production abroad. Since, in this model, the level of

environmental damage (di) is determined by the level of environmental standards (ei), the clean

…rm will generate a higher level of environmental damage with its FDI production abroad than

with its domestically-located production.

The pro…t function of, respectively, the home and the foreign …rms is given by:

¼FDIy = y1py1 + y2py2 ¡ ey(y1 + y2) ¡ tyy1 (29)

¼FDIx = x1px1 + x2px2 ¡ exx1 ¡ eyx2 ¡ Fx (30)

According to equation (30), the pro…ts of the FDI host country (i.e., the foreign country)

increase with total sales revenues (from both, the domestic and the export market) and decreases

with both the foreign pollution tax (ey) and the foreign tari¤ (ty). The pro…t function of the FDI

source country (i.e., the home country) di¤ers in two aspects. First, the home …rm pays the home

pollution tax (ex) on the polluting good it produces in the home country and the foreign pollution

23

tax (ey) on the polluting good it produces in the foreign country. Second, it incurs a lump-sum

set-up cost Fx to engage in FDI activities in the foreign country.

The …rst-order pro…t maximization conditions yield the following optimal supply functions:

xFDI1 =

2¯(®1 ¡ ex) ¡ °(®2 ¡ ey ¡ ty)D

= xCN1 (31)

xFDI2 =

2¯(®1 ¡ ey) ¡ °(®2 ¡ ey)D

(32)

yFDI1 =

2¯(®2 ¡ ey ¡ ty) ¡ °(®1 ¡ ex)D

= yCN1 (33)

yFDI2 =

2¯(®2 ¡ ey) ¡ °(®1 ¡ ey)D

(34)

where D = 4¯2 ¡ °2: As in the basic case presented in Section 2, the concavity assumption of

the aggregate utility function associated with the above demand functions implies that ¯2¡°2 > 0.

We continue to assume that the own-price e¤ects are greater than the cross-price e¤ects, that is,

¯ > °.

While the presence of home FDI activities in the foreign country does not alter the sales in

the home market (i.e., xFDI1 = xCN

1 and yFDI1 = yCN

1 ), it a¤ects those in the foreign market. In

particular, whether the foreign market sales are higher or lower under an FDI regime than under

the standard Cournot-Nash regime described in Section 2.1 depends crucially on the relationship

between the tax burden imposed by the foreign country (ey) and that imposed by the home country

(ex + tx). In particular,

xFDI2 R xCN

2 if (ex + tx) R ey (35)

yFDI2 R yCN

2 if (ex + tx) Q ey (36)

4.2 Condition for FDI

The home country chooses to engage in FDI activities in the foreign country if its pro…ts are

higher under an FDI regime than under an intra-industry trade regime. The relative pro…tability

24

between these two regimes is given by:

¼FDIx ¡ ¼CN

x = ¯£(xFDI

2 )2 ¡ (xCN2 )2

¤¡ Fx (37)

If this expression is positive, it is pro…table for the home …rm to invest abroad and hence, to

incur the initial set-up cost necessary to produce x2 in the foreign country. If (¼FDIx ¡ ¼CN

x ) = 0;

the home …rm is indi¤erent between producing x2 in the home country (and paying import tari¤s

to the foreign country) and incurring the initial set-up cost to produce x2 in the foreign country

(and evading the foreign country’s import tari¤s). Finally, (¼FDIx ¡ ¼CN

x ) < 0 corresponds to the

situation in which it is in the home …rm’s best interest to produce x2 at home and to export its

production abroad, rather than to invest and produce abroad.

The conditional expressions given in (35) and (36), together with the home pro…t di¤erential

function given in (37) indicate that home export sales and hence, home pro…ts, are always smaller

under an FDI regime than under an exports regime when ey > (ex + tx). In this situation, it

is never pro…table for the home …rm to engage in FDI activities. Indeed, the home …rm engages

in FDI only when ey < (ex + tx), that is, when a smaller tax burden is levied on the home

good produced abroad under FDI than on the home good produced in the home country and

subsequently exported to the foreign country. While ey < (ex + tx) is a necessary condition for the

home …rm to consider FDI activities, it is not a su¢cient one. This can be seen from equations

(37), where the …rm’s relative pro…tability requires not only to produce a higher level of output

under an FDI regime than under an exports regime but also to cover its initial set-up cost Fx

associated with FDI. Thus, we need an additional condition to determine under which conditions

it is pro…table for the home …rm to engage in FDI activities.

For given pollution taxes, there exists a critical tari¤ rate at which the home …rm is indi¤erent

between undertaking FDI activities in the foreign country and exporting x2 to the foreign country.

This critical tari¤ rate, tcx; can be determined by di¤erentiating the home pro…t di¤erential given

25

in equation (37) with respect to the foreign import tari¤ tx:

tcx = (®1 ¡ ex) ¡ °2¯

(®2 ¡ ey)

The home …rm engages in FDI if the tari¤ level exceeds this critical tari¤ rate. Thus, while

the su¢cient condition for the home country to engage in FDI activities in the foreign country

is given in equation (37), the necessary set of conditions for the home country to undertake FDI

requires ey to be smaller than (ex + tx) and tx to be greater or equal to tcx:

Proposition 8 The necessary set of conditions for the home country to undertake FDI requires:(i) that ey is smaller than (ex + tx); and (ii) that tx is greater or equal to tcx:


In the previous section, we have shown that when ey ¸ (ex+tx), it is never pro…table for the home

…rm to engage in FDI activities, in which case the home …rm exports x2 to the foreign country.

In the context of the present paper, this is not an interesting situation since a unilateral trade

liberalization by the foreign country (dtx < 0) does not alter the home country’s initial decision

to export and thus, yields the same results as those already derived in Section 2.3.

If, however, ey < (ex + tx), the home country may choose to either undertake FDI activities

or export, depending on whether tx ? tcx: In particular, when tx > tcx, it is more pro…table for the

home …rm to incur the costs associated with FDI and to produce x2 abroad. But when tx < tcx,

it becomes more pro…table for the home …rm to produce x2 at home and to export its production

to the foreign market. This highlights an interesting implication for trade policy in the context of

intra-industry trade.

Assuming that the environmental damage generated under an FDI regime is signi…cantly dif-

ferent from that generated under an exports regime, a unilateral trade liberalization by the foreign

country can a¤ect the quality of the environment by inducing the home country to switch away

from an FDI regime toward an exports regime. Clearly, the extent to which one country bene…ts

from trade liberalization depends on several factors, including which country is liberalizing, which

26

country is experiencing inward FDI, which regime is more harmful to the environment and which

type of pollution is occurring.

We turn now to the environmental damage when the home country engages in FDI activities in

the foreign country to circumvent high trade barriers and to bene…t from the lower environmental

standards enforced in the host country.

4.4 Environmental Damage Di¤erential

Assuming that the home country engages in FDI activities, the environmental damage borne by,

respectively, the home and the foreign country is given by:

EdFDIx = dxx1 + ýdy [x2 + y1 + y2] (38)

EdFDIy = dy(y1 + y2 + x2) + ´xdxx1 (39)

Again, by substituting the appropriate value for í; the degree of pollution spillover, the above

expressions illustrate the environmental damage under local (í = 0), transboundary (0 < í < 1),

and global (í = 1) pollution.

According to equation(38), the home country su¤ers from two sources of pollution. While the

…rst source is caused by the polluting production taking place in the home country, the second

source is generated by pollution spillovers from abroad, which are caused by both, the foreign

production and the home FDI production. Similarly for the foreign country, which su¤ers from

the pollution caused by the polluting production taking place in the foreign country (including

both, the foreign production and the home FDI production), and from the pollution spillovers

generated by the home production in the home country.

We want to determine which regime supports a higher level of pollution and hence, to examine

the environmental consequence of a given trade policy. This is possible by comparing the envi-

ronmental damage produced under an FDI regime (given in equations (38) and (39)) with that

produced under an intra-industry trade regime (given in equations (11) and (12)). In particular,

27

we are interested in solving the expression¡EdFDI

i ¡ EdBNi

¢for i = x; y under, respectively, local,

transboundary and global pollution. If this expression is positive, the environmental damage is

higher under an FDI regime than under a Cournot-Nash exports regime and a trade liberalization,

which discourages the home country to engage in FDI activities, is good for the environment. If,

however, this expression is negative, the environmental damage is higher under a trade regime

than under an FDI regime and a trade liberalization is bad for the environment.

4.4.1 Local Pollution

Assuming that pollution is local, the environmental damage di¤erential for the foreign country

between an FDI regime and an exports regime is given by:

¡EdFDI

y ¡ EdCNy

¢l= xFDI

2 dy +¡yFDI2 ¡ yCN

2¢dy 7 0 (40)

We have already shown above that if the home country engages in FDI activities, it must be

true that ey < (ex + tx). According to equation (36), this implies that yFDI2 is smaller than yCN

2

and hence, that the sign of equation (40) is ambiguous. More precisely, it is possible to solve for

the condition under which the environmental damage of the foreign country is higher under an

FDI regime than under an intra-industry trade regime. This is given in equation (41) below.

(EdFDIy ¡ EdCN

y )l > 0 iff2¯°

>(®2 ¡ ey) + (ex + tx ¡ ey)

(®1 ¡ ey)(41)

From a trade policy perspective, equation (41) says that there exists a parameter range over

which the foreign country can improve its environment by liberalizing trade to a point where tx <

tcx. Indeed, by reducing its tari¤ level below the home critical level, the foreign country discourages

inward FDI and thereby, redirects the home pollution-intensive FDI production away from the

foreign country towards the home country. While this policy can improve the environmental

quality in the foreign country, it deteriorates it in the home country. The latter result is shown

28

in equation (42), where the environmental damage for the home country is always lower under an

FDI regime than under an intra-industry trade regime.

¡EdFDI

x ¡ EdCNx

¢l= ¡xCN

2 dx < 0 (42)

Proposition 9 There exists a parameter range under which a trade liberalization by the foreigncountry, which induces the clean country to switch from an FDI regime to an exports regime, im-proves the environmental quality in the dirty country. Such a regime shift, however, unambiguouslydeteriorates the environmental quality in the clean country.

4.4.2 Transboundary Pollution

When pollution is transboundary, the environmental damage di¤erential between an FDI regime

and an exports regime of, respectively, the home and the foreign country is given by:

¡EdFDI

x ¡ EdCNx

¢t= (yFDI

2 ¡ yCN2 )ýdy +

£xFDI

2 ýdy ¡ xCN2 dx

¤7 0 (43)

¡EdFDI

y ¡ EdCNy

¢t= xFDI

2 dy ¡ xCN2 ´xdx +

¡yFDI2 ¡ yCN

2¢dy 7 0 (44)

Assuming that the home country engages initially in FDI activities, we know that the …rst

bracket in equation (43) is negative, while the second bracket is positive. Thus, the sign of

equation (43) depends on the relative size of these two con‡icting e¤ects. But it is easy to see

that in the presence of a relatively small pollution spillover from the foreign country (i.e., a small

ý); the second (positive) bracket becomes very large, making it possible for the home country

to improve the quality of its environment by liberalizing trade. In particular, the environmental

damage in the home country is always higher under an FDI regime than under a Cournot-Nash

trade regime under the following condition:

(EdFDIx ¡ EdCN

x )t > 0 iff

2¯°

>(®2 ¡ ey)(ýdy ¡ dx) ¡ (ey ¡ ex ¡ tx)ýdy

(®1 ¡ ey)(ýdy ¡ dx) ¡ (ey ¡ ex ¡ tx)dx(45)

If this equation holds, a trade liberalization is always good for the environmental quality of the

home country. Thus, according to equation (45), a regime shift can be good for the environment

29

in the clean country, provided that the degree of transboundary pollution is relatively large (i.e.,

provided that ´y is relatively large).

As far as the foreign country is concerned, equation (46) shows that there exists also a pa-

rameter range under which a trade liberalization by the foreign country, which induces the home

country to switch from FDI activities to exports, improves the quality of the foreign environment.

In particular, the condition necessary for a trade liberalization to be good for the environment in

the foreign country is given by:

(EdFDIy ¡ EdCN

y )t > 0 iff

2¯°

>(®2 ¡ ey)(dy ¡ ´xdx) ¡ (ey ¡ ex ¡ tx)dy

(®1 ¡ ey)(dy ¡ ´xdx) ¡ (ey ¡ ex ¡ tx)´xdx(46)

By construction, dy is always greater than ´xdx, which implies that the right-hand side of

equation (46) is always smaller than one. Since the left-hand side of equation (46) is always larger

than one, the environmental damage borne by the foreign country is always higher under an FDI

regime than under a trade regime.

Proposition 10 Under transboundary pollution, a trade liberalization by the foreign country,which induces the clean country to switch from an FDI regime to an exports regime, always im-proves the environmental quality in the dirty country. This regime shift can also improve theenvironmental quality in the clean country, provided that the foreign country generate a relativelylarge pollution spillover.

4.4.3 Global Pollution

When pollution is global, the environmental damage di¤erential between an FDI regime and an

exports regime for the global economy is given by:

¡EdFDI ¡ EdCN¢g

=£xFDI

2 dy ¡ xCN2 dx

¤+ (yFDI

2 ¡ yCN2 )dy 7 0

Again, assuming that the home country engages initially in FDI activities, we know that the

…rst bracket is positive, while the second bracket is negative, making the sign of the environmental

di¤erential damage ambiguous. Thus, under global pollution, there exists a parameter range under

30

which a trade liberalization by the foreign country, which induces the clean country to switch from

an FDI regime to an exports regime, improves the global environmental quality. In particular, the

necessary condition for the global environmental damage to be higher under an FDI regime than

under an intra-industry trade regime is given by the following equation:

(EdFDI ¡ EdCN)g > 0 iff

2¯°

>(®2 ¡ ey)(dy ¡ dx) ¡ (ey ¡ ex ¡ tx)dy

(®1 ¡ ey)(dy ¡ dx) ¡ (ey ¡ ex ¡ tx)dx(47)

In the context of our model, we have assumed that dy > dx. This makes the right-hand

side of equation (47) always smaller than one, while the left-hand side of equation (47) is always

greater than one. Thus, given our initial assumptions, the conditional expression given in equation

(47) always holds true and a trade liberalization by the foreign country, which induces the clean

country to switch from an FDI regime to an exports regime, unambiguously improves the global

environmental quality.

The intuition for this result is as follows. When the home country engages in FDI activities, it

produces not only more goods under an FDI regime than under an exports regime (i.e., xFDI2 >

xCN2 ) but its FDI production is dirty rather than clean. Thus, under an FDI regime, the production

of the home country is both quantitatively more abundant and qualitatively more pollution-

intensive. A trade liberalization, which induces a regime shift away from FDI activities towards

trade activities, is good for the environment.

These results can be summarized as follows:

Proposition 11 Under global pollution, a unilateral trade liberalization by the dirty country,which induces the clean country to switch from an FDI regime to an exports regime, improvesunambiguously the quality of the global environment.

We …nd that under certain conditions the results derived in the previous section can be reversed

if one of the …rms (say, the clean …rm) is engaging in FDI activities in the pre-liberalization

equilibrium. For example, assuming that pollution is global, we have seen in Section 2.4 that a

unilateral trade liberalization by the dirty country deteriorates the global environment, unless the

31

pollution di¤erential between the two countries is very large. If, however, the home country is

circumventing high tari¤ barriers and strict environmental standards by engaging in FDI activities

in the foreign country, a unilateral trade liberalization by the dirty country, which induces the

clean country to switch from an FDI regime to an exports regime, improves unambiguously the

quality of the global environment. While these contradictory results are driven by very di¤erent

forces, they both highlight the relevance of recognizing the underlying trade structure and of

examining the environmental damages of trade liberalization in their appropriate context.


So far, we have analyzed the environmental e¤ect of a unilateral trade liberalization when the

home …rm engages in FDI activities in the foreign country. Now, let us consider the impact

of a multilateral trade liberalization on the quality of the environment in the presence of tari¤-

jumping FDI. To do this in a straightforward way, we adjust slightly our framework in order to

introduce two-way FDI. Again, we assume that the …rm that engages in FDI adopts the production

technology of the host country. For example, when the clean (dirty) country engages in FDI

activities in the dirty (clean) country, it adopts the environmental standards imposed by the dirty

(clean) country for its FDI production abroad.

In the presence of two-way FDI, a multilateral trade liberalization (such that dtx = dty = d¿),

which induces both countries to switch from a FDI regime to an exports regime, a¤ects the quality

of the environment in country i (where i = x; y) in the following way:

¡EdFDI

x ¡ EdCNx

¢t= (2xFDI

1 ¡ xCN1 ¡ xCN

2 )dx + (2yFDI2 ¡ yCN

1 ¡ yCN2 )ýdy 7 0 (48)

¡EdFDI

y ¡ EdCNy

¢t= (2xFDI

1 ¡ xCN1 ¡ xCN

2 )´xdx + (2yFDI2 ¡ yCN

1 ¡ yCN2 )dy 7 0 (49)

where the e¤ects of a multilateral trade liberalization on the quality of the environment under

the di¤erent types of pollution are derived by substituting the appropriate value for í, the degree

of pollution spillover (namely, í = 0 for local pollution, 0 < í < 1 for transboundary pollution,

32

and í = 1 for global pollution).

Note that according to expression (48), the e¤ects of a multilateral trade liberalization on the

environmental quality of the home country are ambiguous, and therefore not necessarily bad for the

environment. This is an interesting result because it opens up the possibility (at least in theoretical

terms) for an environmental-friendly multilateral trade liberalization. This is illustrated in the

next conditional expression, where:

(EdFDIx ¡ EdCN

x )t > 0 iff

2¯°

>2(ex ¡ ey)(ýdy ¡ dx) + ¿(dx + ýdy)

¿(dx + ýdy)(50)

Thus, a multilateral trade liberalization can be good for the environment in the home country

if: trade tari¤s (¿) in the pre-liberalization equilibrium are high; transboundary pollution from

abroad (ý) is low (such that ýdy ¡dx < 0); pollution-intensive products are highly di¤erentiated

(high 2¯=°); and, the environmental standards di¤erences between the trading countries are low

(ex ¡ ey > 0).

Similarly, we can show that the e¤ects of a multilateral trade liberalization on the environ-

mental quality of the foreign country are ambiguous also. This is illustrated in the following

expression.

(EdFDIy ¡ EdCN

y )t > 0 iff

2¯°

>2(ex ¡ ey)(dy ¡ ´xdx) + ¿(´xdx + dy)

¿(´xdx + dy)(51)

Again, a multilateral trade liberalization can be good for the environment in the foreign coun-

try if: trade tari¤s in the pre-liberalization equilibrium are high; if transboundary pollution from

abroad (´x) is high (such that dy ¡´xdx is small); pollution-intensive products are highly di¤eren-

tiated (high 2¯=°); and, if the environmental standards di¤erences between the trading countries

are low (ex ¡ ey is small).

33

This is an interesting result, for it predicts that a multilateral trade liberalization does not

necessarily deteriorate the quality of the environment. On the contrary, in the presence of intra-

industry trade (and under a reasonable set of assumptions), a multilateral trade liberalization can

be good for the environment in both, the dirty and the clean country. This result clearly contradicts

the often cited ”dirty-migration hypothesis” argument, according to which trade liberalization

is bad for the environment because it induces the …rms that operate in countries with higher

environmental standards to relocate in countries with lower environmental standards. Our model

suggests that, in the presence of intra-industry trade, this argument may not always hold and

multilateral trade can be good for the environment.

Proposition 12 A multilateral trade liberalization, which generates a shift away from FDI to-wards intra-industry trade in both countries, may be good for the environment in both the cleanand the dirty country and hence, for the global environment. This proposition is particularly truewhen the trade barriers are high, when pollution-intensive products are highly di¤erentiated, andwhen the environmental standards di¤erentials are low.

5 Conclusion

In this paper, we o¤er a new causal mechanism linking international trade to changes in the quality

of the environment. We argue that while trade expansion alters the composition of national output

and hence, its environmental quality, its driving force may be international oligopolistic rivalry

rather than comparative advantage. We do not claim to o¤er a complete resolution of the debate

over trade and the environment. Our contribution is to take a …rst step toward clarifying the role of

intra-industry trade in determining how trade liberalization a¤ects the quality of the environment.

First, our results show that when the driving forces that determine the environmental damage

associated with trade expansion are fueled by neither comparative advantage nor cost di¤erences

but rather by oligopolistic competition, there is no justi…cation for the traditional inter-industry

factor-relocation hypotheses. In particular, we …nd that environmental deterioration is largely

determined by two factors, namely, : (i) by which country liberalizes trade, and (ii) by the nature

of pollution (i.e., whether pollution is local, transboundary or global). This result o¤ers a potential

34

explanation for why the composition e¤ect of trade has only found inconclusive empirical evidence.

Second, this paper sheds light on the question as to whether there are still positive gains from

trade when environmental degradation matters. In the context of intra-industry trade, a unilateral

trade liberalization induces three e¤ects, namely, a product variety e¤ect, a pro-competition e¤ect

and an environmental e¤ect. While the …rst two e¤ects are positive, we show that the third e¤ect

is not necessarily negative. For example, when pollution is transboundary, the global environment

can bene…t from trade liberalization, provided that the most pollution-intensive country liberalizes

trade.

Furthermore, our basic model indicates that a multilateral trade liberalization always deterio-

rates the quality of the environment. We show, however, that this proposition may be reversed in

the presence of tari¤-jumping FDI. This is an interesting result. The literature has long argued

that di¤erent countries have di¤erent pollution assimilation capacities. Implicitly, this argument

suggests that as long as the environmental degradation borne by each country does not exceed

its absorptive capacity, the positive variety and pro-competition e¤ects may well outweigh the

negative environmental e¤ect. Our results go one step further and suggest that, in the presence

of tari¤-jumping FDI, a multilateral trade liberalization may even have a positive impact on the

environment.

Our results also o¤er a new perspective on the role of competition policy in the context of

highly polluting industries. Our model suggests that the presence of a large number of …rms in

the non-liberalizing country magni…es signi…cantly the (negative) environmental impact of trade

liberalization. Thus, anti-trust policies may not always be good for the environment.

Finally, we …nd that market structure is an important factor when determining the environmen-

tal damage associated with trade liberalization. For example, we show that our basic results can

be reversed if polluting …rms are engaging in FDI activities in the pre-liberalization equilibrium.

Assume, for example, that high tari¤ barriers in the foreign country and/or strict environmental

standards in the home country induce the home polluting …rms to engage in FDI activities in the

35

foreign market. Then, even under global pollution, a unilateral trade liberalization by the dirty

country, which induces the clean country to switch from an FDI regime to an exports regime,

improves unambiguously the quality of the global environment.

It is important, however, to recognize the limitations of our analysis. Our analysis is limited

to the channel linking trade and the environment to the composition e¤ect via intra-industry

trade, ignoring other channels such as technological transfers and income e¤ects. Also, our model

su¤ers from extreme stylization. Nevertheless, the simple structure of our model can also be a

virtue since it lays bare the basic relationship driving our results and enhances our understanding

of the relationship between pollution and trade in the context of intra-industry trade. If any-

thing, this paper highlights how much remains to be done in advancing our understanding of the

many complex factors that in‡uence the environmental consequences of trade liberalization in an

increasingly integrated world economy.

36

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Table 1:

Indexes for Intra-Industry Trade in Selected Industries, 1998

Western

US Europe

Agricultural Products 0.87 0.94

Food 0.90 0.97

Raw materials 0.78 0.81

Mining Products 0.70 0.78

Ores and other minerals 0.98 0.67

Fuels 0.57 0.74

Non-ferrous metals 0.89 0.90

Manufactures 0.86 0.98

Iron and steel 0.53 0.97

Chemicals 0.95 0.92

Other semi-manufactures 0.85 0.96

Machinery and transport equipment 0.91 0.98

Automotive products 0.79 0.96

O¢ce and telecom equipment 0.83 0.87

Other machinery and transport equipment 0.95 0.91

Textiles 0.78 0.97

Clothing 0.30 0.80

Other consumer goods 0.26 0.99

Total Merchandise Trade 0.85 0.96Source: WTO Annual Report, 1999

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