Location choice under trade and environmental policies

Abstract

In this paper, we use a game theoretic model to analyze the trade-off between the attractiveness of FDI and the environmental damage caused by production under asymmetric information. In the first stage, the domestic developing country reveals the level of import tariff and pollution tax under information uncertainty about the environmental damage that the foreign firm can cause. The foreign firm from a developed country decides where to locate afterwards with complete information about its own damage. Results show that the developing country can be better off encouraging FDI if and only if the marginal damage of pollution is sufficiently low. The optimal level of pollution taxes attracting FDI is higher than the marginal damage of pollution. However, the optimal pollution tax without FDI can be lower than the marginal damage of pollution with sufficiently high demand in the developing country.

Introduction

For a faster economic growth and lower unemployment, the most of developing countries try to attract FDI. Without sufficiently stiff environmental policies, there is a concrete risk for these countries to become a pollution haven for foreign corporations. Developing countries should certainly analyze this trade-off well, before deciding on environmental and trade policies. Production and abatement technologies are usually relatively inefficient and less environmental friendly in developing countries; with this respect, attracting FDI with a better abatement technology may help to decrease the environmental damage. However, on the contrary, it is not uncommon to see firms from developed countries with strict environmental standards locate their production facilities abroad, especially when their production has severe environmental impact. Thus, before setting their policies and authorizing FDI, developing countries should thoroughly assess the environmental effects of FDI.

Considerable number of studies analyzes the relationship between environmental policy and FDI both empirically and theoretically. List and Co, 2000, Xing and Kolstad, 2002, Dean et al., 2009 are among the studies finding significant evidence for the pollution haven hypothesis. When we look at the theoretical side, there are several papers analyzing the issue of location choice and environmental policies. Markusen et al. (1993) investigated the firms' location choice under international oligopoly and found that a small change in environmental policies may cause firms to change their location choices and alter pollution and welfare levels in the concerned countries. Markusen (1997) looks at the issue from the viewpoint of trade liberalization and shows that liberalization increases production sensitivity of multinational firms to environmental policies. Ulp and Valentini (1997) analyze the same issue by allowing inter-sectoral linkages between industries. More recently, Abe and Zhao (2005) have examined the welfare effects of environmental policies for the case where the choice of investment type between an international joint venture and FDI as well as firm location is endogenously determined. They have showed that if South owns a poor abatement technology, it should impose a high pollution tax to attract FDI; conversely, if it owns a good abatement technology, then attracting joint ventures with a low pollution tax is a better alternative. Kayalıca and Lahiri (2005) analyze the effects of FDI on the environmental policies of a host country competing with another country for a third country market. They show that the host country prefers less severe policies under free entry. Barrett, 1994, Kennedy, 1994 focus on the optimal environmental policies under oligopolistic settings without taking into account location choices and show that optimal pollution taxes are different than the traditional Pigouvian tax, due to the competition effect. In line with the research comparing the effect of environmental policies under trade barriers and free trade, Tanguay (2001) shows that free trade leads to a decrease in welfare at higher levels of pollution, because pollution taxes on their own are not sufficient to control the problems of pollution and imperfect competition. Making a comparison between tariffs and quotas, Furusawa et al. (2004) reached the conclusion that, in the case of asymmetric information and cross-border externalities, import quotas are in some cases preferable to tariffs.

The purpose of this paper is to combine different lines of the relevant literature by analyzing the effects of both trade and environmental policies on the location choice introducing an uncertainty in the level of pollution damage caused by the foreign firm. We construct a two-country theoretical model with two firms located in each of these countries. We indicate the developed country as ‘North’ and the developing country as ‘South’ and assume that the firm located in South has a less efficient production technology than the firm located in North. Each of these firms pollutes the environment. For our purpose, we further assume that the environmental damage caused by the South firm is publicly known, whereas there is asymmetric information about the North firm's damage. North firm has complete information about its own damage; however the South government is uncertain about the level of this damage. In the first stage of the game, South country reveals the level of import tariff and pollution tax under this uncertainty. Observing these policy choices, the North firm decides where to locate in the second stage. In the third stage, depending on the location choice of the North firm, firms play either an international or a domestic Cournot game.

In both lines of the theoretical literature mentioned above (one line analyzes how environmental policies differ depending on the market structure and the second line examines how these policies affect location choice) the governments' problems are simpler. They have a single policy tool to control the environmental pollution and competition environment, however in our model government has both trade and environmental policy tools. There is no other paper combining both types of policies in a model where environmental pollution problem is analyzed together with the FDI decision of a foreign firm. Moreover, in our model all these policy decisions are taken under an uncertainty on North firm's environmental damage. Accordingly, some of our results differ from the existing literature. We show that when all production takes place in the South and when the domestic firm is less efficient than the foreign firm, South government imposes a stronger environmental policy than the traditional Pigouvian tax (which is contradictory with Barrett's (1994) result). According to another result of our model, it is possible to observe that the optimal pollution tax is lower than the marginal damage of pollution under an international Cournot market with sufficiently high demand in the South. As intuitively expected, we also show that South can be better off encouraging FDI if and only if the expected marginal damage of pollution by the North firm is sufficiently low. In other words, as the probability that the North firm can cause high damage to the environment increases, which increases the chance of becoming a pollution haven, environmental policies in the South become stricter and the North firm prefers to export from home. Another interpretation of this result is that when it is more likely to become a pollution haven South government prevents this by imposing stricter environmental policies.

This paper is organized as follows: In Section 2, the basic model and the solutions of the last two stages are given. Section 3 presents the solution of the policy stage. Comparisons of the pollution levels under two modes of competition are given in Section 4. Finally, Section 5 provides a summary and some concluding remarks.