Price competition, pollution, and environmental policy in an open economy

Abstract.

We study three issues about environmental policy in a two country world in which national governments and polluting firms act strategically. First, we examine the conditions under which the pursuit of unilateral environmental policy by a country in a setting in which polluting firms play a price leadership game, will make that country worse off. Second, we study the results of environmental regulation by means of alternate price control instruments when national governments care about international pollution, but polluting firms that play a price leadership game, do not. Third, we compare our findings with the corresponding results when polluting firms play a quantity leadership (Stackelberg) game. We find that there are plausible theoretical and hypothetical numerical circumstances in which the pursuit of unilateral environmental policy is welfare reducing. We show that the use of a trade policy instrument to control pollution is generally dominated by the other price instruments that we analyze. Finally, if the two national governments are able to compel the polluting firms to choose between prices and quantities, then, generally speaking, they should require the two firms to choose quantities rather than prices.