The consequences of a one-sided externality in a dynamic, two-agent framework

We discuss a dynamic model where all agents contribute to a global externality, but only those in a speci c region su er from it. We model this in a dynamic setting via a two agent, non-cooperative overlapping generations model and analyze the consequences for economic growth and intertemporal choices. We nd that multiple steady states may result from this asymmetry. In particular, if the agent who is affected by the externality has to spent a large share of his income to o set it, then he may be stuck in an environmental poverty trap. We provide conditions for the existence of, and local convergence to, the equilibria, as well as a condition for the global convergence to the poverty trap. While, in addition to maintenance expenditures, externalities tend to be addressed via studying taxes, investment in R&D or alike, we focus on capital market integration. Speci cally, agents in the a ected region can open up their capital market to enable capital in ows. We investigate whether an open capital market improves or worsens their welfare. While we do nd that capital market integration eliminates the environmental poverty trap, we show that capital market integration is not always in both agents' interest. In particular, we provide conditions under which the agents prefer autarkic or integrated capital markets. JEL classi cation: Q27; Q56; F2.