Intra-Industry Trade in Intermediate Products, Pollution and Internationally Increasing Returns

This paper examines the relationship between intra-industry trade in intermediate products, pollution and increasing returns. We develop a two-country model in which production occurs in two stages, final and intermediate good production. Intermediate goods are produced under monopolistic competition and final good production exhibits increasing returns with respect to the number of varieties of intermediates. Pollution occurs in the production of the final good when polluting intermediates are used. We analyze the effects of international trade in intermediate products on pollution, output and welfare under both an exogenous and endogenous tax scenario. The results show that, because of increasing returns, international trade either leads to lower total pollution in each country or lower pollution per unit of output in at least one country. In addition, if pollution taxes are exogenous trade causes countries to import the environmental quality of their trading partners.