Environmental regulation and intra-industry trade

ABSTRACT

The paper analyses complex interactions between intra-industry trade (IIT) and environment by extending Krugman's model of monopolistic competition and trade. It is found that an increase in exogenous environmental tax by a country leads to a fall in its output (the scale effect) and aggregate pollution, and an increase in its number of varieties (the selection effect). With IIT, if Home is a net exporter, an increase in its environmental stringency leads to a negative scale effect, which reduces its export demand and raises its import demand. In contrast, a positive selection effect reduces its import demand. However, the first-order scale effect on exports dominates the second-order effect on imports, implying a rise in Home's share of IIT with Foreign. The opposite holds true when Home is a net importer. Furthermore, the impact of a rise in environmental tax on aggregate welfare comprises the following counteracting effects: a negative scale effect, a positive selection effect, a lower level of aggregate pollution and a higher environmental tax revenue in autarky, and two additional effects, namely, changes in the level of exports and imports, under free trade. The overall change in aggregate welfare, in both autarky and free trade, is in general ambiguous.

KEYWORDS:

• Intra-industry trade
• monopolistic competition
• environmental regulation
• Grubel–Lloyd index
• scale effect
• selection effect

Disclosure statement

No potential conflict of interest was reported by the authors.

Notes

1 The case of θ being of function of the number of varieties is assumed in Gurtzgen and Rauscher (2000). Rauscher (1997) also considers θ to be an increasing function of the number of varieties for one of his results. This is ignored in the current analysis as it only makes it mathematically intractable, without changing any of the important results qualitatively.

2 Rauscher (1997) takes the variable cost of production to be dependent on the quantity produced and the factor prices for the environmental resource and capital, that is, the emissions tax rate and the rate of interest r. The unit costs take a generic form, . Further, the fixed cost of production is , where is the initial fixed capital required for the production of each variety.

3 Being a monopolist, each firm can charge a price higher than the marginal cost, with the price mark-up captured by

4 Droge and Schroder (2005) also derive similar results in the context of welfare comparison of ad valorem and unit taxes under monopolistic competition.

5 A similar result can be found in Lancaster (1984) and Gros (1987) who have modelled trade policy in the context of IIT and Rauscher (1997) who has modelled the interaction between environmental policy and intra-industry trade.

6 We thank an anonymous referee for pointing out the need to highlight this.

7 This is based on the fact that the price of Foreign varieties, which is the same for all varieties in equilibrium, is assumed to be the numeraire.

8 It should be noted that, in accordance with Result , Home and Foreign policy variables are independent of each other and, therefore, in our model there is no impact of a change in Home's environmental policy on Foreign's variables and vice versa. Thus, reproducing Propositions 3.4–3.6 for the Foreign country would only generate results symmetric to that of the Home country.

9 Mathematically, this can be seen as follows: when Home is a net exporter, the G–L index is given as follows: . Dropping the subscripts and totally differentiating the above results in: . And, since we know that the first-order effect of the fall in exports () dominates the second-order effect on a change in imports (), the resultant term in the square bracket becomes positive, implying that the share of IIT rises with a rise in the environmental tax in Home.

10 Lancaster (1980) uses a model of monopolistic competition to analyse IIT and finds that the protection of the agricultural sector by the country with comparative disadvantage in agriculture might even result in an increase in the IIT in manufactures.

11 It should be noted here that, although the tax revenue is not a part of the utility function of the consumer, it nonetheless remains a part of the welfare function. We would like to thank an anonymous referee for emphasizing the need to clarify this assumption.

12 The actual amount of welfare gain from the reduction in aggregate pollution would depend on the specific form of disutility from pollution function, which has not been specified in our analysis.

13 Again, the amount of welfare gain on this account would depend on the exact functional form used for disutility as well as the value of the pollution spillover parameter (δ), which is not explicitly modelled here.

14 In this paper, we do not attempt an optimization problem to endogenously derive the optimal environmental taxes. Instead, we take the environmental taxes as exogenously given. (See Benarroch & Weder, 2006; Gurtzgen & Rauscher, 2000 for an estimation of the optimal environmental tax.)