1. Chapter 10 Trade and the Environment

2. Key Questions What are the classical theorems of international trade and the implications of extending them to environmental resources? When does trade liberalisation damage the environment and if so does it matter? Do countries competitively reduce environmental standards and if so for what purpose? Does banning trade in products made from endangered species necessarily augment stock size? Does adherence to the General Agreement on Tariffs and Trade unduly constrain attempts to tackle environmental problems? Does the empirical evidence suggest that differences in the stringency of environmental regulations are a major determinant of trade flows?

3. Viewpoints Concerns expressed by environmentalists about international trade: Will gains from trade liberalisation be outweighed by the damage to the environment? Is there an incentive for countries to engage in ‘ecological dumping’ where one country lowers its emissions standards to gain some competitive advantage? Will footloose industries migrate to ‘pollution havens’? Will countries competitively lower environmental standards to generate trade benefits resulting in a ‘race to the bottom’? What about the environmental impact of transporting goods internationally? Businessmen often argue that environmental regulations: will result in the loss of jobs, and that the production of pollution intensive goods will merely be pushed offshore. Politicians are concerned about the resulting unemployment. Debate about the impact of international trade on the environment grew noisier in the early 1990s, mainly in response to fears about the possible impact of the proposed North American Free Trade Agreement (NAFTA) between Canada, the US and Mexico. Standing on a populist platform former US presidential candidate Ross Perot claimed that NAFTA would result in a giant sucking sound of jobs flowing to Mexico and recommended that Mexican goods be barred from entering the US unless they were produced under conditions meeting US standards for environmental protection. The exchange between Daly (1993) and Bhagwati (1993) is between two of the chief protagonists in the debate over NAFTA.

4. Debate Debate about the impact of international trade on the environment grew noisier in the early 1990s... Mainly in response to fears about the possible impact of the proposed North American Free Trade Agreement (NAFTA) between Canada, the US and Mexico. Former US presidential candidate Ross Perot claimed that NAFTA would result in large scale flow from USA to Mexico and recommended that Mexican goods be barred from entering the US unless they were produced under conditions meeting US standards for environmental protection. The exchange between Daly (1993) and Bhagwati (1993) is between two of the chief protagonists in the debate over NAFTA.

5. Free Trade and Welfare Many economists believe that free trade improves economic welfare. Some welcome the fact that industries might wish to relocate in countries with low standards. – For them it just demonstrates that differing endowments are the basis of trade. Economists do not generally accept the argument that countries ought to share the same environmental standards, given the existence of large differences in per capita incomes and population densities between countries. – Many economists therefore would see no reason for biophysical standards and environmental taxes to be harmonised. – Many would also contend that although changes in environmental regulation might result in temporary unemployment, changes in the exchange rate will ultimately restore the trade balance. – Calls for trade restrictions made on environmental grounds should be viewed with suspicion as they might be motivated by protectionist concerns.

6. Structure of this Chapter Review of the traditional theory of trade Extension of this theory to incorporate environmental resources. Why might a country have an advantage in the production of environmentally intensive commodities. Partial equilibrium analysis of the effects of moving from a position of autarky (no trade) to a system of free trade with and without the requisite controls on the production of environmental externalities. – We show that the problem is the absence of economically efficient environmental policy rather than trade liberalisation per se. General equilibrium model analysis of the effect of trade liberalisation on welfare. Consideration of situations in which governments might attempt to manipulate environmental standards in order to benefit national producers. Development of a model in which jurisdictions compete in order to attract capital. – Is this likely to result in an erosion of environmental standards? The role played by the World Trade Organisation (WTO) in policing the global trading system. – What, according to the WTO, is the difference between justifiable and unjustifiable restrictions on trade enacted in the name of environmental protection? Brief overview and critique of attempts to test the proposition that environmental regulations explain trade flows and patterns of Foreign Direct Investment (FDI).

7. Traditional trade theory Traditional trade theory characterised by a number of theorems. These include: – Heckscher-Olin theorem – Stolper-Samuelson theorem – Rybczinski theorem – Factor price equalisation theorem. These are covered by any standard textbook on international trade e.g. Bhagwati and Srinivasan (1983). Like Rauscher (1999) and Steininger (1999) we wish to consider the implications of these theorems when environmental factors of production are brought into the picture alongside capital and labour.

8. The Heckscher-Ohlin theorem A fundamental proposition regarding the pattern of trade between two economies. The Heckscher-Ohlin theorem suggests that trade is determined by differences in factor endowments. – A country will export those goods relatively intensive in its abundant factor of production and import those goods relatively intensive in its scarce factor of production. For example, a country having an abundant supply of capital will find it cheaper to manufacture goods whose production is capital intensive. The country is said to have a ‘comparative advantage’ in the production of such goods. Post free trade the consumption of the labour intensive goods will increase because of an increase in national income and a positive substitution effect whereas the consumption of capital intensive goods may or may not increase. – Taken as a whole, consumers unambiguously reach a higher level of welfare.

9. Heckscher-Ohlin theorem: assumptions The theorem rests on a number of assumptions: Countries have identical constant returns to scale technologies. Countries have identical tastes. There are no impediments to trade and no transport costs. There are two goods, two factors of production available in fixed quantities, and two countries one of which is small and the other one large representing the rest of the world. Factors of production are immobile.

10. Environmental extension (1) How can the HO theorem be extended to include environmental and natural resources as factors of production? The exports of many countries reflect their exploitation of particular natural resource endowments. But the observation that countries with, say, deposits of bauxite should ‘specialise’ in the production of bauxite ore is not especially insightful.

11. Environmental extension (2) But environmental resources include air, soil and water quality, and the capacity of the environment to assimilate the unwanted by products of economic activity. From our perspective a country is therefore well endowed with environmental resources when it is sparsely populated and has a higher assimilative capacity. HO theorem implies that countries well endowed with environmental resources should specialise on the production of environmentally damaging goods.

12. Endowment & Regulation Ultimately, a country’s endowment of environmental resources is determined by environmental regulation. The stringency of environmental regulation should reflect the population’s appetite for environmental quality. The stringency of environmental policy is endogenous so the growth in income that accompanies trade liberalisation might increase the stringency of environmental policy and therefore reduce the endowment of environmental factors of production.

13. Harmonisation of standards? Differences in the abundance of environmental resources and differences in the appetite of populations for environmental quality make it fairly clear that the harmonisation of environmental standards is inappropriate. There are perfectly legitimate reasons why Governments should wish to set different environmental standards.

14. Impact of Regulation on Trade HO theorem predicts that tighter environmental regulation at home leads to increased production of environmentally intensive products abroad. These environmentally intensive products are then imported.

15. Topical Example A single country or a bloc of countries imposes restrictions on CO 2 emissions. This should result in an increase in CO 2 emissions elsewhere, (‘carbon leakage’). Economists have utilised CGE models to estimate the extent of carbon leakage associated with attempts to reduce carbon emissions by, say, OECD countries or the EU. It is easy to understand why the threat of carbon leakage might prompt policy makers to: – (a) think about trade restrictions to prevent the import of carbon intensive commodities and – (b) reconsider the wisdom of unilateral measures to reduce carbon dioxide emissions.

16. Other bases for trade in waste and residuals Differences in: population density the waste assimilative capacity of countries national preferences for environmental quality also provide a basis for trade in waste and residuals.

17. Brief comments on some other theorems

18. Stolper-Samuelson theorem The HO theorem explains why a country is able to increase its income through trade. But this does not mean that free trade will be advantageous for everyone. The Stolper-Samuelson theorem demonstrates that those who supply the scarce factor of production can gain through protection that restricts imports of goods intensive in that factor. – A tariff will increase the income of the factor used intensively in the good that receives protection. – Intuition: the resulting increase in the price of the good increases the derived demand and therefore the price of the intensively-employed factor.

19. Applicability of Stolper-Samuelson Many environmental resources are not privately owned. But where environmental resources are subject to private property rights (perhaps because these have been created by the Government in the form of tradable permits) then the Stolper-Samuelson theorem may apply.

20. The Rybczynski theorem An increase in the endowment of one factor will reduce the production of goods intensive in the other factor. For example, if there is an increase in labour the production of capital intensive goods will decline. A de facto increase in environmental resources caused for example by an increased allocation of environmental permits by an incoming Government that cares less for environmental quality should decrease the production of environmentally less-intensive commodities.

21. The factor price equalisation theorem HO suggests that free trade would equalise factor prices since a country would export goods intensive in its abundant factor of production and import goods intensive in its scare factor of production. This would decrease the derived demand for the scarce factor of production and increase the demand for the abundant factor of production thereby reducing international differences in factor prices. Despite the fact that there is much capital mobility, and quite a lot of labour mobility, observation suggests that factor price equalisation does not hold. Unskilled workers in the developed world continue to earn far more than equivalent workers in Less Developed Countries. This could be attributed to the rather rigid assumptions upon which the theorem, and indeed the Heckscher- Ohlin theorem, is based e.g. the existence of free trade and the assumption that production technologies are the same everywhere. The factor price equalisation theorem would seem to suggest that international trade equalises the shadow price of environmental resources – a striking result. The shadow price of environmental resources means environmental tax rates or the price of environmental permits. Note that this does not require tax rate harmonisation or trade in permits. This of course does not mean that environmental quality will be equalised.

22. 10.1.1 North-South models of trade and the environment So-called North-South models suggest that the source of the poor South’s advantage is not that they have abundant environmental resources but that the use of these resources is unregulated by the Government. Such models are associated with the seminal paper of Chichilnisky (1994). This gives the South an illusory comparative advantage in the production of environmentally intensive goods. It is customary to refer to the region suffering from absent property rights governing access to the environmental resource as the ‘South’ and the region in which property rights both exist, and are enforced, as the ‘North’. Due to the mismanagement of environmental resources trade may exacerbate the environmental problems of the South whilst the rich North benefits from trade.

23. 10.2 Does free trade harm the environment? A partial equilibrium analysis The preceding section extended classical theories of trade to include environmental resources. We will now address the twin questions of (a) whether trade is bad for the environment and (b) whether it matters in a partial equilibrium setting in which the production of a single good gives rise to external costs. For the sake of simplicity these external costs are assumed to arise from the production of the good rather than the use of particular production processes. The country is assumed to be small such that it cannot affect its own terms of trade. Factors of production are assumed to be immobile and there is no transboundary pollution.

24. Cases to consider This analysis follows closely that of Anderson (1992). Assume that the country switches from an initial position of autarky to one of free trade. Four cases to consider a)the country already imposes,and retains, an (allocatively efficient) environmental tax or permit quantity of the correct amount and becomes a net importer b)the country already imposes, and retains, an environmental tax and becomes a net exporter c) the country does not already impose, nor introduces, an environmental tax and becomes net importer d) the country does not already impose, nor introduces, an environmental tax and becomes net exporter. Liberalising trade in the good whose production harms the environment can be welfare enhancing or not depending upon whether the country already imposes the efficient tax rate on domestic production.

25. Cases c) and d): efficient tax not imposed c)the country does not impose an environmental tax and becomes net importer d) the country does not impose an environmental tax and becomes net exporter. Begin with cases where the country does not impose an efficient environmental tax, and trade is liberalised in the good whose production harms the environment. If the good ends up being imported then welfare is definitely improved. This is because real resource costs fall whilst at the same time domestic pollution levels fall.

28. Case (d): Figure 10.2 The horizontal line P is now higher, indicating that opening up to trade will result in a higher price for consumers and increased domestic production leading to exports. Production rises from Q to Qx whilst consumption falls to Cx. The change in economic surplus is given by eik although there is an increase in environmental costs of dekm. The relative size of these areas and therefore the overall welfare impact is unclear. Consequently if a country without environmental taxes ends up being a net exporter then the gains from trade may be more than outweighed by the losses from increased production and the external costs that this generates – a situation of some concern.

29. Cases a) and b): efficient environmental tax already imposed If the pollution tax is already in place when trade is liberalised then benefits from trade are secured irrespective of whether the final position of the country is one of exporter or importer. For the case in which the good ends up being imported, Figure 10.1 shows that the change in welfare is qcf. For the case in which the commodity ends up being exported, Figure 10.2 shows that the change in welfare is cij. So even if production is increased to supply the export market the benefits from trade more than outweigh the monetised losses from increased pollution.

30. Is a pollution tax superior to a tax on exports or a subsidy to imports as means of controlling environmental problems? Suppose that rather than imposing an environmental tax on pollution, a tax is instead imposed on the exports of the polluting commodity. This reduces the price faced by domestic consumers of that commodity, meaning that they will now purchase too much of the good. More specifically, they value infra marginal units of the good less than do foreign consumers. Accordingly, whilst trade taxes and subsidies can influence domestic pollution levels they do so by imposing higher costs. What happens to the small country when emissions taxes are placed upon the production of an environmentally damaging commodity in the rest of the world? Does this increase or decrease the benefits from free trade to the small open economy? – If the country is already an exporter of the commodity, Anderson shows that an increase in the international price of the commodity increases pollution levels in the small economy. However, the benefits to the economy are always positive if the correct tax on pollution is already in place since the gains from trade always outweigh the losses from more pollution. – If the appropriate tax is not already in place there could be either benefits or disbenefits since the quantity of pollution is already excessive. – If, on the other hand, the country is an importer and remains an importer then the gains from trade are reduced.

31. Summary of the partial equilibrium analysis Free trade is better than no trade provided that the requisite efficient environmental taxes, or their equivalent, are in place – provided, that is, that the externality is efficiently internalised. Taxes or subsidies on trade could alter domestic production levels and hence pollution but they are inferior to taxing environmental pollution. Countries have no incentive to depart from the economically efficient level of tax placed on the production of environmentally damaging goods. What about the assumptions underlying the analysis? – As developed countries raise their environmental standards the production of environmentally damaging goods will move to developing countries. Eventually developing countries will become exporters of environmentally damaging products. But any further increases in international standards will benefit developing countries. – The ability to import or export factors of production – assumed absent in the foregoing discussion – in response to changes in environmental targets actually enhances the gains from trade. – The assumption that pollution does not cross national boundaries is important since with transboundary pollution increases in pollution affect all countries. Such transboundary pollution would, however, occur even in the absence of trade.

32. Limitations of partial equilibrium models of trade and the environment Partial equilibrium models are used for the purposes of analysing the effects of liberalising trade in one sector of the economy, when that sector is small in relation to the rest of the economy. But there are important questions that a partial equilibrium approach cannot answer. – What happens when trade is liberalised across several sectors of the economy at once such that the economy grows? – What happens to the shadow price of pollution? – What happens to economy-wide emissions? Answering these and other questions requires a general equilibrium approach in which all markets clear simultaneously.

33. 10.3 General equilibrium models of trade and the environment We show the derivation of a general equilibrium level of pollution in an open economy as a function of the general equilibrium marginal abatement cost curve and marginal damage curves. It goes on to consider the general equilibrium effect of trade liberalisation on economic welfare.

34. The Copeland and Taylor Model Deals with a small open economy facing prices p for two commodities x and y. Production of commodity x results in pollution and is referred to as the dirty good. Production of good y produces no pollution and is the clean good. Economy has at its disposal L units of labour and K units of capital. Emissions are denoted z and are proportionate to potential output of good x. Emissions can be reduced by sacrificing some of the output of good x. Reducing emissions shifts the economy’s production possibility frontier.

35. Model Specification (1) The national income function G of the economy has as its arguments world prices, the level of both factor inputs, and permissible emissions G returns the maximum value for national income which can be achieved given prevailing world prices, available factor inputs and production technologies, and maximum allowable emissions. Differentiating the national income function with respect to emissions yields the general equilibrium marginal abatement cost function. It indicates by how much national income would increase if emissions were allowed to rise by one unit. Associated with the general equilibrium marginal abatement cost function is the marginal tax rate τ necessary to ensure that emissions do not exceed z.

36. Model Specification (2) We turn now to the consumer side of the economy in which there are N individuals. The indirect utility function V of each individual is given by where I=G/N is per capita income. The indirect utility function gives the maximum amount of utility as a function of prevailing prices, available income and emissions (which impact negatively on utility).

37. Deriving the Model Solution (1) The indirect utility function gives the maximum amount of utility as a function of prevailing prices, available income and emissions (which impact negatively on utility). This function is maximised subject to the constraint linking national income to permitted emissions.

38. Deriving the Model Solution (2) The first order conditions include Given the assumption that world prices are wholly independent of national emissions rearranging equation 10.4 yields

39. Deriving the Model Solution (3) The RHS of (10.5) is the Marginal Damage (MD) from emissions. This will be a function of prices, per capita income and emissions. For optimality we already know aggregate marginal damage should be set equal to the tax on emissions so

40. Deriving the Model Solution (4) The optimal level of emissions is therefore implicitly defined by The optimal level of emissions and the emissions tax rate are jointly determined by the intersection of the ‘supply’ of emissions (i.e. the aggregate marginal damage curve) and the ‘demand’ for emissions (i.e. the marginal abatement cost curve).

41. The Copeland and Taylor model and the EKC This framework can be used to trace out the relationship between national income and emissions – the environmental Kuznets curve. There is no straightforward relationship between national income and emissions. – Both z and G are endogenous variables and the precise relationship between national income and emissions depends on what underlies the economic growth. If economic growth is caused by an accumulation of human capital then the economy will increasingly specialise in the labour intensive non polluting commodity (Rybczynski T). Hence demand for pollution falls whilst the growth in income causes the supply of pollution to fall. These effects are reinforcing => a negative relationship between economic growth and emissions. If growth in income is caused by an increase in the capital stock then the demand for pollution increases. This may be more than sufficient to offset any income-induced reduction in the supply of emissions => positive relationship between economic growth and emissions. Economic growth first characterised by increased capital and latterly by increased human capital generates the stylised inverse U-shaped relationship between income and emissions - the EKC. But that is only one of many possible outcomes.

42. The effects of trade liberalisation What do C&T mean by trade liberalisation? Trade liberalisation means either reducing the level of some tariff which has been placed on some imported commodity or alternatively, a reduction in trade frictions. In order to export a unit of a commodity an amount (1+ρ) units has to be shipped, where ρ>0. This is known as the ‘iceberg’ model for obvious reasons. This generates a real resource cost to international trade representing perhaps, the transportation costs of international trade.

43. Trade Frictions Trade frictions create a difference between foreign and domestic prices but do not result in any Government revenue. If the home country imports x the domestic price will be pd=p(1+ρ) where p is the world price. If x is exported then pd=p/(1+ρ). These frictions serve to reduce trade.

44. Trade liberalisation: key results due to Copeland and Taylor If trade is distorted by the presence of trade frictions, then trade liberalisation will necessarily increase welfare providing that the tax is set optimally. C & T demonstrate that the same analysis can also be carried out when the trade distortion is in the form of a tariff. Once more, we see that if the pollution tax is set optimally trade liberalisation would be necessarily beneficial. C & T enquire further under what circumstances the change in emissions will be positive or negative as a result of trade liberalisation. But irrespective of whether or not emissions increase or decrease following trade liberalisation provided that the tax on emissions has been set optimally welfare is guaranteed to increase. And if emissions are controlled via a system of tradable permits then welfare necessarily improves following trade liberalisation. Trade liberalisation can therefore have quite different consequences depending on whether the country has a comparative advantage in the production or the clean good, and depending on whether environmental policy is optimally adjusted, and if not what policy instruments are used to control pollution.

45. Scale, composition and technique effects: Grossman and Krueger (1993) G & K give a useful decomposition for thinking about the reasons underlying changes in emissions. Emissions are by definition equal to the overall scale of activity S, multiplied by the share of dirty goods in total output σ, multiplied by the emissions per unit of the dirty good, e. Taking logarithms and then totally differentiating this expression gives This says that the percentage change in emissions is equal to the percentage change in the scale of output plus the percentage change in the share of the dirty commodity plus the percentage change in emissions intensity of the dirty commodity.

46. Reasoning which follows from this Trade liberalisation boosts market access which will generate economic growth, so likely to lead to an increase in the scale of economic activity. Other things being equal the scale effect will be environmentally damaging. Trade liberalisation is also likely to alter the composition of output. – If a country enjoys a relative abundance of the environmental factor of production then that country will increasingly specialise in the production of environmentally intensive ‘dirty’ commodities. – Similarly, if a country possesses a relative abundance of capital then that country will specialise in the production of capital intensive commodities. In fact many goods are both capital intensive and environmentally intensive. The overall effect of the composition effect on the environment is therefore ambiguous. Insofar as trade liberalisation increases per capita income levels the public will call for greater environmental quality. – Assuming that the Government is responsive to such demands it will tighten environmental regulations. – Put another way, less of the environmental resource will be allocated to production thereby compelling producers to adopt different production techniques. – This is the technique effect of trade liberalisation. The detrimental impact of trade liberalisation on the scale effect, the ambiguous impact of trade liberalisation on the composition of output effect, and the likely beneficial impact of trade liberalisation on the technique effect means that the overall impact of trade liberalisation is an empirical question.

47. Box 10.1 The effect of trade liberalisation on emissions: An empirical test Cole and Elliott (2003) empirically analyse (using panel data regression techniques ) the effect of an increase in trade intensity (the ratio of imports plus exports to GDP) on the per capita emissions of four different pollutants: SO2, NOx, CO2 and Biological Oxygen Demand (BOD). An increase in trade intensity is taken as synonymous with trade liberalisation. With regards to the situation under autarky, Cole and Elliott find that increases in the capital-labour ratio increase per capita emissions of SO2, NOx and CO2 although for SO2 each additional increase in the capital labour ratio has a diminishing impact. For BOD, they find no statistically significant relationship between emissions and the capital-labour ratio. The combined impact of the scale and technique effects appears to be negative for SO2, positive for NOx and CO2, and curvilinear for BOD. The effects of an increase in trade intensity depend on the relative value of the capital-labour ratio. A high income country with a high level of environmental regulations will find that an increase in trade intensity increases SO2 emissions. Nevertheless, a high income country will experience falls in NOx and BOD emissions in response to an increase in trade intensity. Cole and Elliott’s findings for NOx and BOD are quite different to those for SO2 and CO2. For BOD, the trade intensity coefficient is negative and significant, whilst for NOx it is positive but insignificant. With regards to SO2 emissions, an increase in income of 1 percent will generate a reduction in per capita emissions of 1.7 percent whereas the trade intensity elasticity is 0.3 percent. The results for BOD suggest that increased trade intensity will reduce per capita emissions; for NOx and CO2 it is likely to increase emissions. In an attempt to isolate the technique effect, Cole and Elliott also estimate the impact of changes in income and trade intensity on emissions per unit of output. For all four pollutants, growth in per capita income appears to reduce the emissions intensity of output. The trade intensity elasticity of emissions per unit of output is either negative or statistically insignificant.

48. Do governments have an incentive to manipulate environmental standards for trade purposes? Do governments distort their environmental policies for trade purposes and if so what can or should be done about it? Environmentalists often express the concern that Governments have an incentive to engage in ‘ecological dumping’ i.e. lowering environmental standards in order to gain competitive advantage. This claim can be examined in the context of a model of duopoly. – Analysis suggests that because international trade agreements severely restrict the use of more preferred policy instruments, policy makers might strategically manipulate environmental standards. – But, critically, policy makers sometimes have incentives to adopt stronger rather than weaker environmental standards. In the context of a two-stage game Barrett (1994) examines the incentives for Governments to behave strategically whilst setting environmental standards. – Production is assumed to generate environmental emissions which cause localised environmental damage even though such emissions may be abated; there are no transboundary pollution flows; and for convenience consumers are located in a third country. – In the first stage of the game Governments choose permissible emissions. In the second stage of the game the firms choose their output. Depending on the form of competition that ensues, Governments have an incentive to set an environmental policy that is either too weak or too strong. Whilst Governments have an incentive strategically to manipulate environmental standards, such a measure is always inferior to conventional export subsidies or taxes. Governments would always prefer using such measures if they were permitted.

49. Other results Brander and Spencer (1985), employing a similar setup, find it optimal for Governments to subsidise their own firms. However, Barratt demonstrates that although the Government is able to provide an implicit subsidy by increasing the limit on emissions this has a cost in the form domestic pollution problems. In this sense it differs from a pure subsidy. Consequently, a Government would prefer to use a pure subsidy for the purpose of inducing a higher level of output if only such a measure were available to it. The foreign Government would also respond strategically. This gives the Nash response and ironically both firms earn lower profits and experience higher levels of pollution. However neither country has the incentive to alter its behaviour. Barratt’s paper further shows that both countries have an interest in cooperating and imposing and stronger environmental standards than that corresponding to the environmentally optimal emissions standard. Although there is policy competition between the two Governments this does not result in a race to the bottom since there is a cost to Governments engaged in an attempt to gain an increased share of the world market in the form of increased levels of domestic pollution. Finally Barratt considers the case of Bertrand competition where firms compete over prices rather than output. The analytical model suggests that Government should strategically reduce permissible emissions. Governments need to know the form of oligopolistic interaction being used in the market in which they want strategically to intervene.

50. Other results (2) How important are the assumptions of no domestic consumers and no transboundary pollution flows to this particular model? Ulph (2000) explains that relaxing these assumptions actually reinforces the conclusion that Governments have incentives to engage in ecological dumping. – Since imperfect competition implies less output than socially desirable, Governments would positively desire that their firms expand output. Similarly, where there are transboundary pollution problems Governments have an incentive to reduce foreign output and hence foreign pollution flows. Do these arguments carry over to other kinds of markets? There is no strategic element in competitive markets since the world price cannot be altered. In the monopoly case there is no rival firm whose output can be manipulated. There are however circumstances in which Governments have incentives to manipulate the terms of trade in their favour but, where prevented from using export taxes and subsidies for this purpose, manipulate environmental standards as a second best. – For example, a country that is a major importer of a polluting commodity will increase permissible emissions to encourage domestic production if unable to use an import tax to depress world prices. Likewise a country which is a major exporter of a dirty commodity will reduce permissible emissions if it cannot use an export tax to raise world prices.

51. What can be done about Governments using environmental policy for trade purposes? One possibility is to allow countries to take action against those believed to be engaged in environmental dumping. – However “to substantiate such a claim it would be necessary at the very least to demonstrate that the standards are even lower than would be expected on the basis of such factors as the level of per capita income and the characteristics of the physical environment. Clearly that would be very difficult to do” (GATT, 1992). Another possibility is to allow environmental policy to be set at the supranational level e.g. at the level of the EU. What form might such intervention take? It is is very difficult to support the harmonisation of biophysical standards and environmental taxes. Harmonisation is inappropriate because environmental preferences differ as well as differences in the ability of countries to dissipate waste whereas minimum standards presumes that if one country increases its environmental standards to the required minimum that another country is not then tempted to reduce its own standards, standards that currently exceed the minimum.

52. Environmental policy and competition between jurisdictions for mobile capital The view that national and regional Governments are likely to compete to attract new firms in part by relaxing environmental standards is pervasive. Numerous calls have been made for minimum standards to prevent the excessive degradation of environmental standards (e.g. Cumberland, 1981). But what precisely are the incentives to engage in a race to the bottom? If residents care about environmental quality as well as labour income then competitively lowering environmental standards patently imposes a cost on the community. Indeed, rather than a race to the bottom arguably we are witnessing the perpetual tightening of environmental standards. But is this the consequence of federal Governments actively restricting the ability of jurisdictions to use environmental regulation as a tool to attract new businesses?

53. Oates and Schwab (1984) model of inter- jurisdictional competition In a community composed of homogeneous and geographically immobile individuals, workers select a tax rate on capital and simultaneously the level of environmental quality. Attracting capital boosts wages. But attracting capital via reducing taxes reduces non-labour income, whilst attracting capital via increasing permitted emissions reduces utility. Model conclusions: Only in very specific circumstances is there a tendency for Governments to competitively lower environmental standards. And there are even circumstances in which Governments might wish to competitively raise standards.

54. Oates and Schwab then go on to consider the situation in which the economy is populated by heterogeneous individuals: those who work and those who rely on revenue from taxing capital. Labourers would prefer an influx of capital that will raise wages whereas non-workers want higher capital tax revenues. What happens depends on which group is in the majority. If workers are in the majority then there will be a subsidy to capital. Workers gain the benefit of a larger capital stock in the form of higher wages but bear only a fraction of the cost of providing the subsidy. To summarise, Governments have no incentive to manipulate environmental standards in order to attract capital unless they are obliged to tax capital for revenue raising purposes. – In this case the marginal benefit of improving the environment should exceed the marginal cost. – But in regions populated by heterogeneous individuals this rule can be reversed.

55. Banning trade in endangered species Measures to protect endangered species often include banning international trade in animal products e.g. skins and ivory, as well as better enforcement of anti-poaching regulations and compensation for preservation benefits enjoyed by rich countries. The 1973 Convention on International Trade in Endangered Species (CITES) banned trade in animal products listed in Appendix 1 to the agreement. Trade in the animal products of species listed in Appendix II to the agreement is also tightly regulated. The African elephant was added to Appendix 1 in 1989 following a serious decline in elephant numbers during the 1970s and 1980s. Some sales of ivory from stockpiles have nevertheless been permitted. Since then elephant populations in Eastern and Southern Africa have been steadily increasing to the extent that South Africa is now considering a culling program. According to the IUCN’s African Elephant Status Report 2007 there are between 470,000 and 690,000 African elephants in the wild. Although adding the African elephant to Appendix I has seemingly increased numbers, the following question arises: Does banning international trade in endangered species like the African elephant necessarily increase stocks?

56. Does banning international trade in endangered species like the African elephant necessarily increase stocks? Addressed by the model of Bulte and Van Kooten (1996). Key finding is that the effect of a trade ban on stock levels is ambiguous remain. A key matter is the changed incentives of the Government to limit the activities of poachers under a trade ban. There can be no presumption that banning trade will necessarily increase the stock of an endangered species. At a minimum it is necessary to know about the prevailing interest rate and the growth rate of the species before recommending a trade ban.

57. GATT and WTO The objective of the General Agreement on Tariffs and Trade (GATT) is the reduction of barriers to international trade achieved through the gradual elimination of tariffs, quantitative restrictions and subsidies. The GATT treaty was created in 1947 and lasted until 1995 when it was subsumed into the World Trade Organisation (WTO). Discussing the lowering of tariffs is undertaken in periodic rounds of negotiations frequently extending over several years. Recent rounds have dealt with amongst other things trade in services, agricultural products and property rights. The latest of these, the Doha round, collapsed in 2008. Amongst other things the WTO administers trade agreements, serves as a forum for negotiations and the resolution of disputes, monitors trade policies, provides assistance to Less Developed Countries and cooperates with other international bodies. The original GATT agreement contained a list of 38 articles of which the two most important are: – the most favoured nation provision (Article I) and – the national treatment provision (Article III). Under the GATT agreements, countries cannot discriminate between trading partners. What this means is that imports from any contracting party should be treated no less favourably than like products imported from any other contracting party. Imported and locally produced goods should be treated equally.

58. GATT Article XX Deals with measures to protect human, animal or plant life or health. Extracts from text of GATT article XX “Subject to the requirement that such measures are not applied in a manner which would constitute a means of arbitrary or unjustifiable discrimination between countries where the same conditions prevail, or a disguised restriction on international trade, nothing in this agreement shall be construed to prevent the adoption or enforcement by any contracting party of measures:... (b) necessary to protect human, animal or plant life or health;... (g) relating to the conservation of exhaustible natural resources if such measures are made effective in conjunction with restrictions on domestic production or consumption” Source: the WTO website: http://www.wto.org/http://www.wto.org/

59. Tuna and dolphins A dispute between Mexico and the US over tuna and dolphins has come to assume particular importance in how many environmentalists view the GATT and the WTO. When tuna are fished using purse seine nets dolphins can become unintentionally trapped and suffocate. The US Marine Mammal Protection Act (MMPA) sets out standards for the protection of dolphins in the Eastern Tropical Pacific Ocean. If a country exporting tuna to the US cannot prove that its standards meet those enshrined in US law then the US must embargo all imports of tuna and tuna products from that country and any intermediary countries that purchase tuna from the country subject to the embargo. The US embargoed tuna from Mexico, Venezuela and Vanuatu, as well as a number of intermediary countries because the methods used to catch the tuna in these countries did not meet the requirements of the MMPA. In 1991 Mexico alleged that the US embargo on their tuna exports was inconsistent with the provisions of GATT. The dispute settlement panel found that article III requiring that imported products be accorded a no less favourable treatment than domestic products had indeed been violated. The US could not curtail imports of tuna from Mexico simply because the fishing method employed did not satisfy regulators in the US. The dispute settlement panel also declined to uphold the embargo under article XX since although the article dealt with measures necessary to protect animals and exhaustible natural resources this did not permit a country to enforce measures falling outside its territorial jurisdiction. The argument of the dispute panel aimed to avoid countries attempting to impose ethical standards on other countries over which they have no jurisdiction. Although the US and Mexico ultimately decided to settle their dispute bilaterally the tuna dolphin case seemed to have troubling consequences. Environmental impacts often cross national boundaries. Surely a country can have a legitimate interest in environmental events occurring in areas outside its legal jurisdiction? Furthermore, the dispute resolution panel seemed not to distinguish between environmental resources which were not in the jurisdiction of any state such as atmospheric or oceanic resources, and those that were within the jurisdiction of a state. The GATT secretariat soon after made it explicitly clear that it was “not possible under GATT rules to make access to one’s own market dependent on the domestic environmental policies or practices of the exporting country”.

60. A critique of Article XX For a measure to be justified under Article XX it must be first shown that it falls under at least one of ten exceptions under Article XX of which only (b) and (g) allude to the environment, and then that the measure satisfies the introductory paragraph (referred to as the “chapeau” of Article XX), i.e. that it does not constitute “a means of arbitrary or unjustifiable discrimination between countries where the same conditions prevail” and is not “a disguised restriction on international trade”. Article XX does not even use the word ‘environment’. Likewise, article XX does not make clear what it means by ‘exhaustible’ natural resources. Obviously, the GATT was drafted at a time when the environment was not the priority that it is today. The insistence that Governments should employ measures that are ‘least inconsistent with GATT policies’ is hard to understand. The suggestion that scientific evidence is required before a commodity can be restricted even on a non-discriminatory fashion raises further issues. Environmentalist’s antipathy towards the GATT and the WTO seems partly based on the belief that trade causes environmental degradation and competitive lowering of environmental standards. But such beliefs might be misplaced. GATT does not prevent countries from using market based instruments or traditional command and control techniques for the purposes of environmental protection. Neither does the GATT prevent a country from dealing with environmental problems arising from goods whose production is linked to environmental externalities whether these goods are produced domestically or imported. The absence of any clause in Article XX allowing trade sanctions to be used in the case of pollution spillovers or degradation of the global commons is troubling. There is nevertheless, justifiable concern about environmental issues being exploited by those with protectionist motives. We have already explained the risk that environmental regulations will be used in place of the kind of exports taxes and subsidies that the GATT has done so much to combat.

61. Summary (1) Basic trade theory suggests that countries will specialise in those commodities that are intensive in their most abundant factor of production. Countries can be considered abundant in environmental resources if they are sparsely populated, possess environments capable of dissipating environmental residues and have populations that do not much care for environmental quality, perhaps because of low incomes. Such inter-country differences as exist make it hard to sustain calls for the harmonisation of environmental standards. A partial equilibrium model suggests that trade liberalisation could have a positive or negative effect on the environment, but that even if it did have a negative effect this might well be outweighed by the real resource gains. And even this could be avoided by imposing the appropriate environmental tax from the outset. In a general equilibrium model changes in trade frictions or resource endowments cause changes in environmental emissions. These can be usefully decomposed into changes arising from the scale of economic activity, changes in the composition of output and changes in production technique. It is possible to construct models in which there are incentives to lower environmental standards for trade purposes but this generally occurs because countries are not allowed to use more conventional measures. Depending on the precise form that competition takes a country might even have incentives to raise environmental standards. Likewise there are circumstances in which Governments might wish to lower environmental standards in order to attract capital inflows. This could occur if the Government is obliged to tax capital. But there is an optimal degree of relaxation involved and certainly no ‘race to the bottom’.

62. Summary (2) Banning trade in animal products may raise or lower the stock of the species depending amongst other things on the prevailing interest rate and the species’ growth rate. The GATT is required to deal with instances in which calls for environmental protection have protectionist motives. * Empirical studies have generally found little evidence to suggest that patterns of trade are determined by environmental standards in the manner suggested by theory. ** Although it might be correct in particular instances, the belief that trade is bad for the environment, that countries are forced to lower environmental standards, that the WTO undermines attempts to improve environmental quality and that footloose firms exploit differences in environmental regulations is not generally correct.

63. Discussion questions 1.“I think the economic logic behind dumping a load of toxic waste in the lowest wage country is impeccable and we should face up to that.” Do you think that the economic reasoning displayed here is right or wrong? This is another quotation is taken from an infamous memo allegedly written by Lawrence Summers. The full memo can be found on our website (as well as many other internet sites). 2.Does international trade compel countries to lower environmental standards? 3.Do you think that it is acceptable for the EU to try to ban US beef containing growth hormones? Do you think that such a manoeuvre would be acceptable under GATT rules? 4.How would you test empirically the hypothesis that differences in environmental regulations provide a basis for trade? What difficulties would you expect to encounter?