Environmental Policy and International Trade when Governments and Producers Act Strategically

Some environmentalists express concern that trade liberalization may damage the environment by giving governments incentives to relax environmental policies to give domestic producers a competitive advantage. Support for such concern may be given by models of imperfectly competitive trade where there may be “rent-shifting” incentives for governments to relax environmental policies. But there are also incentives for producers to act strategically, e.g., through their investment in R&D, and in this paper I extend the literature on strategic environmental policy by allowing for strategic behavior by producers as well as governments. I show that (i) allowing for producers to act strategically on balance reduces the incentive for governments to act strategically; (ii) allowing governments to act strategically increases the incentive for producers to act strategically; (iii) welfare is lower when both parties act strategically; and (iv) strategic behavior by producers and governments is greater when governments use emission taxes than when they use emission standards.