Trade, Factor Mobility and Endogenous Environmental Policy: An Economic Geography Approach

This paper formulates a two-country economic geography model of trade and the environment, in which “entrepreneurs” who own capital are internationally mobile under monopolistic competition. When the environmental policy is predetermined, the model follows the traditional economic geography prediction where industries agglomerate in one country above certain level of trade openness. Moreover, we find that the cross-border spillover of pollutants enhances such mobility. When environmental policies in both countries are endogenous in a way to optimize the resident’s welfare, the Nash equilibrium for pure local pollution is found at the symmetric capital allocation between the two countries regardless of the level of trade openness. Beyond some degree of transboundary pollution, however, the full agglomeration is sustainable in the country even with higher pollution tax than the other country. At the respective equilibrium, the aggregate worldwide pollution is in fact maximized for pure local pollution, while minimized for pure global pollution. An introduction of shifts in domestic policy regimes based on the median voter theorem generates the results in which the full agglomeration takes place in the country with pro-labor regimes, while the symmetric allocation may prevail under the pro-capital regimes in both countries. JEL Code: F12, F18, F2, H23 Keyword: trade and the environment, factor mobility, economic geography *Department of Economics, University of Virginia and the World Bank. Email: [email protected]