The political economy linkage between trade liberalization and domestic environmental regulations

This paper considers the political economy linkage between trade liberalization and domestic environmental regulations in a duopolistic product market. We investigate the environmental consequences and welfare implications of a home country’s unilateral tariff reduction on a polluting good. In a framework where the domestic environmental tax is subject to the influence of the home firm, we find that a tariff reduction on a good producing a consumption-type externality will improve the home country’s environmental quality. Moreover, we find that the home country’s tariff reduction will unambiguously enhance the home country’s welfare; and it will damage the foreign firm’s profits and thus the foreign country’s welfare, provided that the weight that the home government attaches to its social welfare is sufficiently small. This result also suggests the possibility that a unilateral tariff reduction will achieve a Pareto improvement.