## Abstract

We examine the effects of trade liberalization in environmental goods in a model with one domestic downstream polluting firm and two upstream firms (one domestic, one foreign). The upstream firms offer their technologies to the downstream firm at a flat fee. The domestic government sets the emission tax rate after the outcome of R&D is known. The effect of liberalization on the domestic upstream firm’s R&D incentive is ambiguous. Liberalization usually results in cleaner production, which allows the country to reach higher welfare. However, this increase in welfare is typically achieved at the expense of the environment (a backfire effect).

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## Notes

- 1.
Antweiler et al. (2001) find that trade liberalization has generally reduced SO\({_{2}}\) concentrations. Cole and Elliott (2003) suggest it will reduce BOD, but increase CO\(_{2}\) and NO\(_{x}\) emissions. Managi et al. (2009) conclude that trade has benefited the environment in OECD countries, but increased SO\(_{2}\) and CO\(_{2}\) emissions elsewhere. Lovely and Popp (2011) empirically examine two effects of trade openness: While it improves access to the latest clean technologies, it also reduces industry’s ability to pass on regulatory costs to consumers.

- 2.
See Sinclair-Desgagné (2008) for a description of the global eco-industry.

- 3.
OECD (2005) predicts that the EGS market will grow by less than 1 % annually in developed countries and by 8.6 % in the developing countries, while Sinclair-Desgagné (2008) predicts growth figures of 3–5 and 10–15 % respectively. In 2003, nearly 80 % of the global exports of EGS originated in developed countries (Hamwey 2005).

- 4.
- 5.
In a different context, with heterogeneous firms and an exogenously fixed emission tax rate, Bréchet and Ly (2013) also show that the adoption of cleaner technology can increase pollution.

- 6.
All papers discussed here assume welfare-maximizing governments. See Canton (2008) for a political-economy model with the eco-industry in an international setting.

- 7.
If there were multiple downstream firms, we would have to consider the upstream firms’ incentives to increase revenue by licensing to a limited number of firms at a higher fee.

- 8.
If \(K_{i}=0,\) technology

*i*is a blueprint that requires no equipment. - 9.
- 10.
Price competition can be seen as the process that endogenizes bargaining power, resulting in complete (no) bargaining power for firm 1 (2) vis-a-vis the downstream firm.

- 11.
In fact, in scenario

*nn*, the upstream firms compete the fee down to \(K_{n}\) and the downstream firm as well as the government are indifferent between the two suppliers. For expositional simplicity, we let the domestic firm supply the technology. - 12.
- 13.
Trade liberalization which opens up the domestic market to the foreign upstream firm always increases the foreign firm’s R&D incentive, because its net revenue from licensing to the domestic downstream firm is higher (or at least equally high) with the new technology.

- 14.
- 15.
Further details are available from the corresponding author upon request.

- 16.
- 17.
- 18.

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## Acknowledgements

We thank Rod Falvey, Arijit Mukherjee, Joanna Poyago-Theotoky, the anonymous referee and seminar attendants at ZEW Mannheim and the Universities of Strathclyde (Glasgow) and Tor Vergata (Rome) for valuable comments. Any remaining errors are our own. The views expressed in this paper do not reflect the views of NOMS, the Ministry of Justice or Her Majesty’s Government.

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## Appendices

### Appendix 1: Conditions for \(q_{2}^{s}>0\)

*Autarky.*
\(q_{d}^{id}\) in (19) is decreasing in \(\lambda\) and has an interior minimum in \(e_{i}\in \left[ 1/\sqrt{\lambda };1\right]\) given \(\lambda\). To make sure that \(q_{d}^{id}>0\) for all \(e_{i}\in \left[ 1/\sqrt{\lambda };1\right] ,\) we calculate the \(\lambda\) where the minimum equals zero. Setting \(q_{d}^{id}=0\) and \(dq_{d}^{id}/de_{i}=0\) in (19) yields, respectively:

The only positive solution for \(\lambda\) and \(e_{i}\) is \(\lambda =\frac{5}{2 }\sqrt{5}+\frac{11}{2}.\) Therefore, \(q_{d}^{id}>0\) for all \(e_{i}\in \left[ 1/ \sqrt{\lambda };1\right]\) if and only if:

*Free trade.* Comparing (19) and (24), we see that \(q_{f}^{nf}>q_{d}^{nd}\) by (18). Thus, condition (44) that ensures \(q_{d}^{nd}>0\) is also sufficient for \(q_{f}^{nf}>0.\)

Output \(q_{h}^{jh},\ j=f,n,\) in (29) is positive for all values of \(e_{j}\) for which the second-order condition holds (which implies that the denominator on the RHS of (29) is positive) if and only if:

where \(\hat{e}_{j}\) as a function of \(e_{h}\) and \(\lambda\) is implicitly defined by:

The point where the LHS of (45) switches from \(+\infty\) to \(-\infty\) is where

and (46) holds. Solving (46) and (47) simultaneously for \(\lambda\) and \(e_{j},\) we find that the only positive real solution features \(\lambda =\frac{1}{2e_{h}^{2}}\left( 3\sqrt{5} +5\right) .\) Then, \(q_{h}^{jh}>0\) for all \(e_{j}\) if and only if:

### Appendix 2: The licence fee

In Sect. 4, we introduced the restriction that the licence fee should be decreasing in \(e_{1}.\) In this appendix, we discuss the conditions under which this is the case.^{Footnote 15}

### Autarky

Figure 1 shows the licence fee \(F_{h}^{id}\) (given by 20) as a function of \(e_{i}\) for different values of \(\lambda\) with \(\tilde{\alpha }=1\). The condition \(dF_{h}^{id}/de_{i}<0\) is binding for \(i=n,\) because it is clear from Fig.1 that when \(dF_{h}^{nd}/de_{n}<0,\) then \(dF_{h}^{hd}/de_{h}<0\) as well, since \(e_{h}>e_{n}\). Thus, \(e_{n}\) should exceed \(\bar{e}_{n},\) where \(\bar{e}_{n}\) is defined implicitly by:

### Free trade

*Domestic firm has found the new technology.* Comparing \(dF_{h}^{nf}/de_{n}\) in (25) to \(dF_{h}^{nd}/de_{n}\) in (20) with \(i=n,\) we see that qualitatively the only difference lies in the less efficient technology 2 which has \(e_{f}<1\) in scenario *nf* and \(e=1\) in *nd*. At \(\bar{e}_{n}\) as defined by (49) we must have \(dt^{nd}/de_{n}>0\) by (13). Then, since emissions with the less efficient technology \(E_{2}\) are lower in scenario *nf* than in *nd*, \(dF_{h}^{nf}(\bar{e}_{n})/de_{n}<0\) and \(dF_{h}^{nf}/de_{n}=0\) occurs at an \(e_{n}<\bar{e}_{n}\).

*Domestic firm has not found the new technology.* It can be shown that \(F_{f}^{jh}\) in (30)\(,j=n,f,\) is first increasing and then decreasing in \(e_{j}.\) Then, the condition \(dF_{f}^{jh}/de_{j}<0\) is binding for \(j=n,\) since when \(dF_{f}^{nh}/de_{n}<0,\) then \(dF_{h}^{fh}/de_{f}<0\) as well, since \(e_{f}>e_{n}\). Thus, \(e_{n}\) should exceed \(\tilde{e}_{n},\) where \(\tilde{e}_{n}\) is defined implicitly by:

It can be shown that \(\tilde{e}_{n}(e_{h})\) is an increasing function of \(e_{h}\).

### Conclusion

We have found two minimum values of \(e_{n}\): \(\bar{e}_{n}\) in (49) does not depend on \(e_{h},\) while \(\tilde{e}_{n}\) in (50) is increasing in \(e_{h}.\) This means that for low values of \(e_{h},\) the binding constraint is \(e_{n}>\bar{e}_{n},\) while for higher values of \(e_{h}\) it is \(e_{n}>\tilde{e}_{n}.\) Table 2 shows how the minimum \(e_{n}\) value changes with \(e_{h}\) for selected values of \(\lambda .\) With \(\lambda =3,\) for instance, \(\bar{e}_{n}=0.708\) while \(\tilde{e}_{n}=0.708\) for \(e_{h}=0.779.\) Thus, for \(0.708<e_{h}<0.779,\) the binding constraint is \(e_{n}> \bar{e}_{n}=0.708.\) For \(e_{h}>0.779,\) the binding constraint is \(e_{n}> \tilde{e}_{n},\) with \(\tilde{e}_{n}\) increasing in \(e_{h}.\) For the maximum value of one for \(e_{h},\) \(\tilde{e}_{n}=0.807.\) For the \(\lambda\) values of 3 and 5, the maximum value of \(e_{h}\) is one, whereas for higher \(\lambda\)’s it is constrained by (48).

### Appendix 3: Proofs

### Proof of Proposition 1

Let us first collect the expressions for welfare. Substituting (17) and (19) into (16) yields welfare in scenario \(id,\ i=h,n\):

Substituting (22) and (23) into (21) gives welfare in scenarios *nn* and *nf* as:

Substituting (27) and (29) into (26) gives welfare in scenario \(jh,\ j=f,n,\) as:

Before proving the Proposition, we first establish the following two lemmas:

###
**Lemma 1**

When the domestic firm has not found the new technology, welfare is higher with free trade than under autarky:\(\ W^{jh}>W^{hd}\) with \(j=f,n.\)

###
*Proof*

From (51) with \(i=h\) and (53), it is clear that \(W^{hd}=W^{jh}\) for \(e_{j}=e_{h}.\) From (53):

The sign of \(dW^{jh}/de_{j}\) in (54) is the sign of the numerator on the RHS. Defining \(a\equiv e_{j}/e_{h},\ b\equiv \lambda e_{j}^{2},\) the sign of the numerator is the sign of:

\(\Phi\) has a maximum in *b* for:

\(b^{*}\) is positive for\(\ a\in (\bar{a};1],\) with \(\bar{a}\approx 0.414.\) For \(a\in \left[ 0;\bar{a}\right] ,\) \(\Phi\) reaches its maximum at \(b=0\), which from (55) is clearly negative.

Substituting \(b=b^{*}\) from (56) into (55), we find the maximum possible value of \(\Phi\) given \(a\in (0.414;1]\):

Plotting this expression shows that \(\Phi ^{*}<0\) for all \(a\in (0.414;1]\). Thus, \(\Phi <0\) in (55) for all feasible values of *a* and *b*, which means that \(dW^{jh}/de_{j}<0\) in (54). This combined with \(W^{hd}=W^{jh}\) for \(e_{j}=e_{h}\) proves the lemma. \(\square\)

###
**Lemma 2**

In scenario *nf* with free trade, welfare \(W^{nf}\) net of the domestic upstream firm’s net revenue \(R_{h}^{nf}\) exceeds welfare \(W^{hd}\) in scenario *hd* under autarky: \(W^{nf}-R_{h}^{nf}>W^{hd}.\)

###
*Proof*

Differentiating (57) with respect to \(e_{n}\), we obtain:

with

where \(a\equiv e_{n}/e_{f},\ b\equiv \lambda e_{n}^{2}.\) Note that \(b<\frac{5 }{2}+\frac{3}{2}\sqrt{5}\) by (48).

The sign of the RHS of (58) is the sign of \(\Omega\) which is quadratic in *a* with a maximum (minimum) for \(b>(<)3.\) The highest value of \(\Omega\) is then at \(\partial \Omega /\partial a=0\) for \(b>3\) (if this is an internal maximum) and at either the highest or lowest value of *a* for \(b\le 3\). The highest value of *a* is 1, for which \(\Omega =-2(b+1)<0.\) The lowest value for *a* is where \(dF_{h}^{nf}/de_{n}=0\) from (25). Substituting this into (59), we find \(\Omega =-2a^{2}b\left( b+1\right) <0.\) For \(b>3,\) the maximum value of \(\Omega\) in (59) occurs at:

Substituting this into (59), the highest possible value of \(\Omega\) is:

We see that \(a^{*}>0\) and \(\Omega ^{*}<0\) for \(b\in \left( 3;2+\sqrt{ 5}\right)\) and \(a^{*}<0\) and \(\Omega ^{*}>0\) for \(b\in \left( 2+ \sqrt{5};\frac{5}{2}+\frac{3}{2}\sqrt{5}\right) .\) Thus, for all values of *b* for which there is potentially an interior maximum (\(a^{*}>0\)), \(\Omega ^{*}\) is negative. We conclude that \(\Omega\) is negative so that the RHS of (58) is negative. The lowest possible value of \((W^{nf}-F_{h}^{nf})\) is thus achieved at the maximum value of \(e_{n},\) which is \(e_{f}.\) Setting \(e_{n}=e_{f}\) in (57), we find from (51):

The inequality follows from (4) and \(e_{f}<e_{h}.\) \(\square\)

We will now prove Proposition 1 by examining each possible combination of R&D decisions in turn.^{Footnote 16}

#### No R&D in autarky; (No R&D, No R&D) with trade

In autarky, welfare is \(W^{hd}.\) With trade, welfare is \(W^{fh}.\) By Lemma 1, \(W^{fh}>W^{hd}.\)

#### No R&D in autarky; (No R&D, R&D) with trade

In autarky, welfare is \(W^{hd}.\) With trade, welfare is \(W^{nh}\) if the foreign firm’s R&D is successful and \(W^{fh}\) if it is not. By Lemma 1, \(W^{jh}>W^{hd},\ j=n,f.\)

#### No R&D in autarky; (R&D, R&D) with trade

In autarky, welfare is \(W^{hd}.\) With trade, welfare is \(W^{nn}-C^{h}=W^{nf}-C^{h}\) if the domestic firm’s R&D is successful and \(W^{jh}-R,j=f,n,\) if it is not. Thus, we have:^{Footnote 17}

The first inequality follows from \(C^{h}<C_{2}^{h}\) in (R&D, R&D), with \(C_{2}^{h}\) given by (36). The second inequality follows from Lemmas 1 and 2.

#### R&D in autarky; (No R&D, No R&D) with trade

In autarky, welfare is \(W^{nd}-C^{h}\) if R&D by the domestic firm is successful and \(W^{hd}-C^{h}\) if it is not. With trade, welfare is \(W^{fh}.\) Thus:

Solving for \(p^{h}\), we see that expected welfare under free trade is higher than under autarky if and only if inequality (40) holds.

#### R&D in autarky; (No R&D, R&D) with trade

In autarky, welfare is \(W^{nd}-C^{h}\) if R&D by the domestic firm is successful and \(W^{hd}-C^{h}\) if it is not. With trade, welfare is \(W^{nh}\) if the foreign firm’s R&D is successful and \(W^{fh}\) if it is not. Thus:

The RHS is positive if and only if (43) holds.

#### R&D in autarky; (R&D, R&D) with trade

In autarky, welfare is \(W^{nd}-C^{h}\) if R&D by the domestic firm is successful and \(W^{hd}-C^{h}\) if it is not. With trade, welfare is \(W^{nf}-C^{h}=W^{nn}-C^{h}=W^{nd}-C^{h}\) if the domestic firm’s R&D is successful and \(W^{jh}-C^{h},j=f,n,\) if it is not. Thus, we have:

The inequality follows from Lemma 1.

### Proof of Proposition 2

Let us first collect the expressions for emissions. Emissions in each scenario are given by \(e_{1}q_{1}.\) Thus, in scenario \(id,\ i=h,n,\) we have from (19):

In scenarios *nf* and *nn*, emissions are, from (23):

In scenario \(jh,\ j=f,n,\) emissions are, from (29):

Before turning to the Proposition, we first establish:

###
**Lemma 3**

When the domestic firm has not found the new technology, emissions are higher with free trade than under autarky:\(\ E^{jh}>E^{hd}\) with \(j=f,n.\)

###
*Proof*

From (60) and (62), it is clear that \(E^{jh}=E^{hd}\) for \(e_{j}=e_{h}.\) From (62):

Setting \(e_{j}=e_{h}\) yields:

Thus, when reducing \(e_{j}\) below \(e_{h},\) \(E^{jh}\) initially rises above \(E^{hd}.\) However, for lower values of \(e_{j}\), \(E^{jh}\) may decline again.

Defining \(a\equiv e_{j}/e_{h},\ b\equiv \lambda e_{h}^{2},\) we can write ( 62) as:

so that

The (potentially) positive solutions for \(E^{jh}=E^{hd}\) are \(e_{j}=e_{h}\) and

There are only real solutions for *a* when \(b^{2}-6b+1\ge 0,\) which is satisfied for \(b\le 3-2\sqrt{2}\) and \(b\ge 3+2\sqrt{2}.\) The first inequality is irrelevant by (18). In case the second inequality holds, the highest possible value for *a* is for the maximum value of *b* given by (48), combined with the “+” sign on the RHS of (63), so that:

Note that (28) can be written as \(ba^{3}+a-2>0.\) Substituting *a* from (64) and \(b=\frac{5}{2}+\frac{3}{2}\sqrt{5}\) from (48), we find \(ba^{3}+a-2=0,\) so that (28) is violated. Thus, \(E^{jh}=E^{hd}\) cannot hold and pollution is higher with trade than under autarky. \(\square\)

We will now prove Proposition 2 by examining each possible combination of R&D decisions in turn.^{Footnote 18}

#### No R&D in autarky; (No R&D, No R&D) with trade

In autarky, emissions are \(E^{hd}\). With trade, emissions are \(E^{fh}.\) By Lemma 3, \(E^{fh}>E^{hd}.\)

#### No R&D in autarky; (No R&D, R&D) with trade

In autarky, emissions are \(E^{hd}\). With trade, emissions are \(E^{nh}\) if the foreign firm’s R&D is successful and \(E^{fh}\) if it is not. By Lemma 3, \(E^{jh}>E^{hd},\ j=n,f.\)

#### No R&D in autarky; (R&D, R&D) with trade

In autarky, emissions are \(E^{hd}\). With trade, emissions are \(E^{nn}=E^{nf}\) if the domestic firm’s R&D is successful and \(E^{jh},j=f,n,\) if it is not. We know from Sect. 1 that \(E^{nn}=E^{nf}>E^{hd}\) and from Lemma 3 that \(E^{jh}>E^{hd}\) with \(j=f,n.\)

#### R&D in autarky; (No R&D, No R&D) with trade

In autarky, emissions are \(E^{nd}\) if R&D is successful and \(E^{hd}\) if it is not. With trade, emissions are \(E^{fh}\) with \(j=f.\) Thus:

Solving for \(p^{h},\) we see that the expected pollution damage under free trade is greater than under autarky if and only if (42) holds.

#### R&D in autarky; (No R&D, R&D) with trade

In autarky, emissions are \(E^{nd}\) if R&D is successful and \(E^{hd}\) if it is not. With trade, emissions are \(E^{nh}\) if the foreign firm’s R&D is successful and \(E^{fh}\) if it is not. Thus, we have:

By Lemma 3, a sufficient condition for \(D^{NR}>D^{R}\) is (41).

#### R&D in autarky; (R&D, R&D) with trade

In autarky, emissions are \(E^{nd}\) if R&D is successful and \(E^{hd}\) if it is not. With trade, emissions are \(E^{nn}=E^{nf}=E^{nd}\) if the domestic firm’s R&D is successful and \(E^{jh},j=f,n,\) if it is not. Thus, we have:

The inequality follows from Lemma 3.

## About this article

### Cite this article

Dijkstra, B.R., Mathew, A.J. Liberalizing trade in environmental goods and services.
*Environ Econ Policy Stud* **18, **499–526 (2016). https://doi.org/10.1007/s10018-015-0121-6

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### Keywords

- Eco-industry
- R&D
- Trade and environment
- Trade liberalization
- Backfire effect

### JEL Classification

- F12
- F18
- L24
- O32
- Q55
- Q58