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Environmental Policy, North-South Trade and FDI

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Abstract

We analyze trade between two countries, called the North and the South. There is one firm in each country and production costs are lower in the South. To serve foreign markets firms may export or engage in FDI. Both countries set tariffs on imported goods. We find that the implementation of an environmental policy by the South may affect the location decision of the Southern firm. When only the North sets an environmental tax, firms engage in FDI if the difference in costs between the two countries is low, otherwise the South exports and the Northern firm engages in FDI. If the South also sets an environmental tax, this does not restrict FDI by Northern firm, encourages FDI by the domestic firm, reduces its environmental damage and increases joint welfare. Finally, in equilibrium the South decides to implement an environmental policy and both firms engage in FDI.

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Notes

  1. There are a great many papers that analyze the factors leading firms to engage in FDI but ignore environmental issues. See, for example, Petit and Sanna-Randaccio (2000), Head and Ries (2003), Helpman (2006), Leahy and Naghavi (2010), Afonso and Gil (2013), Bárcena-Ruiz and Garzón (2014), and Zhai (2014).

  2. Some papers analyzing the relationship between FDI and environmental policies find evidence that developing economies are becoming a pollution haven for foreign firms. See, for example, List and Co (2000), Cole and Elliott (2005), and Dean et al. (2009).

  3. Copeland and Taylor (1994, 1995) find that free trade improves the environment of developed countries but worsens that of developing ones. Chichilnisky (1994) argues that differences in property rights create a motive for trade between otherwise identical regions. The South has ill-defined property rights on environmental resources, which results in over-exploitation of resources and leads to environmental deterioration. By considering that the South has worse abatement technology than the North, Abe and Zhao (2005) analyze welfare effects of emission taxes when the Northern firm chooses between an international joint venture and FDI. They find that if the South has poor (good) abatement technology its best policy is to impose a high (low) emission tax which means that firms engage in FDI (prefer joint ventures).

  4. An example can be taken from the automobile sector. Although most of the cars manufactured in China are sold within the country, exports totaled 814,300 units in 2011. The PSA Group has several plants in China with an annual production capacity of 600,000 cars (www.psa-peugeot-citroen.com). This group has several plants in the EU to serve the European market. Although Chinese producers export cars to the EU, some of them are starting to produce cars there. For example, Geely Motors acquired the European Brand Volvo in 2010 (www.geely.com) and Great Wall Motors has set up a plant in Bulgaria (www.gwm-global.com). In the coming years they intend to offer a diverse line-up of vehicles on the EU market.

  5. We assume that international agreements prevent countries from restricting the way in which firms choose to serve foreign markets (by forbidding imports or FDI, for example).

  6. There is evidence that firms from developing countries are acquiring Northern firms and engaging in FDI in the North. In this regard, data from UNCTAD state that in terms of stock the FDI of Chinese firms increased by 25% per annum from 2000 to 2010. China has been one of the main drivers of outflows from Asia. China moved up from being the sixth to the third largest investor in 2012, after the United States and Japan (UNCTAD 2013).

  7. We assume in Section 3 that developed countries set more stringent environmental policies than developing ones. For the sake of simplicity in this section we consider that only the North implements environmental policies. Abe and Zhao (2005) point out that developing countries are reluctant to employ stiffer environmental policies for fear of becoming less competitive. Yunfeng and Laike (2010) argue that China’s economic growth has been described as an economic miracle, but that it has come at the expense of the environment.

  8. Developing countries such as China are starting to set stringent environmental measures. Recently, the Chinese government announced ten air pollution and control measures to combat atmospheric pollution and start solving China’s environmental problems (http://www.theclimategroup.org). One of the main measures is a target to reduce emissions from heavily polluting industries by 30% by 2017.

  9. Tariffs are used by many governments to protect domestic firms. World Tariff Profiles (2012) contains a compilation of the main tariff parameters for each WTO member. Each country’s profile gives information on tariffs imposed by that economy on imports.

  10. The advantage of country S may be due to lower wage costs, abundance of labor (which means lower levels of automation of industrial processes with the consequent saving in machinery), or lower prices of raw materials, energy, and land.

  11. We assume that governments do not subsidize production and thus cannot use tariffs or environmental taxes for that purpose. As a result tariffs and environmental taxes cannot be negative.

  12. Environmental damage could comprise, for example, adverse health impacts from water and air pollution, drinking-water shortages associated with water pollution and damage to materials by acid rain. According to a study by the World Bank (2007), the health costs of air and water pollution in China amount to about 4.3% of its GDP. If the non-health impacts of pollution, estimated at about 1.5% of GDP, are added the total cost of air and water pollution in China is about 5.8% of GDP.

  13. This type of damage function is commonly used in the relevant literature, and assumes that environmental damage is a convex function of the total pollution level and is exogenous for consumers. See, for example, van der Ploeg and de Zeeuw (1992) and Ulph (1996).

  14. To simplify the exposition of the results we do not consider the case in which firm N exports and firm S engages in FDI since it is not necessary to prove our results.

  15. It can be shown that when governments do not set tariffs, in equilibrium firm N engages in FDI and firm S exports. In that case firm N (firm S) engages in FDI (exports) to avoid paying environmental taxes and abatement costs, and thus produces with the low marginal production cost. Thus, tariffs encourage Southern firms to engage in FDI when parameter c is low enough. On the other hand, if it is considered that welfare does not include environmental damage it is found that both firms always engage in FDI to avoid tariffs, and to reduce production costs in the case of the Northern firm.

  16. It can be shown that it is a dominant strategy for the North to set up an environmental tax.

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Acknowledgements

We thank two anonymous referees for their helpful comments. Financial support from Ministerio de Ciencia y Tecnología (ECO2012-32299, ECO2015-66803-P), the Basque Government (IT1124-16) and the University of the Basque Country (EHU14/05) is gratefully acknowledged.

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  1. Departamento de Fundamentos del Análisis Económico I, Facultad de Economía y Empresa, Universidad del País Vasco, UPV/EHU, Avenida Lehendakari Aguirre 83, 48015, Bilbao, Spain

    Juan Carlos Bárcena-Ruiz & María Begoña Garzón

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  1. Juan Carlos Bárcena-Ruiz
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Correspondence to María Begoña Garzón.

Appendices

Appendix 1 Both Firms Export

Each firm locates its two plants in its home country and both governments set tariffs on imports. The profits of the two firms are:

$$ \begin{array}{c}\hfill {\pi}_N=\left[\left({p}_1\hbox{--} c\right){q}_{1N}-{t}_N{e}_{1N}\hbox{--} {a}_{1N}^2/2\right]+\left[\left({p}_2\hbox{--} c\hbox{--} {\tau}_S\right){q}_{2N}\hbox{--} {t}_N{e}_{2N}\hbox{--} {a}_{2N}^2/2\right],\hfill \\ {}\hfill {\pi}_S = \left[\left({p}_1\hbox{--} {\tau}_N\right){q}_{1S}\right]+\left[{p}_2\ {q}_{2S}\right].\hfill \end{array} $$

In the third stage each firm chooses the output and abatement levels of its two plants that maximize its profit. Solving these problems simultaneously gives: a 1N  = a 2N  = t N , q 1N  = (α − 2c − 2t N  + τ N )/3, q 2N  = (α − 2c − 2t N  − 2τ S )/3, q 1S  = (α + c + t N  − 2τ N )/3, q 2S  = (α + c + t N  + τ S )/3. In the second stage the two governments choose import tariffs and government N sets the environmental tax that maximizes domestic welfare. Solving these problems gives the following result.

Lemma A1

When both firms export, in equilibrium,

  1. i)

    If c< \( \frac{98\alpha }{425}\approx 0.2305\alpha \): \( {t}_N^{EE}=\frac{41\left(2\alpha -3c\right)}{556} \), \( {\tau}_N^{EE}=\frac{43\alpha +5c}{139} \), \( {\tau}_S^{EE}=\frac{98\alpha -425c}{1112} \), \( {\pi}_N^{EE}=\frac{6459{\left(2\alpha -3c\right)}^2}{154568} \), \( {\pi}_S^{EE}=\frac{248180{\alpha}^2+237356\alpha c+90253{c}^2}{1236544} \).

  2. ii)

    If \( c\ge \frac{98\alpha }{425}\approx 0.2305\alpha \): \( {t}_N^{EE}=\frac{173\alpha -298c}{1081} \), \( {\tau}_N^{EE}=\frac{9\left(37\alpha +5c\right)}{1081} \), \( {\tau}_S^{EE}=0 \), \( {\pi}_N^{EE}=\frac{216690{\alpha}^2-719872\alpha c+618337{c}^2}{1168561} \), \( {\pi}_S^{EE}=\frac{2\left(106570{\alpha}^2+154374\alpha c+60741{c}^2\right)}{1168561} \).

Appendix 2 Proof of Proposition 1

  1. i)

    As c<0.2305α: \( {\pi}_N^{FE}-{\pi}_N^{EE}=\frac{30332972{\alpha}^2+43011540\alpha c-32258655{c}^2}{402031368}>0 \), \( {\pi}_N^{FF}-{\pi}_N^{EF}=\frac{5{\alpha}^2+4\alpha c-4{c}^2}{54}>0 \), \( {\pi}_S^{FF}-{\pi}_S^{EF}=\frac{162992{\alpha}^2-721162\alpha c+97129{c}^2}{2719201}>0 \).

Thus, it is a dominant strategy for firm N to engage in FDI; in that case firm S also engages in FDI.

  1. ii)

    As c≥0.2305α: \( {\pi}_N^{FE}-{\pi}_N^{EE}=\frac{347502602{\alpha}^2+1346886972\alpha c-1418173695{c}^2}{6078854322}>0 \) and \( {\pi}_N^{FF}-{\pi}_N^{EF}=\frac{5{\alpha}^2+4\alpha c-4{c}^2}{54}>0 \); \( {\pi}_S^{FF}-{\pi}_S^{EF}=\frac{162992{\alpha}^2-721162\alpha c+97129{c}^2}{2719201}>0 \) if and only if \( c<{c}^{\ast }=\frac{\alpha \left(360581-11543\sqrt{857}\right)}{97129}\approx 0.2333\alpha \).

As it is a dominant strategy for firm N to engage in FDI, firm S chooses to export if c ≥ c*, and to engage in FDI if c < c*.

Appendix 3 Proof of Lemma 3 and Proposition 2

As c<\( \overset{-}{c} \): \( {W}_N^{FF}-{W}_S^{FF}=\frac{1568{\left(\alpha -c\right)}^2}{9409}>0 \), \( {W}_N^{FE}-{W}_S^{EF}=\frac{282{c}^2-308c\alpha +369{\alpha}^2}{867}>0 \), \( {CS}_S^{FF}-{CS}_N^{FF}=\frac{2\left(81c+16\alpha \right)\left(-81c+178\alpha \right)}{84681}>0 \), \( {CS}_S^{EF}-{CS}_N^{FE}=\frac{\left(15c+7\alpha \right)\left(61\alpha -15c\right)}{5202}>0 \), \( {ED}_S^{FF}-{ED}_N^{FF}=\frac{2\left(33c+64\alpha \right)\left(-33c+130\alpha \right)}{84681}>0 \), \( {ED}_S^{EF}-{ED}_N^{FE}=\frac{\left(55\alpha -6c\right)+\left(30c+31\alpha \right)}{5202}>0 \). Finally: \( {PS}_N^{FE}-{PS}_S^{EF}=\frac{139{c}^2-276c\alpha +58{\alpha}^2}{578}>0 \) if and only if c < 0.2388 α.

Appendix 4 Both countries set environmental taxes

When firm N exports and when it engages in FDI, its respective profits are given by:

$$ \begin{array}{c}\hfill {\pi}_N={\pi}_{1N}+{\pi}_{2N}=\left[\left({p}_1\hbox{--} c\right){q}_{1N}\hbox{--} {t}_N{e}_{1N}\hbox{--} {\left({a}_{1N}\right)}^2/2\right]+\left[\left({p}_2\hbox{--} c\hbox{--} {\tau}_S\right){q}_{2N}\hbox{--} {t}_N{e}_{2N}\hbox{--} {\left({a}_{2N}\right)}^2/2\right],\hfill \\ {}\hfill {\pi}_N = {\pi}_{1N}+{\pi}_{2N}=\left[\left({p}_1\hbox{--} c\right){q}_{1N}\hbox{--} {t}_N{e}_{1N}\hbox{--} {\left({a}_{1N}\right)}^2/2\right]+\left[{p}_2{q}_{2N}\hbox{--} {t}_S{e}_{2N}-{\left({a}_{2N}\right)}^2/2\right].\hfill \end{array} $$

When firm S exports and when it engages in FDI, its respective profits are given by:

$$ \begin{array}{c}\hfill {\pi}_S={\pi}_{1S}+{\pi}_{2S}=\left[\left({p}_1\hbox{--} {\tau}_N\right){q}_{1S}\hbox{--} {t}_S{e}_{1S}\hbox{--} {\left({a}_{1S}\right)}^2/2\right]+\left[{p}_2{q}_{2N}\hbox{--} {t}_S{e}_{2S}\hbox{--} {\left({a}_{2S}\right)}^2/2\right],\hfill \\ {}\hfill {\pi}_S={\pi}_{1S}+{\pi}_{2S}=\left[\left({p}_1\hbox{--} c\right){q}_{1S}\hbox{--} {t}_N{e}_{1S}\hbox{--} {\left({a}_{1S}\right)}^2/2\right]+\left[{p}_2{q}_{2N}\hbox{--} {t}_S{e}_{2S}\hbox{--} {\left({a}_{2S}\right)}^2/2\right].\hfill \end{array} $$

Let subscript t denote that both countries set taxes. When both firms engage in FDI: \( {t}_{Nt}^{FF}=\frac{16\left(\alpha -c\right)}{97} \), \( {t}_{St}^{FF}=\frac{16\alpha }{97} \), \( {\pi}_{Nt}^{FF}={\pi}_{St}^{FF}={PS}_{Nt}^{FF}={PS}_{St}^{FF}=\frac{857\left({c}^2-2c\alpha +2{\alpha}^2\right)}{9409} \), \( {CS}_{Nt}^{FF}=\frac{1458{\left(\alpha -c\right)}^2}{9409} \), \( {CS}_{St}^{FF}=\frac{1458{\alpha}^2}{9409} \), \( {T}_{Nt}^{FF}=\frac{352{\left(\alpha -c\right)}^2}{9409} \), \( {T}_{St}^{FF}=\frac{352{\alpha}^2}{9409} \), \( {ED}_{Nt}^{FF}=\frac{242{\left(\alpha -c\right)}^2}{9409} \), \( {ED}_{St}^{FF}=\frac{242{\alpha}^2}{9409} \), \( {W}_{Nt}^{FF}=\frac{2425{c}^2-4850c\alpha +3282{\alpha}^2}{9409} \), \( {W}_{St}^{FF}=\frac{857{c}^2-1714c\alpha +3282{\alpha}^2}{9409} \).

When both firms export, plant 2 N abates all emissions; thus, if c > 0.2012α: \( {t}_{Nt}^{EE}=\frac{3\left(449\alpha -612c\right)}{10688} \), \( {t}_{St}^{EE}=\frac{852c+1523\alpha }{10688} \), \( {\tau}_{Nt}^{EE}=\frac{164c+1303\alpha }{5344} \), \( {\tau}_{St}^{EE}=\frac{21\left(173\alpha -212c\right)}{10688} \), \( {\pi}_{Nt}^{EE}=\frac{3\left(13374992{c}^2-17961352c\alpha +6234689{\alpha}^2\right)}{114233344} \), \( {\pi}_{St}^{EE}=\frac{2975248{c}^2+7030840c\alpha +103081774{\alpha}^2}{57116672} \). If c < 0.2012α, plant 1S abates all emissions; thus: \( {t}_{Nt}^{EE}=\frac{4\alpha -5c}{31} \), \( {t}_{St}^{EE}=\frac{c+4\alpha }{31} \), \( {\tau}_{Nt}^{EE}=\frac{3c+10\alpha }{31} \), \( {\tau}_{St}^{EE}=\frac{10\alpha -13c}{31} \), \( {\pi}_{Nt}^{EE}=\frac{622{c}^2-886c\alpha +331{\alpha}^2}{1922} \), \( {\pi}_{St}^{EE}=\frac{67{c}^2+224c\alpha +331{\alpha}^2}{1922} \).

When firm N engages in FDI and firm S exports plant 1S abates all emissions; thus: \( {t}_{Nt}^{FE}=\frac{4\alpha -5c}{31} \), \( {t}_{St}^{EF}=\frac{16\alpha }{97} \), \( {\tau}_{Nt}^{FE}=\frac{3c+10\alpha }{31} \), \( {\pi}_{Nt}^{FE}=\frac{5\left(893855{c}^2-1430168c\alpha +901498{\alpha}^2\right)}{18084098} \), \( {\pi}_{St}^{EF}=\frac{451632{c}^2+677448c\alpha +1901197{\alpha}^2}{18084098} \).

A comparison of the above results leads to the following.

If c < 0.2012α: (i) \( {\pi}_{Nt}^{FF}-{\pi}_{Nt}^{EF}=\frac{-1383123{c}^2+1185534c\alpha +1393111{\alpha}^2}{18084098} \), \( {\pi}_{Nt}^{FE}-{\pi}_{Nt}^{EE}=\frac{-1383123{c}^2+1185534c\alpha +1393111{\alpha}^2}{18084098} \); (ii) \( {\pi}_{St}^{FF}-{\pi}_{St}^{EF}=\frac{1195522{c}^2-3971756c\alpha +1393111{\alpha}^2}{18084098} \). These expressions are positive since c < 0.2012α. Thus, it is a dominant strategy for firm N to engage in FDI; in that case firm S also engages in FDI.

If 0.2012α < c< \( \overset{-}{c} \): (i) \( {\pi}_{Nt}^{FF}-{\pi}_{Nt}^{EF}=\frac{-1383123{c}^2+1185534c\alpha +1393111{\alpha}^2}{18084098} \), \( {\pi}_{Nt}^{FE}-{\pi}_{Nt}^{EE}=\frac{-107541884863024{c}^2+78790091866264c\alpha +88329737559997{\alpha}^2}{1032903493881856} \), which are positive since 0.2012α < c< \( \overset{-}{c} \) , implying that it is a dominant strategy for firm N to engage in FDI; (ii) \( {\pi}_{St}^{FF}-{\pi}_{St}^{EF}=\frac{1195522{c}^2-3971756c\alpha +1393111{\alpha}^2}{18084098} \), which is positive since 0.2012α < c< \( \overset{-}{c} \) implying that as firm N engages in FDI, firm S also engages in FDI.

Appendix 5 Proof of Lemma 4 and Proposition 4

$$ {W}_{St}^{FF}-{W}_{Nt}^{FF}=\frac{1568c\left(2\alpha -c\right)}{9409}>0\kern0.2em \mathrm{since}\kern0.2em c<\overline{c}. $$

Comparing the results obtained when only the North sets a tax with those obtained when both governments set taxes, the following is obtained.

If c < 0.2333α: \( {W}_N^{FF}-{W}_{Nt}^{FF}=\frac{1696{\alpha}^2}{84681}>0 \), \( {W}_S^{FF}-{W}_{St}^{FF}=-\frac{128{\alpha}^2}{873}<0 \), \( {W}_N^{FF}+{W}_S^{FF}-{W}_{Nt}^{FF}-{W}_{St}^{FF}=-\frac{10720{\alpha}^2}{84681}<0 \). If 0.2333α < c< \( \overset{-}{c} \): \( {W}_N^{FE}+{W}_S^{EF}-{W}_{Nt}^{FF}-{W}_{St}^{FF}=\frac{2\left(389214{c}^2+1366824c\alpha -3107489{\alpha}^2\right)}{24472809}<0 \), \( {W}_N^{FE}-{W}_{Nt}^{FF}=\frac{274122{c}^2+129204c\alpha +247105{\alpha}^2}{2879154}>0 \), \( {W}_S^{EF}-{W}_{St}^{FF}=\frac{-3103218{c}^2+3270828c\alpha -16630741{\alpha}^2}{48945618}<0 \).

If c < 0.2333α: \( {CS}_N^{FF}={CS}_{Nt}^{FF} \) , \( {ED}_N^{FF}={ED}_{Nt}^{FF} \) , \( {T}_N^{FF}={T}_{Nt}^{FF} \) , \( {PS}_N^{FF}-{PS}_{Nt}^{FF}=\frac{1696{\alpha}^2}{84681} \) , \( {CS}_S^{FF}-{CS}_{St}^{FF}=\frac{5696{\alpha}^2}{84681} \) , \( {PS}_S^{FF}-{PS}_{St}^{FF}=\frac{1696{\alpha}^2}{84681} \) , \( {ED}_S^{FF}-{ED}_{St}^{FF}=\frac{16640{\alpha}^2}{84681} \) , \( {T}_S^{FF}-{T}_{St}^{FF}=-\frac{352{\alpha}^2}{9409} \) . If 0.2333α < c< \( \overset{-}{c} \): \( {CS}_S^{EF}-{CS}_{St}^{FF}=\frac{5696{\alpha}^2}{84681} \) , \( {CS}_N^{FE}-{CS}_{Nt}^{FF}=-\frac{\left(1403c-1791\alpha \right)\left(433c-45\alpha \right)}{5438402}>0 \), \( {PS}_N^{FE}-{PS}_{Nt}^{FF}=\frac{10022337{c}^2-10391040c\alpha +2957930{\alpha}^2}{48945618}>0 \), \( {PS}_S^{EF}-{PS}_{St}^{FF}=\frac{-874161{c}^2+6490458c\alpha -976784{\alpha}^2}{24472809}>0 \) , \( {T}_S^{EF}-{T}_{St}^{FF}=-\frac{352{\alpha}^2}{9409} \) , \( {T}_N^{FE}-{T}_{Nt}^{FF}=\frac{105270{c}^2+194047c\alpha +114679{\alpha}^2}{2719201}<0 \), \( {ED}_N^{FE}-{ED}_{Nt}^{FF}=\frac{2\left(478c-381\alpha \right)\left(104c-7\alpha \right)}{2719201}<0 \), \( {ED}_S^{EF}-{ED}_{St}^{FF}=\frac{\left(1164c+3049\alpha \right)\left(1164c+5293\alpha \right)}{48945618}>0 \) .

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Bárcena-Ruiz, J.C., Garzón, M.B. Environmental Policy, North-South Trade and FDI. J Ind Compet Trade 17, 371–386 (2017). https://doi.org/10.1007/s10842-016-0241-0

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