Environmental regulation and love for variety

• Author: Luciana Echazu,Martin Heintzelman
• Published date: 01 February 2019
• DOI: http://doi.org/10.1111/roie.12382
• Date: 01 February 2019

Rev Int Econ. 2019;27:413–430. wileyonlinelibrary.com/journal/roie © 2018 John Wiley & Sons Ltd

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INTRODUCTION

Economists rarely concur so much as on the issue of free trade where we, as a profession, are al-

most entirely in agreement that free trade promotes welfare by increasing economic activity, reducing

prices, and making a larger number of product varieties available to consumers. However, we must

also be concerned about the impact of international trade on the environment, as this is another im-

portant aspect of a society’s well‐being. Similarly, it is important to understand how environmental

regulations affect the gains from trade. Do lower trade barriers result in greater environmental degra-

dation? How does international trade policy interact with environmental regulations set independently

by each country? How does the transboundary nature of environmental degradation affect this inter-

action? The objective of this paper is to shed light into these questions.

We present a theoretical model of trade, based on Krugman’s (1980) new trade theory that in-

corporates the strategic decisions of governments when implementing environmental standards. Our

Received: 18 February 2018

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Revised: 20 September 2018

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Accepted: 1 October 2018

DOI: 10.1111/roie.12382

ORIGINAL ARTICLE

Environmental regulation and love for variety

Luciana Echazu

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Martin Heintzelman

David D. Reh School of Business, Clarkson

University, Potsdam, New York

Correspondence

Luciana Echazu, David D. Reh School of

Business, Clarkson University, Potsdam, NY

13699‐5790.

Email: lechazu@clarkson.edu

Abstract

Using a model of monopolistic competition, we examine

the relationship between intra‐industry trade and environ-

mental regulation. The decisions on emission standards set

by each country show strong strategic interactions. In

closed economies regulations act as strategic substitutes,

and in equilibrium there is under‐regulation relative to the

cooperative outcome. Trade liberalization may lead to

stricter or laxer environmental standards, depending on

the consumers’ preference for product variety. In addition,

we show that with open trade environmental regulations

may act as strategic complements and countries may set

environmental standards that are as strict (or stricter) than

those in the cooperative outcome.

JEL CLASSIFICATION

Q56, F12, F18

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ECHAZU And HEInTZELMAn

model portrays two countries and two sectors, one homogeneous (and clean), and one differentiated

(and dirty). The differentiated sector exhibits CES preferences and is characterized by monopolistic

competition. Consumers spend a proportion of their budget on the differentiated good; once countries

open up to trade, this proportion can be regarded as the share of all trade that is intra‐industry. The cen-

tral planner in each country sets the standards for environmental quality, which determines how much

each firm in the differentiated sector must invest in abatement technology. These standards impact the

total number of varieties available for consumption and thus affect welfare in opposite directions: they

decrease it by decreasing the number of varieties, and they increase it by increasing environmental

quality. These standards also affect the levels of both local and global levels of environmental degra-

dation, and are set strategically in a noncooperative game‐theoretic setting.

In our model, when countries are closed to international trade environmental regulations act as

strategic substitutes, each country free rides on the standards set by the other, and in equilibrium

there is under‐regulation and over‐pollution relative to the cooperative equilibrium. Opening to trade

allows domestic and foreign consumers to enjoy a greater variety of imported goods. In this context,

costly environmental regulations generate environmental benefits both locally and globally (a positive

externality leading to strategic substitutability) but they also act as a barrier to trade. Given love for

variety on the consumers’ side, (stricter) environmental regulations also negatively affect consumers

by reducing the varieties enjoyed (a negative externality leading to strategic complementarity). This

means that, under open trade, environmental standards may be strategic complements and, more im-

portantly, that equilibrium regulatory standards may be as strict (and possibly stricter) as those in the

cooperative equilibrium (which itself always entails laxer regulation standards than the cooperative

equilibrium without trade). Open trade is, in this sense, more conducive to globally optimal pollu-

tion levels, although it may result in stricter or laxer standards (relative to autarky) depending on the

strength of consumer preferences for product varieties.

As countries open to trade, economic activity increases, which fosters growth; this brings the additional

consideration of how growth affects the environment. In our model, we consider productivity as an indi-

cator of economic growth and assess how exogenous changes in productivity affect emissions given the

abatement technology available, production and the strategic interaction between countries regarding en-

vironmental regulations. Our results are consistent with the existence of an environmental Kuznets curve.

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Relation to previous literature

The relationship between trade and environmental outcomes has been the focus of a large literature

for some time (see for instance Antweiler et al., 2001; Cherniwchan et al., 2017; Cole & Elliott, 2003;

Copeland & Taylor, 1994, 1995, 2004; Halicioglu & Ketenci, 2016; Levinson & Taylor, 2008). While

most of the initial research was based on interindustry trade, there has been an increasing trend in

research on intra‐industry trade, recognizing the vast volume of trade that happens within industries

(see Aralas & Hoehn, 2010; Benarroch & Weder, 2006; Cole & Elliott, 2003; Fung & Maechler,

2007; Gürtzgen & Rauscher, 2000; Haupt, 2006; Levy & Dinopoulos, 2016; Roy, 2017 among oth-

ers). Furthermore, authors are also taking into consideration the strategic interactions among govern-

ments when it comes to environmental regulation, not only because opening to trade brings about

interaction and competition among countries but also because environmental degradation is often of a

transboundary nature. Environmental regulation, in this strategic context, can be regarded as a barrier

to trade or as a way to enhance competitiveness (see Anouliès, 2010; Barrett, 1994; Coconi, 2003;

Hubbard, 2014; Ulph, 1996; Ulph & Ulph, 2007).

Grossman and Krueger (1995) find a peculiar relationship between growth and environmental deg-

radation, which takes the shape of an inverted U. They gave this relationship the term “Environmental