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Carleton Economic Paper CEP 03-01 Can Technology Transfer Induce the South to Sign International Environmental Agreements?

Febuary 2003 Larry D. Qiua and Zhihao Yub Abstract We develop a North-South model of international trade and transboundary pollution to analyze the relationship between environmental technology transfer and the South’s incentive to sign an international environmental agreement (IEA). First, we show that technology transfer could either increase or reduce the South’s incentive to sign the IEA. Second, we show that the South’s participation in the IEA would reduce the market incentive of technology transfer. Both results have very clear policy implications for (i) the sequence of technology transfer and the South’s IEA membership and (ii) the legitimacy of South’s subsidies for technology transfer.

JEL Classification No.: Key Words:

F12, F18 Trade and environment, Environmental technology transfer, Imperfect competition

–––––––— a Department of Economics, Hong Kong University of Science and Technology, Clear Water Bay, Kowloon, Hong Kong. Tel number: +(852)2358-7628, Fax number: +(852)2358-2084, Email:, Web site:˜larryqiu. b Department of Economics, Carleton University, 1125 Colonel By Drive, Ottawa, Ont., K1S 5B6, Canada; Tel: 1-613-520-2600 ext. 3763; Fax: 1-613-520-3906; Email: zhihao; Website:˜zyu Acknowledgment: We would like to thank Scott Barrett and Ray Riezman for their helpful comments and suggestions. This paper has benefitted from presentation at various international conferences including China and the World Economy (held in Hong Kong, June, 2002), Environment and Trade in the Age of Globalization (held in Nagoya, Japan, July, 2002) and The 2nd World Congress of Environmental and Resource Economists (held in Monterey, CA, USA, June, 2002). The usual disclaimer applies.

1. Introduction
With increasing awareness of environmental issues, we have witnessed the emergence of many international environmental agreements (IEAs) over the past two decades. While signatory countries are expending efforts to adhere to the agreements, they are also trying hard to increase the number of signatories using various measures and opportunities. So far over 20 IEAs have included trade measures to induce nonsignatories to sign the agreements.1 However, discriminatory trade-restricting measures are neither consistent with the most-favored-nation principle of the World Trade Organization (WTO) nor are they effective.2 Instead, a view is commonly shared that nonsignatory countries, which are most likely developing countries, may not be able to afford to raise their environmental standards given their existing technologies. Accordingly, it is often recommended that positive measures and incentives, such as financial assistance and environmental technology transfer, should be used since they are more efficient and effective than punitive measures. In this paper, we develop a North-South model of international trade and transboundary pollution to formally analyze the relationship between environmental technology transfer and the South’s (a nonsignatory country) incentive to sign an IEA (formed by the North). Two questions are particularly interesting. First, will technology transfer induce the South to sign the IEA? Second, will the South’s participation in the IEA increase the market incentives for technology transfer? We use a trade model with imperfect competition to highlight the trade effects of both national environmental policy since it is the key issue that fuels the discussion about market access and competitiveness (see Bhagwati and Hudec, 1996).3 By signing an IEA, the South has to increase its environmental taxes from an optimal level to an IEA-specified higher level. But, in return, it receives financial transfers from the North as compensation. Contrary to the common perception, we show that the transfer of environmental technology does not necessarily increase (rather, it could either raise or reduce) the South’s incentive to sign the IEA. The reasons are two folds. On the one hand, with cleaner environmental technology due
For example, the Basel Convention bans the trade in hazardous wastes with non-signatories. The Montreal Protocol also bans trade in ozone-depleting substances and products between signatories and non-signatories. 2 See Hudec (1996), WTO (1996) and UNE and IISD (2000). 3 Other approaches based on general equilibrium trade models can be found in, for example, Copeland and Taylor (1994, 1995).


to technology transfer, the negative effect of an increase in environmental taxes on the South’s welfare becomes smaller. This raises the South’s incentive to sign. On the other hand, however, the South’s optimal environmental tax after technology transfer is found to be lower than before. Because of this, the IEA membership requires the South to depart from its optimal policy level more in the case of technology transfer than in the case of no technology transfer. Hence, the South is more reluctant to sign the IEA after receiving the better technology. The South’s overall incentive depends on the relative importance of these two effects. An implication of this result is that the assisted environmental technology transfer by the IEA member countries should be given before a developing country becomes a signatory of the IEA if technology transfer raises the participation incentive, but it should be given after the country commits to signing the IEA if the technology transfer reduces the participation incentive. Second, we show that the South’s IEA membership reduces the market incentives for technology transfer. Participation in the IEA is the Southern government’s decision, but the technology transfer involves decisions by firms in both the North and the South. Because of the financial compensation, the Southern government may be willing to sign the IEA, but the South’s inclusion in the IEA means that the average pollution tax increases, which in turn means less profit gains to the firms from a technology transfer. Based on this finding, we can draw the following policy implication: Financial transfer, at least in part, should be provided to assist firms in environmental technology transfer or the South should be allowed to subsidize environmental technology transfer. The literature on the theory of IEAs has been growing during the last decade.4 It has been concluded that carrots and sticks (e.g., financial assistance and technology transfers as carrots and sanctions as sticks) are needed to induce countries to become signatories of IEAs and to stabilize IEAs (see Barrett, 1997a & b). The use of trade sanctions is based on the idea of an “issue-linkage” to enforce IEAs and that of monetary transfers is based on the principle of “gainers compensate losers”. Technology transfers are also considered to be vital, especially for developing countries, because they simply may not have access to the necessary technology on favorable terms (Charnovitz, 1993; WTO, 1996). However, to our knowledge, our study is the first to provide a formal analysis of how environmental technology transfer affects developing
See Hoel (1992), Carraro and Siniscalco (1993, 1994), Heal (1993), and Barrett (1994b, 1997a, 1997b), among others.


countries’ incentives to sign IEAs and how their participation in an IEA affects the market incentive for environmental technology transfer. We focus on pollution tax as the environmental policy in this paper. In a model with imperfect competition in the product market, such policies have the same effects as more familiar strategic trade policies. Barrett (1994a), Kennedy (1994), Conrad (1996), and Ulph (1996) provide useful analyses on strategic environmental policies in various contexts. However, none of these studies deals with environmental technology transfers or IEA-related issues. The rest of this paper is organized as follows. Section 2 develops the model without IEAs and analyzes the equilibrium. Section 3 introduces IEAs to the model and provides an analysis, together with a numerical example, of the relationship between technology transfer and IEA participation. Section 4 includes some concluding remarks.

2. The Model
There are two countries, called the North (representing a developed country) and the South (representing a developing country). We assume that there is only one firm in each country: we call the firm located in the North the N-firm and that in the South the S-firm. These firms produce an homogenous product. Production of this product emits pollution. However, the N-firm has cleaner technology than the S-firm in the sense that the pollution content (i.e., the amount of pollutant generated when producing one unit of output) of the N-firm, denoted en , is lower than that of the S-firm, denoted es , i.e., en < es . The firms are otherwise identical. The N-firm could license its technology to the S-firm, and if it does, the S-firm’s pollution content will be reduced to en .5 The Northern government imposes an environmental tax, denoted tn , on each unit of pollution generated by the N-firm. The corresponding tax imposed by the Southern government is assumed to be ts . To emphasize the policy effects on a country’s welfare and their strategic aspects, we assume that the firms sell their products to a third market. This allows
5 Environmental technology may also be possessed by a third party (a firm that does not produce the product). But most production related know-how and patents are owned by the firms that produce the product. Therefore, we adopt the second approach (which also simplifies the model). Also, it has been argued that prior to technology transfer, the N-firm must spend some effort/money, c, to make the technology suitable for the S-firm. We included this sunk cost in an earlier version of this paper and found no qualitative changes in any of the results.


us to put aside the changes in consumer surplus resulting from price changes.6 Assume linear demand, p = 1 − (qn + qs ), where qi (i = n, s) is the output of the i-firm. For simplicity, assume that the firms have constant marginal cost of production and without loss of generality, assume this cost to be zero. The firms compete in quantity (i.e., in Cournot fashion). We consider the following sequence of moves. In the first stage, the N-firm makes its licensing decision and the firms together decide on the licensing fee. In the second stage, both governments set their respective tax policies, in a non-cooperative way. In the final stage, the firms produce and compete in the product market. We will derive and analyze the subgame perfect Nash equilibrium (SPNE). Figure 1 highlights this game structure and gives a road map of analysis of this section. <Figure 1 about here> It is worth stressing that in contrast to most studies (with the exception of Ulph, 1996), we assume that the governments move in the second stage. By this, we do not intend to argue that governments can never make earlier commitments before the firms’ technology transfer decision, but we have two reasons for considering this sequence. First, once technology is transferred, it is irreversible, but the governments can always change their policies. Second, the world is now in an era in which countries are negotiating about the environmental issues and these negotiations will surely lead to changes in environmental policies in the near future. Anticipating this, firms may act earlier before the policy changes. We seek to examine how the firms behave in this regard and how their decisions affect future policy changes (especially for the South). 2.1. A subgame without technology transfer In this subsection, we focus on the subgame perfect equilibrium in which there is no technology transfer in the first stage. Given any tax policies, t = {tn , ts }, of the second stage, each firm’s profit function is given as πi = (p − ti ei )qi and the equilibrium output and profits
0 = (1 − 2t e + t e )/3 and π 0 = (1 − 2t e + t e )2 /9, respectively, where and hereafter are qi i i j j i i j j i 0 and π 0 constitute the third-stage superscript 0 denotes no technology transfer. In this case, qi i

Since it is usually the producers and the environmentalists that are active in lobbying for IEA related issues, it seems appropriate to isolate consumers surplus from our model.


A country’s welfare is equal to the sum of its firm’s profit, the pollution disutility for its population and tax revenue:
0 0 0 0 ei + γ qj ej ) + ti ei qi , Wi0 = πi − Di (qi


where γ ∈ (0, 1) measures the degree of transboundary pollution and the disutility function, Di (·), has the following properties: Di > 0, Di > 0 and Di ≥ 0. We now analyze the second stage game, in which each government chooses its tax policy to maximize its country’s welfare, Wi0 . Note the first-order derivative is7
0 + γ e q0) 0 + t e q0 ) ∂ (ei qi ∂ Wi0 ∂ (πi j j i i i 0 = Di , − ∂ ti ∂ ti ∂ ti
0 00

i, j = n, s, i 6= j.


The first term then is negative, suggesting that each government tends to provide a subsidy (ti < 0). This is the familiar strategic profit-shifting incentive. However, each government also has the incentive to discourage production in order to reduce pollution. This incentive is
0 + γ e q 0 )/∂ t ] < 0, i.e., the total pollution in captured by the second term of (2). If [∂ (ei qi j j i

country i decreases as ti increases, then the second term is positive and thus the government of this country has an incentive to raise ti . We refer to this as the pollution-reducing incentive. The final outcome of the policy, i.e., whether ti is positive (tax) or negative (subsidy), depends upon the relative degrees of the pollution-reducing incentive and the profit-shifting incentive.
0 + γ e q 0 )/∂ t ] is not necessarily However, for sufficiently strong transboundary pollution, [∂ (ei qi j j i 0 /∂ t > 0. For example, note that since the North’s tax encourages the negative because ∂ qj i

S-firm’s production while it discourages the N-firm’s production, an increase in the North’s tax
0 +γ e q 0 )/∂ t may may not be able to reduce the total pollution level in the North. That is, ∂ (en qn s s n

be positive. In this case, the pollution-reducing incentive moves in line with the profit-shifting incentive, always calling for a subsidy in the North. To make the analysis as clear as possible, we focus on a special disutility function from now on: Di (x) = βi x, where parameter βi captures regional difference regarding pollution disutility. Assume βn > βs > 0.8 Then, setting ∂ Wi0 /∂ ti = 0 from (2) gives the first-order condition for
00 ≥ 0, it is straightforward to verify the second-order and stability conditions for optimal Given Di 2 2 2 2 2 2 2 policies: ∂ Wi /∂ t2 i < 0 and (∂ Wn /∂ tn )(∂ Ws /∂ ts )−(∂ Wn /∂ ts ∂ tn )(∂ Ws /∂ tn ∂ ts ) > 0. 8 Many factors may give rise to this assumption, for example, that the North has higher income than the South, or that people in the North have stronger environmental awareness than do those in the South. 7


optimization, from which we can derive each government’s policy reaction function: ti (tj ) = 1 [3(2ei − γ ej )βi − ej tj − 1], i, j = n, s and i 6= j. 4ei (3)

0 and R0 , are depicted in Figure 2. It is straightforward to compute The two reaction curves, Rn s 0 the equilibrium policies, denoted t0 n and ts ,

t0 i =

1 1 [4(2ei − γ ej )βi − (2ej − γ ei )βj − 1] = [(8βi + γβj )ei − 2(βj + 2γβi )ej − 1]. 5ei 5ei


Some interesting properties of the above equilibrium policies shall be particularly helpful in understanding the main results in the paper and therefore they are summarized in the following lemma: Lemma 1: The equilibrium environmental taxes in the case of no technology transfer have the following properties: (i) ∂ t0 ∂ t0 ∂ t0 ∂ t0 ∂ t0 i i i > 0, < 0; (ii) i > 0, < 0; (iii) n < 0. ∂βi ∂βj ∂ ei ∂ ej ∂γ ¤

Proof: See Appendix (i).

<Figure 2 about here> The intuitions behind these results are as follows. First, we discuss the effect of βi on equilibrium pollution taxes. The result of ∂ t0 i /∂βi > 0 is straightforward since (marginal) pollution damage is higher when βi goes up. The result of ∂ t0 i /∂βj < 0 comes from the fact that the policy (pollution taxes) reaction functions are downward-sloping, i.e., the policies are strategic substitutes. Therefore, a larger βj leads to a higher tax in country j, which in turn results in a lower tax in country i. These two inequalities together suggest that if the two countries are different only because the North has higher marginal pollution damage than the
0 South has (i.e., βn > βs ), then the North will set a higher tax than the South (i.e., t0 n > ts ).

Second, the effect of ei on equilibrium pollution taxes can be illustrated as follows. For
T example, a reduction of es would shift the Northern government’s reaction curve outward to Rn

[since ∂ tn /∂ es = −(3γβn + ts )/4en < 0 from (3)] but would shift the Southern government’s


T ,9 and we therefore have ∂ t0 /∂ e > 0 and ∂ t0 /∂ e < 0 (see Figure reaction curve inward to Rs i j i i

2). The inequality ∂ t0 i /∂ ei > 0 indicates that a country will lower its tax if its firm becomes
2 more efficient. Notice that ∂ t0 i / ∂ ei can be decomposed into two parts, (1 + 2ej βj )/5ei and

4γ ej βi /5e2 i . Both are positive from the proof in the appendix (i). The first part is associated with the strategic effect of “profit-shifting” and the second part is associated with the transboundary effect of “carbon leakage”. The strategic effect is similar to Neary’s (Neary, 1994) result in the strategic trade literature in the sense that “subsidies” should be higher for more efficient firms. A lower environmental tax here plays the role of a “subsidy” to the domestic firm. The “carbon leakage” effect comes from the fact that the North also cares about the pollution generated by the South using the less-efficient technology. With a more-efficient technology, the North would benefit from a lower pollution tax simply because it would discourage production (and hence pollution) in the South. The results of ∂ t0 i /∂ ej < 0 can be understood similarly. Parts (i) and (ii) of Lemma 1 suggest that if βn is sufficiently larger than βs (e.g., due to the income effect), the pollution tax in the North will be higher even though it has more efficient technology. We assume that this is the scenario for our analysis. Finally, the intuition for the result of ∂ t0 n /∂γ < 0 is again associated with the transboundary effect of carbon leakage. When transboundary pollution becomes severe (γ is larger), the North would lower its pollution tax to discourage production in the South. The effect of such a move on the Southern policy (∂ t0 s /∂γ ), however, is ambiguous. The difference stems from the fact that the North has cleaner technology than the South (hence the North has a stronger incentive to lower the tax) and the two polices are strategic substitutes. We now restrict the parameters values so that observed scenario is attained: t0 i > 0 and
0 0 t0 n > ts . Condition ti > 0 basically says that the profit-shifting incentive is dominated by the

pollution-reducing incentive in both countries. This condition also translates to the following conditions on the parameters (given that en < es ) and therefore we assume C1: (i). 1 γ es < en 2 and (ii). 1 + (2ej − γ ei )βj 4(2ej − γ ei )βj − 1 < βi < . 4(2ei − γ ej ) (2ei − γ ej )

The above conditions can be easily interpreted. C1(i) shows that the transboundary pollution
To see this, note that from the reaction function, ∂ ts /∂ es = {6βn es − [3(2es −γ en )βs −en tn −1]}/4e2 s = (3βs − 2ts )/2es . The maximum for ts is when es = 0, at which, from the Southern government’s reaction function, ts = [3(2es − γ en )βs − 1]/4es , which is smaller than 3βs /2. Hence, ts < 3βs /2 for all ts , and so ∂ ts /∂ es > 0.


should not be too serious because otherwise the North may actually subsidize its firm (referring to the property ∂ t0 n /∂γ < 0). In light of this, we further assume γ < 1/2. The first inequality in C1(ii) says that βi needs to be sufficiently large so that the pollution-reducing incentive dominates the profit-shifting incentive (referring to ∂ t0 i /∂βi > 0). However, if βi is too large, the other country may end up subsidizing its firm due to strategic substitutes of the policies (referring to ∂ t0 j /∂βi < 0). This can be avoided by the second inequality of C1(ii). C1(ii) also implies βi > 1/3(2ei − γ ej ).
0 For t0 n > ts to be the outcome, we impose the necessary and sufficient condition: 2 C2: (8 − γ )(βn − βs )en es > 2[(βs + 2γβn )e2 s − (βn + 2γβs )en ] + (es − en ).

Basically, C2 is more likely to be satisfied by a larger βn − βs , a smaller es − en and a smaller γ . To see why, we first set γ = 0 in order to focus on the effects of the technology and the preference. C2 reduces to 2en (βn − βs )(4es + en ) > (es − en )[2βs (en + es ) + 1], which is more likely to hold for a larger difference between βn and βs and a smaller difference between es and
0 en . According to Lemma 1, a larger βn (for given βs ) increases t0 n and decreases ts , while a 0 smaller es (for given en ) also increases t0 n and decreases ts .

We next focus on the effect of γ . Note that the LHS of C2 is decreasing with γ but the RHS
2 is increasing with γ (∂ RHS/∂γ = 4(βn e2 s − βs en ) > 0). Hence, C2 is less likely to hold for a larger

γ . Recall the effect of γ on the equilibrium policies discussed above: an increase in γ results in
0 0 a smaller t0 n , but the effect on ts is ambiguous. If it results in a larger ts , then obviously the 0 inequality t0 n > ts becomes less likely to hold. If, however, an increase in γ also results in a smaller 0 0 0 0 t0 s , the reduction of ts is smaller than that of tn , because ∂ (tn − ts )/∂γ = 3βn (en − es )/5en < 0. 0 Therefore, the inequality t0 n > ts is also less likely to hold.

2.2. A subgame with technology transfer We now turn to derivation of the SPNE in which technology transfer takes place in the first stage. Assume that the license fee, f, cannot be made contingent on the second-stage government policies. The fee is completely specified and the S-firm pays it to the N-firm before the secondstage game begins. Then, given {t, f }, the firms’ profit functions are πn = (p − tn en )qn + f
T = and πs = (p − ts en )qs − f , respectively. We can compute the equilibrium outputs as qi


T = π t + f and π T = π t − f, where (1 − 2ti en + tj en )/3 and the equilibrium profits as πn n s s t = (1 − 2ti en + tj en )2 /9 πi


is the i-firm’s market profit and hereafter we use superscripts T and t to denote the technology transfer. In the second stage, the governments choose their taxes to maximize their respective welfare,
T − D (q T e + γ q T e ) + t e q T . It is easy to calculate the equilibrium taxes WiT = πi i i n i n i j n

tT i =

1 [en (2 − γ )(4βi − βj ) − 1]. 5en


T T Note that tT n > ts since βn > βs . In addition, the necessary and sufficient conditions for ti > 0

are C3: 4en (2 − γ )βj − 1 1 + en (2 − γ )βj < βi < . 4en (2 − γ ) en (2 − γ )

The inequalities also imply that βi > 1/3en (2 − γ ). Note that the above equilibrium results can also be obtained by setting es = en in the previous section. Hence, the properties of tT i can be similarly derived and understood and condition C3 can be similarly interpreted. Let us compare each country’s equilibrium tax with technology transfer to that without
0 T T technology transfer. Defining ∆ts ≡ t0 s − ts and ∆tn ≡ tn − tn , we obtain

∆ts = ∆tn =

1 ∂ ∆ts (es − en )[2(βn + 2γβs )en + 1] > 0 and > 0; 5en es ∂ es 2 ∂ ∆tn (es − en )(βs + 2γβn ) > 0 and > 0. 5en ∂ es

Proposition 1 below and Figure 3 show the ranking of all taxes. Proposition 1: (i) The Southern (resp. Northern) pollution tax is lower (resp. higher) with
0 0 T technology transfer than without, that is, tT s < ts and tn > tn . (ii) The difference between the tax

with technology transfer and that without is larger for the South than for the North: ∆ts > ∆tn . Proof: See Appendix (ii). ¤

<Figure 3 about here>


Part (i) of Proposition 1 contradicts a common perception because it shows that after technology transfer, the optimal pollution tax for the South becomes lower. However, this is a direct result of Lemma 1 and, as mentioned earlier, is consistent with Neary (1994). Technology transfer lowers es and a country’s tax is lower with the cleaner technology. Alternatively, one can also
0 understand the intuition based on ∂ t0 s /∂ es > 0 and ∂ tn /∂ es < 0 (Lemma 1) or Figure 1. Part

(ii) of Proposition 1 says that technology transfer lowers the South’s tax more than the increase in the North’s tax. As a result, the average tax rate is lower than without technology transfer. This is simply because the average technology has been improved by technology transfer. 2.3. Equilibrium choice of technology transfer With the analyses in the previous two subsections, we are now ready to examine the first stage of the game regarding technology transfer. Suppose the N-firm is willing to transfer its technology to the S-firm. Then, the two firms bargain over the price of the technology. Following Katz and Shapiro (1985), we assume that this price is a fixed fee, f .10 Assuming that the N-firm’s bargaining power is α ∈ (0, 1) and that of
T − π 0 )α (π T − π 0 )1−α . the S-firm is 1 − α, the equilibrium transfer price is given by f ∗ = argmax (πn n s s T − π 0 )α (π T − π 0 )1−α or, equivalently, to maximize αln(π t + f − Choosing f to maximize (πn n s s n 0 ) + (1 − α)ln(π t − f − π 0 ) yields the equilibrium fee πn s s 0 0 t t ) + (1 − α)(πn ). f ∗ = α(πs − πs − πn


We now show that as a result of technology transfer and the second-stage policy changes, the
t > π 0 ) while the N-firm loses (i.e., π 0 > π t ). All changes S-firm gains in the market (i.e., πs s n n

resulting from the technology transfer give rise to this market-profit redistribution. On the one hand, technology transfer lowers the S-firm’s pollution content from es to en . As a result, for the same tax rate, the S-firm pays less amount, reducing the marginal “costs”. Furthermore, as shown in Proposition 1, technology transfer induces the South to lower its tax rate from t0 s to tT s , which further reduces the S-firm’s marginal “costs”. On the other hand, the North raises its
T tax rate from t0 n to tn , resulting in higher marginal “costs” to the N-firm. Each of these changes

leads to an increase in profit for the S-firm and a reduction in profit for the N-firm. Because
Introducing royalties of technology transfer will not change the basic insight of this paper but only complicate the model with the additional strategic effect due to the royalty fee.


of this redistribution of market profits, the S-firm is required to pay (f ∗ > 0) to the N-firm for the technology. The equilibrium fee given by (7) is chosen to cover part of the N-firm’s losses
0 − π t ) and to share part of the S-firm’s gains (π t − π 0 ), with the proportions determined (πn s n s

according to their relative bargaining powers. We now examine the conditions for technology transfer to take place. First, the S-firm is
T − π 0 > 0. willing to pay for the Northern technology if and only if its return will be improved: πs s

Using (7), this condition is equivalent to
0 0 t t > πn πs − πs − πn


0 0 t t πn + πs > πn + πs .


The interpretation of the above condition is simple: So long as the market-profit gain by the S-firm outweighs the market-profit loss of the N-firm, or the joint market profits with technology transfer are larger than without, the S-firm is willing to pay f ∗ for the technology (Tirole, 1988). Second, the N-firm is willing to transfer its technology if and only if its return will be enhanced:
T − π 0 > 0. Using (7), we find that this condition is equivalent to (8). That is, the two πn n

firms have the same incentives to transfer the technology and the reason for this is that Nash bargaining with monetary transfer fully internalizes the negative effect on each other’s payoff, resulting in the maximization of the joint profits. Substituting in (8) with the equilibrium profits obtained from the previous two sections yields the necessary and sufficient condition for technology transfer in the first stage:
0 0 0 t0 s (es − en )(2 − 5ts en − 5ts es + 8tn en ) + Aen > 0, 0 0 0 where A ≡ (∆ts − ∆tn )[2(1 − 2t0 s en + tn en ) + 3en (∆ts + ∆tn )] + 6en (tn − ts )(∆ts + 2∆tn ).


2.4. Policy adjustment and technology transfer We have seen in Proposition 1 how the first-stage equilibrium of the technology transfer affects the second-stage equilibrium of the pollution tax. In this subsection, we depart from the SPNE by considering an off-equilibrium case in which the governments adhere to the policies
0 {t0 n , ts } despite the technology transfer. The sole purpose of the off-equilibrium analysis is to

examine the role of the policy adjustment in affecting technology transfer. This will also help us to understand the central issue of the present study, i.e., the interplay of IEA and technology transfer, to be analyzed in section 3. 11

Recall from the analysis at the beginning of this section that both governments’ policy adjustments increase the S-firm’s market profits and reduce the N-firm’s market profit. Based on the bargaining outcome (7), it must be true that the transfer fee is higher when the governments adjust their policies in response to technology transfer than when the governments keep their
0 initial policies {t0 n , ts } unchanged.

Note that the off-equilibrium market outcomes, in which technology transfer takes place but
0 0 0 T0 T0 T0 2 the policies are still {t0 n , ts }, are qi = (1 − 2ti en + tj en )/3 and πi =(qi ) . Substituting them

into the technology transfer condition, similar to (9), we obtain the corresponding necessary and
0 0 T0 T0 sufficient condition for technology transfer: t0 s (es − en )[2(qs + qs ) − (qn + qn )] > 0, which can

be simplified to
0 0 0 t0 s (es − en )(2 − 5ts en − 5ts es + 8tn en ) > 0.


Notice that by substituting t0 i , the term in the second bracket of (10) is equal to [7es + 5en +
2 (74βn − 5γβn − 40βs + 28γβs )es en + 10(βn + 2γβs )e2 n − (56βs + 37γβn )es ]/5es , which is negative

for sufficiently large es . The intuition is that when es is very large, the S-firm produces very little and the N-firm is almost a monopoly in the product market. Therefore, the N-firm has no incentive to transfer technology to the S-firm because that will erode its monopoly power.11 Thus, technology transfer will not occur when the technology gap is large.
0 Now we compare condition (10) with condition (9) . From Proposition 1(i) and t0 n > ts (under 0 T 0 is C2), we note that the second term in A is positive. Also note that (1 − 2t0 s en + tn en ) = 3q

positive. Thus, following Proposition 1(ii), the first term in A is positive since γ ≤ 1/2. Hence, the LHS of (9) is greater than that of (10) and we obtain the following result. Proposition 2: Technology transfer is more likely to occur if governments could non-cooperatively adjust their pollution taxes (i.e., in equilibrium the South would adjust its pollution downward but the North upward) after technology transfer than if they could not, although the fee for technology transfer is higher in the former case. The intuition for the result, that technology transfer is more likely to occur even though the
0 T T transfer fee is higher, is as follows. Notice that Proposition 1(ii) implies t0 n + ts > tn + ts . That
11 This can be easily seen from the condition that leads to (10). When es is very large, the S-firm’s T0 0 T0 0 output is so small such that 2(qs + qs ) − (qn + qn ) < 0. Hence, the condition fails to hold.


is, the average tax drops after the governments adjust their policies. Therefore, anticipating policy adjustment, the firms know that there is an additional gain from technology transfer because technology transfer induces a reduction in the average tax, resulting in a larger total profit (the sum of the two firms’ profits) for them to share.

3. IEAs and Technology Transfer
Since our focus is not on the formation of IEAs, we use a canonical set-up. Specifically, suppose that the North represents an existing IEA and we focus on the Southern government’s decision about whether signing up for the existing IEA (rather than bargaining with the North to form a new IEA). This is applicable to many current IEAs, which have the principle of openmembership. Many factors can affect the government’s decision. However, understanding the role of technology transfer is important. We are particularly interested in the following two questions. First, if the N-firm transfers its technology to the S-firm, will the government in the South be more or less willing to sign the IEA? In other words, does technology transfer facilitate expansion of the IEA’s to include the South? Second, will the firms be more or less willing to transfer the technology in the presence of the IEA? In other words, does the participation of the South in the IEA facilitate environmental technology transfer (in the private market)? In order to examine the above-mentioned issues, we confine our analysis to the situation in which the existing equilibrium, in the absence of an IEA, involves no technology transfer from the North to the South, i.e., condition (9) does not hold. We characterize the IEA agreement as the one that includes the following three elements: (1) the South’s accession requires it to raise its tax to a pre-specified level tm > t0 s ; (2) the North (the existing member of IEA) does not lower its current tax rate, t0 n ; and (3) there is a fixed amount of money, R, transferred from the North to the South. A discussion here is useful. Note that we consider a general signatory condition in the sense that the South is required to increase its environmental tax, tm , which does not have to be equal to or greater than t0 n . Since such a policy change lowers the South’s welfare and raises the North’s welfare because of transboundary pollution and competition in the product market, compensation from the North to the South is unavoidable. In the real world, compensation can take various forms. For simplicity, we consider only lump-sum monetary compensation,


captured by R.12 As mentioned earlier, since we do not allow the South to bargain with the North, both tm and R are assumed to be non-negotiable constants.13 Figure 4 highlights the aforementioned issues and shows the focus of this section. <Figure 4 about here>

3.1. Will technology transfer increase the South’s incentive to sign up for the IEA? It is a common view that less-developed countries would be more likely to sign up for IEAs to increase their environmental standards if they could gain access to the better environmental technology from the developed countries. However, little attention has been paid to a possible outcome implied by our analysis in the previous section, namely, that technology transfer could actually make it less likely for the South to sign up for the IEA. Specifically, Proposition 1 says that the Southern government has an incentive to lower, rather then raise, its pollution tax after its firm has acquired the better environmental technology from the North. Since the
m South’s optimal pollution tax (tT n ) moves further below the IEA level t , technology transfer

may reduce the South’s incentives to sign up for the IEA. To show that technology transfer can either increase or decrease the South’s incentive to sign up for the IEA, we need a rigorous comparison of the South’s welfare levels in different situations. Notice that with the game specified earlier, there are potentially three cases regarding the South’s decision about signing up for the IEA. Case 1: it joins the IEA with or without technology transfer in the first stage; Case 2: it does not join the IEA with or without technology transfer in the first stage; and Case 3: it joins the IEA if and only if there is technology transfer in the first stage. From the IEA agreement for the South, it is quite obvious that, for a sufficiently large R, Case 1 will be the result and, for a sufficiently small R, Case 2 will be the result. Technology transfer does not affect the South’s decision in both cases. Since we are more interested in the role of technology transfer, Case 3 is the focus of the analysis below.
12 In the real world, there are other forms of ‘bribes’ to induce the South to join IEAs. As also discussed earlier, some IEAs use trade measures as such “carrots” and “sticks”. It is not the purpose of this present paper, however, to take part in this discussion. 13 A reason for such an assumption is that we are more interested in the other factor that also affects the Southern government’s decision: technology transfer. It is obvious that the Southern government is more willing to accept the agreement if R is greater and tm is smaller (closer to t0 s ).


Notice that if the Southern government signs the IEA without technology transfer, its welfare is
m0 m m m m m (t ) = πs es + γ qn en ) + tm qs es + R, Ws − βs (qs


m = (1 − 2tm e + t0 e )/3, q m = (1 − 2t0 e + tm e )/3, and π m = (q m )2 . The South’s where qs s s n n n n n s s

welfare is a function of the Southern tax (tm ) and the Northern tax as well. Notice that after the South joins the IEA, the North is not allowed to reduce its pollution tax though it is allowed to raise the tax. The North will however actually keep its tax unchanged at t0 n after the South joins the IEA and so we simply drop it from the expression. To see why the Northern government does not raise its tax in response to the South’s move, recall that without technology transfer
0 and in the absence of an IEA, the equilibrium taxes are {t0 n , ts }. The IEA requires that the

South raise its tax up to tm . Since the two policies are strategic substitutes (∂ tn /∂ ts < 0), it is optimal for the Northern government to lower its tax. But the IEA constrains the Northern
m government from lowering its tax. Therefore, the constrained equilibrium taxes are {t0 n , t }.

Now consider the case in which technology transfer occurs in the first stage and the South decides to join the IEA. Then, what is the Northern government’s optimal choice for the pollution tax? From Lemma 1, notice that there are two opposite forces if the North could adjust its policy. On the one hand, a better environmental technology for the South induces the North to increase its pollution tax because of a reduction of the “carbon-leakage” effect. On the other hand, the
m increase of the pollution tax in the South (from t0 s to t ) induces the North to lower its pollution

tax because of the strategic effect in the product market. From (3) the Northern government’s policy reaction curve with technology transfer is tn (ts ) = [3en (2 − γ )βn − en ts − 1]/4en . When the South raises its tax to the IEA-specified level, tm , it is optimal for the North to set tm n ≡
0 0 m [3en (2 − γ )βn − en tm − 1]/4en . There are two possibilities, either tm n ≤ tn or tn > tn , depending

on which of the two forces is dominant. Although the IEA does not forbid the North to raise its tax, in this subsection we shall derive
0 our results using the first case in which tm n ≤ tn . In light of the IEA constraint, the North does

not lower but keeps its pollution tax at t0 n . In this case, the South’s welfare is
mT m mt mt mt mt (t ) = πs en + γ qn en ) + tm qs en + R, Ws − f m − βs (qs


mt = (1 − 2tm e + t0 e )/3, q mt = (1 − 2t0 e + tm e )/3, π mt = (q mt )2 , and the license where qs n n n n n n n s s mt − π 0 ) + (1 − α)(π 0 − π mt ), where π mt = (q mt )2 is the N-firm’s market profit in fee, f m = α(πs s n n n n


0 the case of technology transfer and the South joining the IEA. The condition tm n ≤ tn implies m tm ≥ [3en (2 − γ )βn − 4en t0 n − 1]/en . That is, there is a minimum level of t . Violation of this

requirement, however, will not affect the main results for the rest of this paper. We discuss this after we obtain the main results (see footnotes 14 and 15). The South’s welfare in the case of not joining the IEA has been analyzed before. If there is no
0 (t0 ) = π 0 −β (q 0 e +γ q 0 e )+t0 q 0 e , where the Northern tax technology transfer, the welfare is Ws s s s s s n n s s s T T T T T T T is t0 n , and if there is technology transfer, the welfare is Ws (ts ) = πs − βs (qs es + γ qn en )+ ts qs es ,

where the Northern tax is tT n. With the above preparation, we are now ready to derive conditions for the South to sign up for the IEA, in the case of technology transfer and in the case of no technology transfer, respectively. Lemma 2: (i) Suppose there is no technology transfer in the first stage. Then, the South does not join the IEA if and only if 2 0 2 (tm − t0 ≡ e2 ∆Ws s ) > R. 9 s (13)

(ii) Suppose there is technology transfer in the first stage. Then, the South signs the IEA if and only if
T ≡ ∆Ws

2e2 en T n m 2 0 T m (t − tT (t − t0 s) + n )[2 + (tn + tn − t )en − 3βs en (1 − 2γ )] ≤ R. 9 9 n ¤


Proof: See Appendix (iii).

0 is the South’s welfare reduction (excluding compensation R) from joining the In (13), ∆Ws

IEA. Clearly, this reduction is larger for a higher tm since the IEA-specified tax rate, tm would deviate further away from the South’s optimal tax level, t0 s , making the South less likely to sign up for the IEA (i.e., inequality (13) is less likely to hold). It is worth pointing out that the
T of (14) corresponds to ∆W 0 of (13), with the same interpretation, but ∆W T first term in ∆Ws s s

has an extra term. That term contains t0 n because even if technology transfer takes place, the
T m North still sets t0 n rather than tn , provided that the South adopts the IEA level t . Should the T North switch from t0 n to tn , it is easy to see that this extra term will vanish. Even including this T /∂ tm = (e2 /9)[4(tm − tT ) − (tT − t0 )] > 0, for γ ≤ 1/2, because extra term, we still have ∂ ∆Ws n s s n

tm − tT s > ∆ts and, by Proposition 1(ii), ∆ts > ∆tn . That is, the South is less likely to sign the IEA if tm increases. 16

If both conditions (13) and (14) are satisfied, then the Southern government does not want to sign the IEA without technology transfer but it does with technology transfer. When this occurs, we say that the Southern government’s incentive compatibility (or GIC in short) condition is satisfied. Based on Lemma 2, there exists a monetary transfer, R, such that the GIC condition
0 is greater than ∆W T . As holds (i.e., both inequalities (13) and (14) hold) if and only if ∆Ws s

we are less interested in the size of R but other parameters, we simply state the GIC condition as (GIC) :
0 2 2 m 0 0 m T 2 T T m 2e2 s (t − ts ) − 2en (t − ts ) − en (tn − tn )[2 + (tn + tn − t )en − 3βs en (1 − 2γ )] > 0.

Therefore, if this GIC condition is satisfied, the South will sign the IEA with technology transfer but will not sign without technology transfer. That is, Proposition 3: Technology transfer facilitates the South’s participation in the IEA if and only if the GIC condition holds. As explained earlier, since the South’s optimal level of pollution tax is further below tm after technology transfer (Proposition 1), technology transfer may not facilitate the South’s IEA participation. To understand the common view that technology transfer facilitates the South’s IEA participation in this model, notice that the South’s welfare is a function of its environmental technology and hence the shape of its welfare function changes with the environmental technology it uses. As shown in Figure 5, with better technology, the shape of the South’s welfare function is flatter, reflecting the fact that the cost of increasing the pollution tax is lower. The converse is true with a less-efficient environmental technology. <Figure 5 about here> Figure 5 illustrates the South’s welfare under various situations. The North’s compensation
0 (t ; t = t0 ) in the case of no technology transfer and shifts the South’s welfare curve (i.e., Ws s n n T (t ; t = t0 ) in the case of technology transfer) up in parallel by a distance equal to R. First, Ws s n n 0 compared with t0 s , the South’s optimal tax in the case of technology transfer (ts ) is further away

from the IEA-specified level, tm , suggesting that the South should have a smaller incentive to increase its tax to tm when there is technology transfer. Second, when the South sign the IEA, 17

T the Northern government chooses t0 n , which is lower than tn when the South does not sign the

IEA. This lower tax in the North reduces the South’s welfare and thus also reduces the South’s incentive to join the IEA. However, as shown in Figure 5, the South’s welfare curve in the case of technology transfer is flatter than that without technology transfer. Hence, welfare reduction when ts departs from its optimal level is less severe in the case of technology transfer than in the case of no technology transfer. When this effect is dominant, it gives rise to the result that the technology transfer increases the South’s incentive to sign the IEA.14 In subsection 3.3, using simulation we show that the GIC condition could either hold or not hold. In summary, technology transfer could either increase or reduce the South’s incentive to join an existing IEA. Therefore, the timing of technology transfer is important. That is, the assisted environmental technology transfer by the IEA member countries should be given before a developing country becomes a signatory of the IEA when technology transfer raises the participation incentive, but it should be given after the country commits to signing the IEA when technology transfer reduces the participation incentive. 3.2. Will the South’s participation in the IEA facilitate technology transfer? Proposition 2 has shown that governments’ responses to technology transfer affect the market incentive for technology transfer. Since the South’s IEA participation requires it to increase its environmental tax, Proposition 2 seems to suggest that the IEA may reduce the market incentive for environmental technology transfer. We will show in this subsection that this is exactly the case. First, if the firms anticipate that the Southern government will not join the IEA, they will not transfer the technology if condition (9) fails to hold. Similar to condition (8), we can derive the condition for technology transfer when the firms anticipate that the Southern government will sign the IEA: the sum of the two firms’ profits when there is technology transfer and when the South signs the IEA is greater than that when
mt + π mt > π 0 + π 0 . there is no technology transfer and the South does not join the IEA, i.e., πn n s s
0 Note that in the case of tm n > tn , we can derive a similar GIC condition and so Proposition 3 applies. m 0 When tn > tn , the South’s welfare would be greater than if the North is forced to set its tax at t0 n because a higher tax in the North benefits the N-firm (strategic reason) and the South’s population T (transboundary pollution). The South’s welfare reduction, ∆Ws , therefore would be smaller, making m the GIC condition more likely to hold. In sum, the case of tn > t0 n reinforces the conclusion obtained in this section. 14


Substituting in the profit functions, this condition reduces to
0 0 m m (t0 s es − t en )(2 − 5t en − 5ts es + 8tn en ) > 0.


From the discussion after (10) we note that the second bracket will be negative if es becomes sufficiently large, and so condition (15) puts an upper bound on es . However, the condition also puts a lower bound on es . For small es , such that the second bracket is positive, the first bracket
m should also be positive, which in turn implies that es cannot be too close to en because t0 s <t

and t0 s increases with es . We say that the technology transfer incentive compatibility (TIC in short) condition is satisfied when (9) fails to hold but (15) holds. Then, when the TIC condition holds, the firms transfers the technology if and only if they anticipate that the South will sign the IEA. If this occurs and the Southern government joins the IEA, then we can say that the IEA facilitates technology transfer. We can simplify the TIC condition, (15), to
0 0 m (TIC): (tm − t0 s )[5en (t + ts ) − 8en tn − 2] − A > 0.


Proposition 4: The TIC condition never holds. That is, the IEA does not facilitate technology transfer in the private market. Proof: See Appendix (iv).15 ¤

Since the firms’ technology transfer incentive depends on the comparison of the total profits with and without technology transfer in various cases, we should examine how the joint profit changes in order to understand why the IEA does not facilitate technology transfer. If the firms do not have any incentive to transfer the technology when there is no IEA, it must be the case
t +πt < π0 +π 0 . that their joint market-profit after technology transfer is lower than before, i.e., πn n s s

The joint market profits with technology transfer are determined by the policy levels, tT n and
mt mt tT s . If the South signs the IEA, the joint market profits, πn + πs , will be determined by the 0 m m policy levels, t0 n and t . Since the average tax in the case of IEA ((tn + t )/2) is higher than T the average tax in the case of no IEA ((tT n + ts )/2), the joint profit will be much lower after
0 The proof contains the case of tm n > tn . Thus, the proposition holds regardless of whether the m 0 m 0 Northern government sets tn = tn or tn > tn , with technology transfer and the South’s IEA membership. 15


technology transfer in the case of the South signing of the IEA. Hence, the IEA lowers the firms’ incentive to transfer technology. Recall that at the end of the preceding subsection, we argue that, under certain circumstances, the South’s pre-commitment to sign up for the IEA is necessary to induce technology transfer. However, Proposition 4 shows that such a pre-commitment is not sufficient. This result, though somewhat pessimistic, does generate a useful policy implication: Monetary transfer or subsidy should be directed to the firms involved in technology transfer. Monetary transfer is made from the Northern to the Southern government to compensate the latter for raising its pollution tax. The S-firm suffers from a higher tax, but it is one of the players making the technology transfer decision. Hence, without appropriate compensation using the transferred money, R, the S-firm will not implement technology transfer. This provides a strong support to the argument that in addition to monetary transfer, IEAs should allow the Southern government to subsidize (or, more generally, assist) its firms for environmental technology transfer. This policy implication in fact is consistent with the existing WTO rules that allow subsidies to facilitate adaptation of new environmental technology and regulations (e.g., see Hoekman and Kostecki, 1995, pp.104-109). 3.3. A numerical example In this section, we provide a numerical example for the results of Proposition 3 that technology transfer could either reduce or increase the South’s incentive to join the IEA. Specifically, we will show the GIC condition could either hold or not hold, depending upon the environmental technology gap, es − en . Assume 1 1 5 and es ∈ (1, 1.38]. en = 1, γ = , βn = , βs = 4 3 21 satisfied under (17). We obtain the following result. Proposition 5: Suppose the model is specified by parameterization (17). Then, for any given
0 m tm ∈ (t0 s , tn ), we have ∂ G/∂ es < 0. In the case of t = 0.12 in G, we have G > 0 for es < 1.146


In Appendix (v), we justify the above specification. In particular, conditions C1-C3 are all

and G < 0 for es ∈ (1.146, 1.38). Proof: See Appendix (v). ¤


Proposition 5 indicates that technology transfer will facilitate the South’s decision to join the IEA if and only if the technology gap is not too wide. Finally, let us provide the intuition for the important role of the technology gap, or the result ∂ G/∂ es < 0. We have known that the only reason that the South is not willing to join the IEA even after technology transfer is
m that its optimal policy level (tT s ) departs further away below the IEA-level (t ). This policy

gap (tm − tT s ) is larger when the technology gap is larger. Hence, technology transfer can induce the South to sign the IEA when the technology gap is small because the targeted level is not too far away from its optimal level and the monetary transfer is large enough to compensate for this loss.

4. Concluding Remarks
Contrary to the commonly shared view that environmental technology transfer would help induce developing countries to join international environmental agreements (since with their existing technology they are simply not able to afford to raise their environmental standards), we show that environmental technology transfer could either increase or reduce the South’s incentives to join an existing IEA. This is the main message of our paper. Although we derive the result in a very specific model (partial equilibrium model of imperfect competition and hence it has to be cautious to discuss general policy implications), the policy implications of our result are relevant and valid. The purpose of this paper is to provide a cautionary note to a general view and hence a specific model should suffice to make the point. We also show that South’s commitment to join the IEA would reduce the market incentive for technology transfer and, therefore, developing countries should be allowed to subsidize their firms for environmental technology transfer. Extensions of the model can be made in a number of directions. For example, one can introduce pollution abatement technologies, available in the North, and examine transfer of this type of technology to the South. Instead of pollution tax, we can also examine the case in

which the governments and IEAs choose to legislate/enforce environmental standards. Finally, the issue regarding developed countries’ incentives to include developing countries in existing IEAs is also interesting.


(i) Proof of Lemma 1: First, based on (4), we obtain ∂ t0 i / ∂βi = 4(2ei − γ ej )/5ei . It is obviously positive for i = s. For i = n, we also have 2en − γ es > 0 since we will impose a condition, C1(i), later in this section to ensure that the optimal policy in each country is indeed taxation. Second, and for the same
0 2 reason, we obtain ∂ t0 i / ∂βj = −(2ej −γ ei )/5ei < 0. Third, ∂ ti / ∂ ei = (1+2ej βj +4γ ej βi )/5ei > 0 0 and ∂ t0 i / ∂ ej = −(βj +2γβi )/5ei < 0. Finally, ∂ tn / ∂γ = (en βs − 4es βn )/5en < 0 because en < es

and βs < βn .


(ii) Proof of Proposition 1: (i) The results are obtained by directly comparing (4) and (6). (ii) Note that ∆ts − ∆tn = 1 (es − en )[2(βn + 2γβs )en + 1 − 2(βs + 2γβn )es ], 5en es

and so ∆ts − ∆tn > 0 if and only if (βs + 2γβn )es − (βn + 2γβs )en < 1/2. Since es > en , the LHS of this condition is less than (βs + 2γβn )en − (βn + 2γβs )en = en (βn − βs )(2γ − 1) ≤ 0 since γ ≤ 1/2. ¤

(iii) Proof of Lemma 2: First, note that for any quadratic function f (x) = ax2 + bx + c, if x0 is the point for maximum or minimum f (x), then f (x) − f (x0 ) = a(x − x0 )2 . (A1)

2 0 Lemma 2(i). Define Wa (t) ≡ (1 − 2es t + en t0 n ) /9 − βs [(1 − 2es t + en tn )es + γ (1 − 0 2en t0 n + es t)en ]/3 + t(1 − 2es t + en tn )es /3, which is a quadratic function of t. Then, we have 0 (t0 ) = W (t0 ) and W m (tm ) = W (tm )+ R. Moreover, t0 is the optimal point of W (t). Hence, Ws a s a a s s 0

using (A1) we obtain 2 2 m 2 2 m 4 0 0 0 2 0 2 m m (t ) − Ws (ts ) = ( e2 W0 s − es )(t − ts ) + R = − es (t − ts ) + R. 9 3 9 The necessary and sufficient condition (13) follows.
2 m T Lemma 2(ii). Define Wb (t) ≡ (1 − 2ten + tT n en ) /9 − f − βs en [(1 − 2ten + tn en ) + γ (1 − T 2tT n en + ten )]/3 + ten (1 − 2ten + tn en )/3, which is a quadratic function of t. Also define Wb1 (t)


0 T T T as the same as Wb (t) except that tT n in Wb (t) is replaced by tn . Then, we have Ws (ts ) = Wb (ts )

and Wtm (tm ) = Wb1 (tm ) + R. Moreover, tT s is the optimal point of Wb (t). Hence, using (A1) we obtain 2e2 4 2 2 2 m n m 2 T 2 (t − tT Wb (tm ) − Wb (tT s ) = ( en − en )(t − ts ) = − s) . 9 3 9 With some calculation, we also have Wb1 (tm ) − Wb (tm ) = en 0 0 T m (t − tT n )[2 + (tn + tn − t )en − 3βs en (1 − 2γ )]. 9 n

m T Hence, Wtm (tm ) − Wb (tT s ) = Wb1 (t ) − Wb (ts ) + R, and, using the above expressions, we obtain

condition (14).


(iv) Proof of Proposition 4:
m ≤ t0 , we have First, by Proposition 1(ii), A > 0 for γ ≤ 1/2. Second, since t0 s < t n 0 0 0 0 0 5en (tm + t0 s ) − 8en tn − 2 < 5en (tn + tn ) − 8en tn − 2 = 2(en tn − 1) < 0. The last equality holds

because p − en t0 n > 0 (for the N-firm to make any profit) and p < 1 (because the demand function is assumed as p = 1 − (qn + qs )). Thus, the TIC condition fails to hold. We now turn to see if the proposition holds when the Northern government sets its tax at
0 tm n > tn with technology transfer and the South’s IEA participation. In this case, the average

tax is (tm + tm n )/2, which is greater than the average tax when the Northern government fixes its tax at t0 n . Thus, the resulting total market profit is lower, reducing the firms’ technology transfer incentive. The TIC condition fails to hold. (v). Proof of Proposition 5: To obtain numerical results, we have to choose values for a set of parameters in the model. First, we normalize en = 1. As a result, es (or es − 1) captures the technology gap. Second, we pick βn = 1/3 to avoid the disutility of the pollution being so severe to create negative welfare. Third, we choose γ = 1/4 in accordance with the assumption that the degree of transboundary pollution is not very large. The values for the rest of the parameters (βs and es ) will be chosen to satisfy assumptions C1-C3. Notice that C1(ii) requires βs > 1/3(2es − γ en ) = 4/3(8es − 1), which implies βs > 4/21 for es being sufficiently close to 1. Therefore, we choose βs = 5/21, which will give us some room
0 to vary es . Finally, recall from Lemma 1, ∂ t0 n /∂ es < 0 and ∂ ts /∂ es > 0. Hence, we need to



0 impose an upper bound on es to ensure C2, i.e., t0 n > ts . Given the above specifications on all 0 parameters other than es , we have t0 n = (145 − 68es )/420 and ts = (167es − 160)/420es . Then,

C2 suggests 34e2 s + 11es − 80 < 0, which implies es ≤ 1.38.
T Using this specification, we obtain tT n = 11/60 and ts = 1/60 and, thus, the GIC condition

m m m G ≡ [280(210tm − 167)tm + 10067]e2 s + 120(413t − 241)es + [18853 + 2800(21t − 1)t ] > 0.

Now we start the proof. From the above expression of G we have ∂ G/∂ es = 2[G1 es + 60(413tm − 241)], where G1 ≡ 280(210tm − 167)tm + 10067. Setting dG1 /dtm = 117600tm − 46760 = 0, we note that G1 reaches its minimum at tm = 1169/2940 ≈ 0.4. However, even at tm = 0.4, G1 = 771. Thus, G1 > 0 for all tm . This result, together with the constraint on es (≤ 1.38), implies ∂ G/∂ es ≤ 2[1.38G1 + 60(413tm − 241)] = 2G2 (tm ), where G2 (tm ) ≡ 81144(tm )2 − 36008tm − 4393. Given tm > 0, the point for G2 (tm ) = 0 is tm ≈ 0.543. Hence, G2 (tm ) < 0 for tm < 0.543. Note that t0 n = (145 − 68es )/420 < (145 − 68)/420 < 0.184 for all
m es and tm < t0 n . Therefore, G2 (t ) < 0 and the result ∂ G/∂ es < 0 follows.



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[16] Katz, M. and C. Shapiro (1985), “On the licensing of innovations”, Rand Journal of Economics 16, 504-20. [17] Kennedy, P.(1994), “Equilibrium pollution taxes in open economies with imperfect competition”, Journal of Environmental Economics and Management 27, 49-63. [18] Neary, J. Peter (1994), “Cost asymmetries in international subsidy games: Should governments help winners or losers?”, Journal of International Economics 37, 197-218. [19] Tirole, Jean (1988), The Theory of Industrial Organization, MIT Press: Mass. Cambridge. [20] Ulph, Alistair (1996), “Environmental policy and international trade when governments and producers act strategically”, Journal of Environmental Economics and Management 30, 265-81. [21] UNEP and IISD (2000), Environment and Trade: A Handbook, The United Nations Environmental Programme (UNEP) and the International Institute for Sustainable Development (IISD). [22] WTO (1996), Report of the CTE, Committee on Trade and Environment, the World Trade Organization, 12 November 1996.


Technology Transfer Yes Policy No Policy

Subsection 2.3, Proposition 2, Eq. (7) & (8)

T tn

t sT

o tn

t so

Subsection 2.1 & 2.2, Proposition 1, Eq. (4) & (5)


Figure 1:

Sequence of Moves without IEA (Section 2)


tn RsT
T tn


T Rn

o tn T ts

o Rn

t so


Figure 2: Policy Reaction Curves


∆t s

∆tn tso tm
o tn T tn



Figure 3: Equilibrium Tax Policies in the Two Regions


Technology Transfer

Signing the IEA

Yes A


No B


t ,t

o n

o s


Benchmark case

Subsection 3.1 and Proposition 3: Subsection 3.2 and Proposition 4:

? ?


Figure 4: Technology Transfer and IEA


WsmT (t m )
T ) WsT (ts ; tn = tn

W (t )

mo s


o ) WsT (ts ; tn = tn

o ) Wso (ts ; tn = tn T to t so



Figure 5: South’s Incentive to Join the IEA