Globalization and Environment in the Presence of Cross-border Pollution

Globalization and Environment in the Presence of Cross-border Pollution
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  February 9, 2005 Globalization and Environment in the Presence of Cross-border Pollution ByPanos Hatzipanayotou  § , Sajal Lahiri  † , and Michael S. Michael  ‡ Abstract We construct a two-country, two-good general equilibrium model of international tradewhere pollution from production is transmitted across borders. Governments in bothcountries impose emission taxes non-cooperatively. Within this framework, we ex-amine the e ff  ect of trade liberalization on Nash emission taxes, emission levels, andwelfare. We also examine how the endogeniety of terms of trade a ff  ects Nash equilib-rium emmision taxes and total emission level. Key Words:  Cross-border pollution, Emission taxes, Terms of trade shocks, Welfare. J.E.L. Classi Þ cation:  Q28, H41. § Department of International and European Economic Studies, Athens University of Economics and Business; 76, Patission Street, Athens 104 34, Greece, and CESifo. † Department of Economics, Southern Illinois University, Carbondale, IL. 62901-4515,U.S.A. ‡ Department of Economics, University of Cyprus, Nicosia, CY 1678, Cyprus, andCESifo. Correspondence:  Sajal Lahiri, Department of Economics, Southern Illinois University,Carbondale, IL. 62901-4515, U.S.A.; Tel. + 1 618 453 9472, FAX + 1 618 453 2717,  1 Introduction More than everbefore, adominant issue incurrent publicpolicydebates amongnationsis that of international externalities associated with pollution generated in countries.This negative externality is allegedly exacerbated with liberalization of internationaleconomic activities ( e.g. , freer international mobility of goods and capital feverishlypursued nowadays by numerous countries and international institutions. 1 In light of such perceived environmental degradation emanating from expanded economic activ-ities, environmentally conscious political and social groups have been staging  Þ erceworld wide reactions against international negotiations ( e.g. , the summits of WTOin Seattle, 2000, of IMF in Prague, 2001, and of the G-8 group in Geneva, 2001)promoting these objectives.Accounting for such growing real world concerns, a sizable literature on the eco-nomics of international trade and cross-border pollution has and is being developed.A strand of this literature analyzes the implications of cross-border pollution and/orexamining the welfare e ff  ects of selected pollution abatement (trade and environmen-tal) policies (see, for example, Markusen, 1975; Copeland, 1994, 1996; Ludema andWooton, 1994, 1997; Beghin et al., 1997; Hatzipanayotou et al., 2002, 2004).There is now a small theoretical literature that examines the e ff  ect of inter-national trade on pollution. Raucher (2001) examines whether it is optimal to em-ploy a policy of ‘ecological dumping’ in the presence of terms of trade considerations.Copeland and Taylor (2003) which synthesizes their earlier papers, examine the e ff  ectof trade liberalization on welfare in, and emission by, a small open economy whichhas optimal environment policies in place. They  Þ nd that when the country adjustsits optimal policies in response to trade liberalization, more trade increases welfarebut can, under certain circumstances, increase pollution. They also consider a modelof two large countries to examine the economic logic behind pollution havens. They 1 See, for example, Copeland and Taylor (2003) for a discussion of the issues. 1  investigate,  inter alia  , if trade driven by environmental policy di ff  erences is bad forthe environment and  Þ nd that it is not necessarily so.In this paper we develop a two-country general equilibrium model with two-way cross-border pollution and terms of trade e ff  ects. Within this framework, we  Þ rstcharacterize, in section 3, the non-cooperative optimal values for the emission tax rateswhen the terms of trade is exogenous. Also, we examine the e ff  ects of a reduction intrade costs on Nash optimal tax rates, net pollution and welfare in the two countries.In section 4, we examine how an endogeniety of the terms of trade a ff  ects the optimaltax rates. Finally, some concluding remarks are o ff  ered in section 5. 2 The Theoretical Framework We consider a general equilibrium model with two countries — Home and Foreign —where pollution as a by-product of production is generated in both countries, andit is transmitted across national borders. For the rest of the analysis, cross-borderpollution is treated either as a two-way or a one-way cross-country externality.The two countries produce, under perfectly competitive conditions, two goods— good 1 and good 2 — which are freely traded in world markets. Good 1 is the numeraire   commodity. Regarding international prices, we consider the cases wherethe international (relative) price of the non-mumeraire good 2 is either exogenous ( eg  .,when both economies are small in the world commodity markets) or it is endogenouslydetermined ( eg  ., when both economies are large in the world commodity markets).Factors of production are internationally immobile and inelastically supplied. Factormarkets in both countries are perfectly competitive. Producers in the two countriesabate some of the pollution they generate in response to government imposed emissiontaxes at the rate  t  and  t ∗ respectively. 2 Let  e  and  e ∗ denote the level of pollution 2 The variables in the foreign countries are marked with asterisks. Moreover, the analysis delib-erately abstracts from the use of other policy, especially trade, instruments (eg., tari ff  s) focusing onthe case of two countries maintaining free commodity exchange between them in the context of abilateral or multilateral trade agreement (eg., France and Germany in the context of the EU, or theUS and Mexico in the context of the NAFTA agreement). 2  emission in the two countries. As has been shown by Copeland and Taylor (2003,ch.4), the e ff  ect of trade liberalization on pollution depends on,  inter alia  , the patternsof trade. We shall examine the implications of the patterns of trade for the results inour framework later on.For simplicity, we shall assume that only one of the two goods is polluting. 3 Which is the polluting good would depend on the nature of the goods and the type of pollutant we consider. For example, if Home is a developing country which typicallyexports agricultural goods and the pollutant is nitrates in the water supply, then good1 is the pollutant. If, on the other hand, the pollutant is industrial waste, then good2 is possibly the pollutant. We shall leave the assumption open for the time being.We proceed now to spell out the model for Home; the model of Foreign followsanalogously. The country’s maximum value of production is denoted by the grossdomestic product, or revenue function,  R (  p,t,v ) , de Þ ned as: R (  p,t,v ) = max x 1 ,x 2 ,e { x 1  +  px 2 − te  : ( x 1 ,x 2 ,e ) ∈ T  ( v ) } , where  p  is the is the world price of the non-numeraire good,  T  ( v )  is the country’s ag-gregate technology set, 4 x 1  and  x 2  are the outputs of good 1 and good 2 respectively, v  is the vector of endowments,  e  is the amount of pollution emission and  t  is the emis-sion tax rate. Since total endowments of all factors of production,  v , are exogenouslygiven, for notational simplicity, it can be suppressed and the revenue function can bewritten simply as  R (  p,t ) . Its partial derivative with respect to  p  (i.e.,  R  p ) denotes thesupply function of the non-numeraire good 2. It is also known (e.g., see Copeland,1994, and Turunen-Red and Woodland, 1998) that its partial derivative with respectto  t  multiplied by − 1  is the amount of pollution emissions by the private sector, i.e., e  = − R t (  p,t ) .  (1)Analogously, for the foreign country we have e ∗ = − R ∗ t ∗ (  p,t ∗ )  (2) 3 For simplicity, we consider only one type of pollution. 4 It includes abatement technology in addition to production technology. 3  The revenue function is strictly convex in commodity prices (i.e.,  R  pp  >  0 ) andin the emission tax rate (i.e.,  R tt  >  0 ). The later property indicates that an increasein the emission tax rate lowers the amount of pollution emission by the private sector.Moreover, if good 2 is the polluting one, a higher emissions tax rate  ( t )  reduces thelevel of its production, i.e.,  R  pt  <  0 . If, on the other hand, good 1 is the pollutingone, we shall have  R  pt  >  0 . Since we do not make any presumption on the patternof trade, without any loss of generality, we assume, unless stated otherwise, that thenon-numeraire good is the polluting good in both countries so that  R tp  <  0  and R ∗ t ∗  p  <  0 .Turning to the demand side of Home, utility, ( u ) , as previously noted is ad-versely a ff  ected by both local pollution,  e , and by foreign pollution,  e ∗ transmittedacross borders. Denoting by  θ  the spill-over parameter, welfare in the home coun-try is adversely a ff  ected by  z  =  e  +  θe ∗ . Let  E  (  p,z,u )  be the expenditure functionwhich gives minimum expenditure required by a representative consumer to achievea given level of utility  u  given commodity (consumers’) price  p  and aggregate levelof pollution  z . The partial derivative of the expenditure function with respect to  u , E  u , gives the reciprocal of marginal utility of income, and that with respect to  p ,  E   p ,gives the compensated demand function of the non-numeraire good. Since pollutionis a public bad, the partial derivative of the expenditure function with respect to  z , E  z , is positive and denotes the households’  marginal willingness to pay for a reduction in pollution   (e.g., see Chao and Yu, 1999). The expenditure function is also strictlyconcave in  p , i.e.,  E   pp  <  0 , and strictly convex in  z , i.e.,  E  zz  >  0 . The later propertyimplies that a higher level of pollution raises the households’ marginal willingness topay for its reduction. Moreover, we also make the natural assumption that  E  zu  >  0 ,that is, a higher level of real income increases the households’ marginal willingness topay for pollution abatement. Finally,  E   pz  ≶  0 , depending on whether cleaner envi-ronment and good 2 are complements (i.e.,  E   pz  <  0 ) or substitutes (i.e.,  E   pz  >  0 ) inconsumption. Note that an increase in  z  increases expenditure for a given utility level,4
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