Reciprocal Dumping and Environmental Polices

Salvador Sandoval Bravo and Rafael Salvador Espinosa Ramírez

Introduction

Greenhouse effect, acid rain, additive and change in the temperature of the oceans
are only a few adverse consequences derived from pollution. In this sense, pollution
is blame for the increase in the social and economic costs caused by natural disas-
WHUVOLNHKXUULFDQHVWZLVWHUVDQGÀRRGV$FFRUGLQJWRWKH([WUHPH:HDWKHU6RXUFH-
book 2008 (National Center for Atmospheric Research, US) hurricanes, twisters and
ÀRRGVKDYHFRVWWRWKH86JRYHUQPHQWD\HDUO\DYHUDJHRIPLOOLRQGROODUVLQ
the 1955-2006 period at 1999 constant prices. Even in some years the cost reached
more than 100 billion dollars. Moreover, the effect of pollution on health of people
has reached alarming levels mainly in the big cities where the respiratory illness
increased 200%, intestinal illness 110%, additive illness 75% in the last ten years ac-
cording to the 2007 Report of World Health Organization.
These devastating effects of pollution in the world call for a coordinated effort made
by the governments all over the world. An example of this attempt was the unsuccessful
Rio Conference in Brazil 1992 and the 2002 Johannesburg Summit. The intensive use
of natural resources and intensity production process is blamed to be the main cause of
pollution. However the governments are not willing to apply policies to reduce pollu-
tion because these policies may increase the industrial costs and undermine the interna-
tional competitiveness of domestic industries. In this sense, pollution control is a barrier
to trade and, nowadays, it is extensively discussed in the free trade agreements.
Even though there is a vast literature on environmental regulations1, the existing
literature on environmental regulations and foreign investment has not been explored

1
An extensive survey is given by Cropper and Oates (1992).

233
 RESEARCH ISSUES ON INTERNATIONAL ECONOMIC RELATIONS

enough. This is our main motivation on this chapter as we try to analyze the welfare
effects of pollution regulation when trade takes place between two similar countries
in the presence of foreign direct investment.
Trade between similar products as the reciprocal export of coffee between Mex-
ico and Costa Rica is an assumption we will consider on this chapter. The natural
explanation is that Costa Rica coffee is slightly different from Mexican coffee, so
some consumers in each market prefer foreign coffee.
This two-way trade in similar (but not strictly identical) products is called intra-
industry trade.2 It has also been referred to as cross-hauling and has been discussed
in the point-pricing literature of perfect competition. However, many attempts have
been made at imperfect competitive framework and especially in a Cournot oligopo-
listic setting.3
%UDQGHUDQG.UXJPDQSURYHWKDWWKHULYDOU\RIROLJRSROLVWLF¿UPVVHUYHV
as an independent cause of international trade. Such rivalry naturally gives rise to
‘dumping’ of output in foreign markets. Such dumping can be ‘reciprocal’, that is,
there may be a two-way trade in the same product.4 On the other hand, they also show
that reciprocal dumping is rather striking in that there is pure waste in the form of
unnecessary transport costs. Without free entry and low transport costs, welfare may
improve as trade opens up and reciprocal dumping occurs. But it is also possible that
welfare may decline with high transport costs.
7KHSUHVHQWFKDSWHUZHDVVXPHWKDW¿UPVORFDWHGZLWKLQDFRXQWU\WKH\KDYHWKH
same marginal costs, but different from those of the other country. We also assume
that, as a result of production, there is environmental degradation. We shall use a re-
ciprocal dumping model with pollution quota restriction and pollution tax restriction
to determine the effect of the environmental policies on the welfare of each country.
Although there is no cross border pollution, each country has to take into account
WKHHIIHFWRIWKHHQYLURQPHQWDOSROLFLHVRQWKHSURGXFHUVXUSOXVRI¿UPVFRQVXPHU
surplus and pollution disutility on local welfare.
The model is spelt out in detail in the following section. In Subsections 3 we deri-
vate (in a non-cooperative equilibrium) the properties of the optimal pollution quota

2
Seminal papers on intra-industry trade are Balassa (1966), Krugman (1979) and Lancaster (1980).
3
Some clear examples are Brander (1981), Brander and Krugman (1983).
4
Normally, the phenomenon of dumping in international trade can be explained by the standard theory
of monopolistic price discrimination. A good survey is provided by Caves and Jones (1977).

234
RECIPROCAL DUMPING AND ENVIRONMENTAL POLICES

and tax respectively. Section 4 compares the welfare levels under the two policy
regimes. Finally, some concluding remarks are made in section 5.

The Model

In this model we assume that there are two countries having a two way trade, country
A and country B, producing a homogeneous good. We consider a partial equilibrium
model of an oligopolistic industry in which there are nLGHQWLFDO¿UPVLQA, and m
LGHQWLFDO¿UPVLQB(DFK¿UPKDVD&RXUQRWSHUFHSWLRQHDFK¿UPWDNHVWKHRXWSXWRI
RWKHU¿UPVDVJLYHQZKLOHPD[LPL]LQJLWVSURGXFWV
7KHKRPRJHQHRXVRXWSXWSURGXFHGE\¿UPVORFDWHGLQA and B are X and Y re-
spectively where X = X A + X B and Y = Y A + Y B such that Y A is consumed in coun-
try A and B A is exported to country B. Similarly, Y B is for local consumption in B and
Y A is exported to A.
7KHPDUJLQDOFRVWVRI¿UPVLQA and B are K X and K Y respectively. These costs
are taken to be constant, and therefore equal the average variable costs.5 A part of
K j ^ j = X, Y h is given by technology and factor market conditions, and another part
is policy induced, and this will be spelt out later on. There is transport cost incurred
in exporting goods from one country to the other which is borne by the producers.
We have segmented markets with homogeneous goods, and the inverse demand
functions are6

(1) PA = a - bD A ,

(2) PB = a - bD B

5
Implicitly, there is a numeraire good in the background which is produced under competitive con-
ditions. There is also just one factor of production in each country whose price is determined in the
competitive sector.
6
We assume that the utility functions, in each country, can be approximated by U A = u ^ X A, Y A h + nA
and U B = u ^ X B, Y B h + nB where X and Y are the goods under consideration and nA and nB are the
expenditure on the numeraire goods. The use of this approximation removes a number of theoretical
GLI¿FXOWLHVLQFOXGLQJLQFRPHHIIHFWV)RUVLPSOLFLW\ZHFRQVLGHULGHQWLFDOSUHIHUHQFHVDQGWKHUHIRUH
the demand parameters are identical in both countries.

235
 RESEARCH ISSUES ON INTERNATIONAL ECONOMIC RELATIONS

where

(3) D A = nX A + mY A

(4) D B = nX B + mY B

7KHSUR¿WVRIHDFK¿UPORFDWHGLQA and B are given by

(5) - A = ^ PA - K X h X A + ^ PB - K X - t h X B ,

(5) - B = ^ PB - K Y h Y B + ^ PA - K Y - t h Y A

(DFK¿UPGHFLGHVZKDWSURSRUWLRQRIWKHFRPPRGLW\LWSURGXFHVLVIRUGRPHVWLF
FRQVXPSWLRQDQGKRZPXFKIRUH[SRUW8QGHU&RXUQRW1DVKDVVXPSWLRQVWKH¿UVW
order maximization conditions are:7

(7) a - K X = b ^ n + 1 h X A - bmY A ,

(8) a - K X - t = b ^ n + 1 h X B - bmY B ,

(9) a - K Y = b ^ m + 1 h Y B - bnX B ,

(10) a - K Y - t = b ^ m + 1 h Y A - bnX A ,

such that we have a separable system where (7) is solved with (10) and (8) with (9).
Positive solutions to this system give us the equilibria where two-way trade arises
and, given the linearity of demand functions, the second order conditions are satis-
¿HG7KHFORVHGIRUPVROXWLRQVIRUWKHIROORZLQJYDULDEOHVDUHREWDLQHGDV

- A = b^ X Ah + b^ X Bh
2 2
(11)

- A = b^Y Bh + b^Y Ah
2 2
(12)

7
They can be considered separately given the assumption of constant marginal costs.

236
RECIPROCAL DUMPING AND ENVIRONMENTAL POLICES

^ n + 1h^ a - K Y - t h - n ^a - K X h
b^m + n + 1h
(13) YA =

^m + 1 h^a - K X h - m ^a - K Y - t h
b^m + n + 1h
(14) XA =

^m + 1h^a - K X - t h - m ^a - K Y h
b^m + n + 1h
(15) XB =

^n + 1 h^a - K Y h - n ^a - K X - t h
b^m + n + 1h
(16) YB =

The equations (1) - (6) and (11)-(16) form the backbone for the following analysis.
2QFHZHKDYHVHWWKHGH¿QHGVROXWLRQVIRUPVQRZZHDUHJRLQJWRVHWWKHZHOIDUH
of the representative consumer in each country taking into account the use of pollu-
tion quota or pollution tax. The welfare of the representative consumer in the host
country, W i ^ i = A, B h can be written as,

(17) W A = n - A + CS A + XA ,

(18) W B = m - B + CS B + XB ,

where

Xi =- }i Z i for the pollution quota policy case or,

Xi = xi Z i - }i Z i for the pollution tax policy case.

In (17) and (18) nPA y mPB DUHWKHSURGXFHUVXUSOXVRI¿UPVORFDWHGLQA and B

respectively. CS i is the consumer surplus and it is well known that

(19) CS A = bD 2A /2 ,

(20) CS B = bD 2B /2 .

237
 RESEARCH ISSUES ON INTERNATIONAL ECONOMIC RELATIONS

Xi is the pollution-policy impact on welfare given by the government induced

policy. In the case of a pollution quota, the impact on welfare will be given by
^Xi =- }i Z i h . On the other hand, in the case of pollution tax, the impact on welfare
will be given by ^ Xi = xi Z i - }i Z i h .
In both cases Z i is the total amount of harmful pollution in country i GH¿QHG
as Z A = nz A X and Z B = mz B Y for country A and B respectively8, where z i is the
amount of pollution per unit of output, }i is the marginal disutility of pollution which
we assume, as do Lahiri and Ono (1998) and Markusen, et. al. (1993 and 1995), it is
constant.9 In order to keep the analysis at a tractable level, we assume that the mar-
ginal disutility of pollution in both countries are the same so that }A = }B = } .10
In the case of pollution quota, the government is going to determine the level
RIDOORZHGSROOXWLRQHPLWWHGE\¿UPVSHUXQLWRIRXWSXW z i ), and consequently the
amount of disutility for pollution. On the other hand, in the case of a pollution tax,
besides the negative impact of pollution disutility, we should consider the term called
tax revenue ^ xi Z i h . In here the government is not going to determine the amount of
pollution produced per unit of output, but the optimal pollution tax ^ xi h . In the next
section we are going to determine both the optimal pollution tax and pollution quota
policies.

Optimal Policies

2QFHZHKDYHGH¿QHGWKHPRGHOWRZRUNZLWKLQWKLVVHFWLRQZHZLOOGHWHUPLQHWKH
optimal pollution policies. Pollution quota and pollution tax are the most common
formal policies used to obtain some control on pollution emissions. The impact of
both policies on welfare may be rather different. In the next subsection we will start
analyzing pollution quota and later on pollution tax taking into account the welfare
maximizing option.

8
As we are considering a small economy, we ignore cross-border pollution. For an analysis of cross-
border pollution see, for example, Copeland (1996).
9
Other authors, like Asako (1979), consider that marginal disutility is an increasing function of the
output. However, this alternative assumption will not contradict our results and a constant marginal
disutility is a more convenient assumption
10
The damage for pollution is the same in both countries. Apart from some particular exceptions, the
damage on any human being is generally identical

238
RECIPROCAL DUMPING AND ENVIRONMENTAL POLICES

3.1. Pollution Quota

7KH¿UVWSROLF\WRDQDO\]HLVWKHSROOXWLRQTXRWD,QWKLVVHQVHWKLVSROLF\LVDUHVWULF-
WLRQ RQ WKH DPRXQW RI SROOXWLRQ DOORZHG WR WKH ¿UPV DV D UHVXOW RI WKH SURGXFWLRQ
SURFHVV,QRUGHUWRGRWKDWZHGH¿QH K j (as seen in (5) and (6)) as follow,

(21) K j = CJ + T j

where C j is the part of the unit cost that is determined by technological and factor
market conditions (it will be called simply marginal cost), and is taken to be constant.
As the production of X and Y implies emission of pollution, T j is the unit policy-
LQGXFHGFRVWRISROOXWLRQDEDWHPHQW7KLVSROLF\LQGXFHGFRVWLVGH¿QHGOLNHLQ/DKLUL
and Ono (1998) as11

(22) T j = c^i - z ih

where i is the amount of pollution per-unit of output produced so that iX and iY

DUHWKHWRWDODPRXQWRISROOXWLRQSURGXFHGSHU¿UPEHIRUHDQ\DEDWHPHQWORFDWHG
in country A and B respectively,12 z i is the maximum quantity of pollution per unit of
RXWSXWSURGXFHGWKDWWKH¿UPVLQFRXQWU\i are allowed to emit into the atmosphere.13
:HDVVXPHWKDWWKHDEDWHPHQWWHFKQRORJ\LVVXFKWKDWLWFRVWVHDFK¿UPDFRQVWDQW
amount c to abate one unit of pollution and it is identical in both countries. The
parameter c and i together with the policy instrument used by the government will
determine the policy induced part of the unit cost K jl s .
From total differentiation of demands (13)-(16) and (21)-(22) we have:

^m + ahc mc
(23) dX A = dX B = ba dz A - ba dz B

11
For simplicity i and aare the same in both countries
12
Implicitly, this unit pollution parameter is taken to be over and above the level which the World
Health Organization (WHO) considers to be harmless. On the other hand, niX and miX are the
countries’ total pollution produced by A and B respectively before any abatement
13
Like in the case of i , these instruments are taken to be over and above the level which the WHO
considers to be harmless.

239
 RESEARCH ISSUES ON INTERNATIONAL ECONOMIC RELATIONS

^n + 1hc nc
(24) dY A = dY B = ba dz B - ba dz A

where a = m + n + 1 .

From (11)-(16), (19), (20), (23) and (24), we obtain the total differentiation of
(17) and (18) with respect to the pollution quota policies in the following expressions:

dW A = b \ 6bD A c + 2b ^ m + 1 h cX - b \ X} - z A 2 ^ m + 1 h Y}@ dz A
n
(25)

+ ba 6bD A c - 2ncbX + z A 2nc@ dz B

m

dW B = b \ 6bD B c + 2b ^ n + 1 h cY - b \ Y} - z B 2 ^ n + 1 h Y}@ dz B
m
(26)

+ ba 6bD B c - 2mcbY + z B 2mc@ dz A

n

7KH¿UVWWHUPLQVLGHWKHVTXDUHEUDFNHWVLQDQGLVWKHFRQVXPHUV¶VXUSOXV

effect. It is unambiguously positive to any pollution quota in both countries since
an increase in the allowed quota will reduce the cost for abatement pollution and
consequently will increase the amount of output produced, reducing the price for
consumers.
The second term inside the square brackets in (25) and (26) is the producer sur-
plus effect. With an increase in the pollution quota in a local country, the cost for
ORFDO¿UPVLVUHGXFHGDQGWKHSURGXFHUVXUSOXVZLOOLQFUHDVH7KHORFDO¿UPVFRVW
advantage give to them a competitive advantage over the foreign competitors and the
SURGXFHUVXUSOXVRIWKHIRUHLJQ¿UPVLVUHGXFHG
Finally, the remaining terms in the square brackets in (25) y (26) represent the
harmful pollution effect. When more pollution is allowed in a local country then the
local welfare will be reduced by a larger negative impact on the people health. There
is an increase in quota, production and thus in harmful pollution. On the other hand,
ZKHQWKHIRUHLJQFRXQWU\DOORZVDKLJKHUSROOXWLRQTXRWDWKHQWKHORFDO¿UPVEHFRPH
UHODWLYHO\OHVVHI¿FLHQWDQGWKHORFDOSURGXFWLRQLVUHGXFHGGHFUHDVLQJWKHKDUPIXO
SROOXWLRQLQEHQH¿WRIWKHKHDOWKRIORFDOSHRSOH
Taking into account the assumptions made before, for the welfare functions to be
concave in z A and z B , we must have

240
RECIPROCAL DUMPING AND ENVIRONMENTAL POLICES

6^c - }h^4 ^m + 1h2h + 4n ^c - ^m + 1 h } h@ 1 0

d2 W A nc
=
dz 2A ba2

6^c - } h^4 ^n + 1 h2 h + 4m ^c - ^n + 1 h } h@ 1 0
d2 WB mc
=
dz 2B ba2

&OHDUO\WKHDERYHFRQGLWLRQVDUHVDWLV¿HGLIDQGRQO\LI

} 2 cDA

} 2 cDB

where
^m + 1hm + a
^m + 1ha
DA = 11

^n + 1hn + a
^n + 1ha
DB = 11

We consider the case where the governments behave in a non-cooperative fashion

to obtain the non-cooperative Nash pollution levels of emission standards, z NA and
z BN 6HWWLQJWKHFRHI¿FLHQWVRI dz A and dz B from (25) and (26) respectively equal to
zero we get

b 6^ 2γ - ψ h α X + γ ^ mY A - nX B h@
γ ψ 2^m + 1h
(27) z NA =

6^2c - }h aX + c ^nY B - mX A h@
b
c}2 ^ n + 1 h
(28) z BN =

The optimal values of z NA and z BN have been not fully characterized yet. Apart from
the marginal costs C X and C Y (expressed in X and Y differences), other parameters

241
 RESEARCH ISSUES ON INTERNATIONAL ECONOMIC RELATIONS

affecting the values of z NA and z BN are the marginal disutility level } and the marginal
cost of abatement c . When c is very small, imposing pollution control has no costs
EXW RQO\ EHQH¿WV 7KHUHIRUH WKH RSWLPDO SROLF\ LQ ERWK FRXQWULHV LV WR LPSRVH WKH
severest pollution restrictions, i.e. z NA = 0 and z BN = 0 . On the other hand, when c
is greater than or equal to } both policy instruments are positive. Formally we can
write the following proposition

Proposition 1. In a reciprocal dumping model of trade, at the non-cooperative equi-

librium, the optimal pollution quotas are given by the followings:

1. if } & c, then z NA = z BN = 0

2. if c $ }, then z NA 2 0, z BN = 0

3. if } b 2c and C X & ^ % h C Y , then z NA 2 ^ = h 0, z BN = ^ 2 h 0

This proposition can be explained intuitively as follows, when the pollution

PDUJLQDOGLVXWLOLW\LVVXI¿FLHQWO\ELJJHUWKDQWKHPDUJLQDOFRVWIRUDEDWLQJSROOXWLRQ
( } & c WKHKDUPIXOHIIHFWRISROOXWLRQRXWZHLJKVWKHEHQH¿WREWDLQHGE\WKHHP-
ployment and consumer surplus. The government sets the severest pollution policy as
it reduces the optimal output and consequently the pollution level.
On the other hand, a higher or equal marginal cost of abatement means that pol-
lution control ( c $ } KDVVLJQL¿FDQWQHJDWLYHLPSDFWRQSURGXFWLRQDQGSULFH$
reduction in output reduces production and consequently producer surplus, in this
sense this reduction in output will increase the prices and reduce consumers’ surplus.
Therefore, in this case ( c $ } ), the government is forced to allow positive amount
of pollution.
As a third result, the explanation is a combination of both previous explanations.
When the difference between } and c is no longer decisive ( } - 2c ). If there
LVDVXI¿FLHQWGLIIHUHQFHLQPDUJLQDOFRVWVWKHPRUHLQHI¿FLHQWFRXQWU\ZLOOEHOD[
LQWKHUHVWULFWLRQVRQSROOXWLRQLWLPSRVHVZKLOVWWKHHI¿FLHQWFRXQWU\ZLOODSSO\WKH
VHYHUHVWUHVWULFWLRQV:LWKDKLJKPDUJLQDOFRVWLQWKHLQHI¿FLHQWFRXQWU\WKHRXWSXW
is small and the governments have incentives to increase the production reducing
WKHLQGXVWULDOFRVWWKURXJKDSRVLWLYHTXRWD,QWKHHI¿FLHQWFRXQWU\WKHRXWSXWDQG
consequently the pollution will be larger, so the pollution disutility may be greater

242
RECIPROCAL DUMPING AND ENVIRONMENTAL POLICES

than the producer surplus and consumer surplus, and the government may apply the
severest pollution quota14.

3.2. Pollution tax

Once we have set the optimal pollution quota, we shall analyze in this section the opti-
mal pollution tax as another common policy used to control pollution degradation. First
of all, the cost structure in the case of pollution tax is different to that of pollution quota.
Even when the unit cost determined by the technological and factor market conditions is
the same as the pollution quota case, the policy induced cost, T j LVGH¿QHGDV

(29) T j = c ^ i - z i h + xi z i

ZKHUHWKH¿UVWWHUPLQLVVLPLODUWRWKHSROOXWLRQTXRWDFDVH

However, in (29), z A and z B are different because these variables are not deter-
PLQHG E\ WKH JRYHUQPHQW EXW E\ WKH ¿UPV7KH\ UHSUHVHQW WKH DPRXQW RI HPLWWHG
pollution that agents impose themselves in order to reduce the cost.15 There is a self-
UHVWULFWLRQDQGZHDVVXPHWKDWWKH¿UPVSRVVHVVWKHSURSHUWHFKQRORJ\WRDEDWHVXFK
pollution. This self-restriction is going to depend on the magnitude of the tax levied
by the government.

14 When we have a monopoly in each country ( , this result can be seen from the difference between
optimal polices as in Espinosa (2004) where

5}c ^ C X - C Y h
2c + 3}
z NA - z BN =

 7KHPRUHLQHI¿FLHQWFRXQWU\ZLOODOORZDJUHDWHUDPRXQWRISROOXWLRQSHUXQLWRIRXWSXW,QWKHDE-
VHQFHRIDQ\SROLF\LQVWUXPHQWWKHDPRXQWRIRXWSXWSURGXFHGE\WKHLQHI¿FLHQW¿UPLVOHVVWKDQWKDW
SURGXFHGE\WKHHI¿FLHQW¿UP7KHUHIRUHGLVXWLOLW\IURPSROOXWLRQLVVPDOOHULQWKHKLJKFRVWFRXQWU\
than in the low cost country. Moreover any increase in the pollution quota in a country will augment
WKH VDPH ¿UP¶V RXWSXW7KLV LQFUHDVH LQ RXWSXW ZLOO LQFUHDVH WKH FRQVXPHU DQG SURGXFHU VXUSOXV
From this point of view, the government has incentives to increase the level of allowed pollution.
7KHUHIRUHJLYHQWKDWWKHLQHI¿FLHQWFRXQWU\FUHDWHVDORZHUOHYHORISROOXWLRQWKDQWKHHI¿FLHQWFRXQ-
WU\WKHLQHI¿FLHQWFRXQWU\LVDOZD\VZLOOLQJWRDOORZDJUHDWHUSROOXWLRQOHYHOWKDQWKHHI¿FLHQWRQH
15
z i LVWKHPD[LPXPTXDQWLW\RISROOXWLRQSHUXQLWRIRXWSXWWKDWWKH¿UPVLQFRXQWU\i allowed them-
selves to emit into the atmosphere.

243
 RESEARCH ISSUES ON INTERNATIONAL ECONOMIC RELATIONS

On the other hand, xi z i in (29) is the tax revenue which is the amount of income
UHFHLYHGE\WKHJRYHUQPHQWDIWHULPSRVLQJDWD[WRWKHSROOXWLQJ¿UPV7KHJRYHUQ-
ment is going to set the optimal tax in order to maximize the social welfare.
:HFDQVHHIURPWKDWWKHSROLF\LQGXFHGFRVWKDVWZRFRPSRQHQWVWKH¿UPV
allow themselves to produce pollution but they have to pay a tax to do so, and be-
VLGHVWKH\KDYHDFRVWWR¿JKWDJDLQVWWKHSROOXWLRQQRDOORZHG,QWKLVVHQVHWKH
¿UPVDUHJRLQJWRGHFLGHWKHOHYHORIDOORZHGSROOXWLRQWDNLQJLQWRDFFRXQWWKHOHYHO
of tax levied by the government. From (29) we can get:

z i = ' i if x 1 c 1
0 if xi $ c
(30)
i

If the tax is larger than the cost of abatement pollution, producing pollution will
be costly and the best option is not to allow pollution at all. It is cheaper to abate all
pollution than paying tax for it. On the other hand, if the tax is smaller than the cost of
DEDWHPHQWSROOXWLRQWKHQDEDWLQJSROOXWLRQLVFOHDUO\FRVWO\DQGWKH¿UPVDUHZLOOLQJ
to allow all the possible pollution and pay a tax for it. In the case in which the tax is
HTXDOWRWKHFRVWRIDEDWHPHQWSROOXWLRQWKH¿UPVZRXOGEHLQGLIIHUHQWEHWZHHQDOORZ
all the pollution or do not pollute at all. However, for simplicity, we will consider that
LQWKLVFDVHWKH¿UPVZLOODEDWHDOOSROOXWLRQ7KHPDUJLQDOFRVWRIWKH¿UPVIURP
and (30)) can be written as

K j = ' C j + xi i if xi 1 c 1
C j + ci if xi $ c
(31)

In order to get the optimal tax we have to consider only the case in which the tax
is smaller than the cost of abatement ( xi 1 c ). The case in which ( xi $ c ), there is
not pollution produced and therefore the impact of tax on welfare is null. The calcu-
lus of the optimal tax, under this last condition, does not make sense and therefore
we will only consider the case in which the optimal tax is smaller than the abatement
cost. Therefore we will consider from (30) that z i = i . Taking total differentiation of
demands (13)-(16) and (21) and (30) we get:
i^m + 1h im
(32) dX A = dX B =- ba dx A + ba dx B

in i^n + 1h
(33) dY A = dY B = ba dxA - ba d x B

244
RECIPROCAL DUMPING AND ENVIRONMENTAL POLICES

From (11)-(16), (19), (20), (32) and (33), we obtain the total differentiation of
(17) and (18) with respect to the pollution tax policies in the following expressions:

nD i 2Xi ^ m + 1 h n n2i2 ^m + 1 h
(34) dW A ;- aA - + n iX + ^ } - x A hc mE dxA
a ba

A hc
+ ;- ^ ba mE dxB
mD A i 2imnX n2i2 m
a + a - } - x

mD B i 2im ^ n + 1 h Y m2i2 ^ n + 1 h
(35) dW B ;- - + miY + ^ } - x B hc mE dxB
a a ba

+ ;- aB + a - ^ } - xB hc ba mE dxA
nD i 2imnX n2i2 m

7KH¿UVWWHUPLQVLGHWKHVTXDUHEUDFNHWVLQDQGLVWKHFRQVXPHUVXUSOXV

effect of a pollution tax on welfare which is negative. Clearly, an increase in tax will
increase the production cost reducing the output and consequently increasing the
price for the consumers.
The second term inside the square brackets in (34) and (35) represent the producer
surplus effect and it is ambiguous. When the government in a country increases a pol-
lution tax to the producers, this tax is levied to the local producer rather than foreign
SURGXFHUV,QWKLVFDVHWKHUHLVDQLQFUHDVHLQWKHSURGXFWLRQFRVWRIORFDO¿UPVJLYHQ
WKHPDFRPSHWLWLYHGLVDGYDQWDJHRYHUWKHIRUHLJQ¿UPV7KHRXWSXWRIGRPHVWLF¿UPV
LVUHGXFHGDQGWKHRXWSXWRIIRUHLJQ¿UPVLQFUHDVHV7KHSURGXFHUVXUSOXVGHFUHDVHV
DQGLQFUHDVHVIRUWKHORFDODQGIRUHLJQ¿UPVUHVSHFWLYHO\
The remaining terms inside the square brackets in (34) and (35) are the pollution
policy impact on welfare. In the case of pollution tax, the pollution policy impact on
welfare has two components: the harm of pollution on welfare and the tax revenue.
As we seen before, an increase in the local pollution tax will reduce the output of the
ORFDO¿UPVDQGLQFUHDVHWKHRXWSXWRIIRUHLJQ¿UPV,QWKLVVHQVHDQLQFUHDVHLQORFDO
WD[ZLOOUHGXFHWKHDPRXQWRIKDUPIXOSROOXWLRQSURGXFHGE\ORFDO¿UPV+RZHYHU
WKHKDUPIXOSROOXWLRQLQWKHIRUHLJQFRXQWU\LQFUHDVHVDVRXWSXWRIIRUHLJQ¿UPVLQ-
creases as well.

245
 RESEARCH ISSUES ON INTERNATIONAL ECONOMIC RELATIONS

In the case of tax revenue, there is a direct and an indirect effect of increasing
a tax: there is a direct positive effect given by the increase in the tax itself. On the
other hand, the indirect effect comes from the reduction in the local output and con-
sequently in the amount of taxes collected. In other words the effect of an increase on
tax on tax revenue and consequently on welfare is ambiguous and is going to depend
on the magnitude of the direct and indirect effects.
Taking into account the concavity of the welfare functions, we consider again
the case in which the government behaves in a non-cooperative fashion to obtain the
optimal pollution tax166HWWLQJWKHFRHI¿FLHQWVRI dxA and dxB from (34) and (35)
respectively equal to zero we get:

6mY A + ^m + 1 h X - nX B@ + }
b
2^m + 1hi
(36) xA =-

6nX B + ^n + 1h Y - mY A@ + }
b
2^n + 1hi
(37) xB =-

The results are pretty ambiguous. In (36) and (37) there are two parameters deter-
mining the value of the taxes: the marginal disutility of pollution and the proportion
RIORFDODQGIRUHLJQ¿UPVSURGXFWLRQ
First of all, let´s assume that the cost structure given by technological and fac-
tor market conditions are similar between countries ^ C Y + C X h such that ^ X B + Y A h
:KHQWKHPDUJLQDOGLVXWLOLW\RISROOXWLRQLVVXI¿FLHQWO\VPDOO ^ } - 0 h , then the
RSWLPDOWD[HVZRXOGGHSHQGRQWKHQXPEHURI¿UPVORFDWHGLQHDFKFRXQWU\:LWKD
VXI¿FLHQWO\ODUJHGLIIHUHQFHEHWZHHQWKHQXPEHUVRI¿UPVORFDWHGLQHDFKFRXQWU\
WKH FRXQWU\ ZLWK WKH ODUJHU QXPEHU RI ¿UPV ZLOO VHW WKH VHYHUHVW SROOXWLRQ SROLF\
:LWKQRGLIIHUHQFHEHWZHHQWKHQXPEHUVRI¿UPVEHWZHHQFRXQWULHVERWKJRYHUQ-
ments will set a subsidy. On the other hand, with a large pollution impact ^ } & 0 h ,
both governments have an extra incentive to set a severe pollution policy in order to
reduce the negative impact on the health of the people.
It is naive to say that a large difference in cost structure between countries is a
source of more ambiguity. Formally we can set:

Obtaining the second derivative from the welfare function we get d W2 A =- n i ^4m + 3h 1 0
2 2 2
16

and d W2 B =- m i ^4n + 3h 1 0 .
2 2 2 dx A ba
dxB ba

246
RECIPROCAL DUMPING AND ENVIRONMENTAL POLICES

Proposition 2. In a reciprocal dumping model of trade, at the non-cooperative

equilibrium, the optimal pollution taxes are given by the followings:

1. If } - 0 and * n % m then xA 1 0 and xB 2 0 4

n & m then xA 2 0 and xB 1 0

n . m then xA 1 0 and xB 1 0

2. If } & 0 and * n % m then xA is ambiguous and xB 2 0 4

n & m then xA 2 0 and xB is ambiguous

n . m then xA 2 0 and xB 2 0

Intuitively speaking, the optimal tax is a decision in which are weighting the con-
sumer and producer surplus on one hand, and the tax revenue and the harm in health
of the people for pollution on the other hand.
When the effect of pollution on the health of the people is negligible in both
FRXQWULHVWKHWD[VHWLVJRLQJWRGHSHQGRQWKHQXPEHURIGRPHVWLFDQGIRUHLJQ¿UPV
:KHQWKHQXPEHURI¿UPVGRPHVWLFDOO\ORFDWHGLVVXI¿FLHQWO\ODUJHUWKDQWKHIRUHLJQ
¿UPVWKHWD[UHYHQXHRXWZHLJKVWKHEHQH¿WLQFRQVXPHUDQGSURGXFHUVXUSOXV6R
WKHGRPHVWLFJRYHUQPHQWLVZLOOLQJWRVHWDSRVLWLYHWD[LQRUGHUWREHQH¿WIURPWKH
large tax revenue despite the loss in domestic production and, consequently, in con-
sumer and producer surplus. On the other hand, the foreign country is willing to set
DVXEVLG\LQRUGHUWREHQH¿WIURPWKHFRPSHWLWLYHDGYDQWDJHRIWKHLU¿UPVDQGJDLQ
from producer and consumer surplus. When both countries have the same number of
¿UPVWKHUHLVQRWFRPSHWLWLYHDGYDQWDJHE\WKHQXPEHURI¿UPVDQGERWKFRXQWULHV
VHWDVXEVLG\LQRUGHUWRLQFUHDVHWKHSURGXFWLRQDQGFRQVHTXHQWO\EHQH¿WIURPWKH
consumer and producer surplus despite the loss in tax revenue.
In a second case, when the effect of pollution on the health of the people is
large in both countries, the governments have incentives to set a positive tax in
order to reduce the impact of pollution on people health. In this context, when the
QXPEHURI¿UPVGRPHVWLFDOO\ORFDWHGLVVXI¿FLHQWO\ODUJHUWKDQWKHIRUHLJQ¿UPV
WKHWD[UHYHQXHDQGWKHEHQH¿WRQWKHKHDOWKRIWKHSHRSOHLVODUJHUWKDQWKHORVVLQ
consumer and producer surplus. The result of this case is similar to the previous
one ( } - 0 ), but the pollution disutility emphasizes the government wiliness to
set a pollution tax. However, different to the previous case, the optimal tax in the
foreign country is ambiguous since the incentive to increase the production given

247
 RESEARCH ISSUES ON INTERNATIONAL ECONOMIC RELATIONS

by a higher production and consumer surplus is inhibited by the larger pollution

harm on the health of the people. When both countries have the same number of
¿UPVDVLQWKHSUHYLRXVFDVHWKHUHLVQRWFRPSHWLWLYHDGYDQWDJHEHWZHHQFRXQWULHV
and the large pollution disutility incentives to both governments to have a tax in
order to reduce the harmful pollution.

Policy comparison

Probably the most interesting feature of reciprocal dumping analysis is in the policy
strategies used in the context of segmented markets. The policy should take into
account not only the development of the local market but the foreign market simul-
WDQHRXVO\DFFRUGLQJWRWKHEHQH¿WREWDLQHGWKURXJKSURGXFHUDQGFRQVXPHUVXUSOXV
Even when a local policy may bring some direct effects on local welfare by affecting
ORFDOPDUNHWVFRQGLWLRQVWKHIRUHLJQPDUNHWFKDQJHVPD\LPSDFWVLJQL¿FDQWO\ORFDO
welfare as well.
The use of certain policies in the context of reciprocal dumping may affect not
only the market conditions, but also the competitive features. Quotas and taxes are
different not only by the tax revenue of the latter, but also by the conditions in which
WKHFRPSHWLWLRQDPRQJ¿UPVLVJLYHQE\7KHSROLF\VWUDWHJ\VHWE\DJRYHUQPHQW
may be different according to the condition in which the policy is implemented, and
may be different even between countries.
,Q WKH FDVH RI TXRWDV ZKHUH WKHUH LV QRW ¿VFDO EHQH¿W E\ FROOHFWLQJ WD[HV
the policy decision is mainly ruled by the environmental impact on health of the
people. With the assumption of identical marginal disutility in both countries, the
quota policy generally (but not always) run in the same sense according to the
model developed above.
In the case in which we have a high level of marginal disutility of pollution rela-
tively larger than the pollution cost for abating pollution ( } & c ), the cost for abat-
LQJSROOXWLRQLVQHJOLJLEOHDQGWKH¿UPVDUHTXLWHHQFRXUDJHGWRSURGXFHPRUHDQG
consequently to emit more pollution into the atmosphere. As the pollution disutility
is large, the governments in both countries are willing to impose the severest policy
restriction. On the other hand when the marginal disutility of pollution is just smaller
than the marginal cost for abatement pollution both governments set a policy ad-
GUHVVHGWRSHUPLWSROOXWLRQLQRUGHUWREHQH¿WIURPFRQVXPHUDQGSURGXFHUVXUSOXV
7KHUHLVQRWDVLJQL¿FDQWLPSDFWRQWKHKHDOWKRIWKHSHRSOHE\SROOXWLRQ

248
RECIPROCAL DUMPING AND ENVIRONMENTAL POLICES

If quota determines the amount of pollution per unit of output emitted into the
DWPRVSKHUHLQWKHFDVHRIWD[HVWKH¿UPVDUHZLOOLQJWRDOORZDOOSRVVLEOHSROOXWLRQ
and the existence of taxes is addresses to control the emission of pollution through the
control of the output produced rather than the amount of pollution per unit of output.
Contrary to quotas, in the case of taxes there exist competitive differences deter-
PLQLQJGLIIHUHQWRSWLPDOSROLFLHVEHWZHHQFRXQWULHV7KHQXPEHURI¿UPVEHWZHHQ
the countries determine not only the amount of tax revenue collected (which is not
necessarily linked between countries), but also the competitive conditions inside and
outside the country where the policy is set. So the policies are linked by competition
FRQGLWLRQVEHWZHHQ¿UPVDQGFRXQWULHV
:LWKDODUJHUQXPEHURI¿UPVLQDORFDOFRXQWU\UHVSHFWWRWKHIRUHLJQFRXQWU\
the tax collected by the local government is an important decision variable since
the amount of income received by levying a tax drives to reduce the amount of
pollution emitted into the atmosphere by restricting the output produced. The local
government is going to set a severe pollution policy independently of the marginal
disutility of pollution.
Different to the quota case, in the tax case the severest policy will be set even
in the case of small marginal pollution disutility. The tax revenue collected by lo-
cal government is the main reason for this result. Additionally, in the case in which
we have a large marginal disutility of pollution, the wiliness of setting a sever
pollution tax is reinforced for the incentive given by the impact of pollution on the
health of the people.
However, in the foreign country the tax revenue collected by foreign government
LVQHJOLJLEOHDQGWKHIRUHLJQ¿UPVIDFHOHVVFRPSHWLWLRQJHWWLQJVRPHPRQRSROLVWLF
advantage shown in the producer and consumer surplus. With a negligible pollution
impact on the health of the people the foreign government is going to set a subsidy
promoting production as in the quota case.
On the other hand, with a large marginal pollution disutility, the foreign gov-
HUQPHQWPD\VHWHLWKHUDVXEVLG\RUDWD[GHSHQGLQJRQWKHEHQH¿WREWDLQHGLQ
consumer and producer surplus and the loss on people health. In the case of quota
the severest policy is set by the foreign government, but in the tax case competitive
advantage may inhibit the loss on people health and the foreign government may
set a subsidy at the end.
)LQDOO\ZKHQWKHQXPEHURI¿UPVLVWKHVDPHEHWZHHQFRXQWULHVWKHUHVXOWVDUH
the same in the quota and tax cases. With a small marginal pollution disutility both

249
 RESEARCH ISSUES ON INTERNATIONAL ECONOMIC RELATIONS

countries will set a lax pollution policy. In the case of a large marginal pollution disu-
tility the impact on health is important and a severe pollution policy is set.

Conclusions

Nations recognize that the creation, implementation and business survival is an es-
sential practice for their economic progress, but they must also take into account, in a
conscientiously way, the environmental facts. Thus, a detailed study of such interde-
pendence is the key to establishing the applicable regulatory policies that maximize
the welfare of businesses and consumers, preserving at the same time the environ-
mental factor.
+RZHYHUJRYHUQPHQWVDUHYHU\FDUHIXOWRHVWDEOLVK¿UPFRQWUROIRUHQYLURQPHQ-
tal protection as this involves increasing production costs undermining the competi-
WLYHQHVVDQGDVDFRQVHTXHQFHGLVFRXUDJHVFUHDWLRQDQGVXUYLYDORIGRPHVWLF¿UPV
as well as the attraction of foreign investment.
In this sense environmental regulation is considered as trade barriers. They are
hotly debated in international forums and regular feature on the negotiation of in-
ternational trade agreements, mainly those that concerns to developing countries,
EHFDXVHWKHVHDUHWKHPRVWH[SRVHGWRWKHHVWDEOLVKPHQWRISROOXWLQJ¿UPV2QWKH
other hand, industrial activity is one of the most important promoters of development,
so these countries and their governments must consider its economic attractions, with
the preservation of natural resources and the cleanliness of their environment in the
short, medium and long term.
We develop here a model of Cournot oligopoly, of partial equilibrium under con-
ditions of reciprocal dumping between two countries. We consider domestic and for-
eign companies producing for local consumption and to export. Companies generate
pollution in their production processes, but in turn, they have appropriate technology
to bring it down. We use two of the most used environmental policy instruments:
quotas (quantitative limits on the emission of pollutants) and taxes (amount charged
per unit of pollution emitted).
Concerning to quotas, we calculate the optimal quota of pollution that maximizes
the welfare in each country. In addition, such quantities determine the optimal strate-
JLFSROLFLHVXQGHUVSHFL¿FFRQGLWLRQVWKDWUHODWHWRWKHFRVWVWUXFWXUHRI¿UPVSDUWLFX-
larly the amount of the abatement cost per unit of pollution and its relationship with
the marginal disutility for contaminating. Such policies have important involvement

250
RECIPROCAL DUMPING AND ENVIRONMENTAL POLICES

on the social welfare function in both countries, which involves the consumer sur-
SOXVWKH¿UPEHQH¿WVDQGWKHVRFLDOFRVWIRUSROOXWH
,QUHJDUGWRTXRWDVWKHUHDUHWKUHHLPSRUWDQWFDVHV,QWKH¿UVWLIWKHFRVWRIDEDWH-
ment is very small compared to the marginal disutility of pollution, the optimal policy
consist to impose the most restrictive quota, in this case the government gives priority
WRSURWHFWLQJWKHHQYLURQPHQWHYHQLILWPHDQVDQLQFUHDVHLQWKH¿QDOSULFHRIWKH
JRRGSURGXFHGZKLOHUHGXFLQJWKHEHQH¿WRIFRQVXPHUVDQGFRUSRUDWHHDUQLQJV
In the second case, if the cost of abatement is very large compared to the disutility
of pollution, then the government allows some emission of pollutants, thereby the
FRVWVRISURGXFWLRQZLOOEHUHGXFHZKLFKKDVDIDYRUDEOHLPSDFWRQFRUSRUDWHSUR¿WV
DQGRQWKHFRQVXPHUV¶SRFNHWDOWKRXJKWKHHPLVVLRQRISROOXWDQWVLQFUHDVHGVLJQL¿-
cantly in turn increases the social cost of pollution.
$QG¿QDOO\LQWKHWKLUGFDVHZHFRQVLGHUWKHFRVWRIDEDWHPHQWVLPLODUWRPDU-
ginal disutility of pollution. In this instance, the optimal environment policy depends
RQ WKH HI¿FLHQF\ OHYHO RI WKH LQYROYHG FRXQWULHV WKH PRUH HI¿FLHQF\ FRXQWU\ ZLOO
LPSRVHWKHVHYHUHVWUHVWULFWLRQZKLOVWWKHLQHI¿FLHQWFRXQWU\ZLOOEHOHVVVWULFWO\RQ
SROOXWLRQUHVWULFWLRQVVRLWZLOOUHGXFHRIWKHSURGXFWLRQFRVWVRI¿UPVSURPRWLQJ
their competitiveness).
In regard to taxes, we have two cases, in both the magnitude of the optimal tax
depends mainly on the size of the marginal disutility of pollution and on the number
RIORFDODQGIRUHLJQFRPSDQLHV,QWKH¿UVWFDVHWKHPDUJLQDOGLVXWLOLW\E\SROOXWLRQ
LVQRWVLJQL¿FDQWZHFDQFRQVLGHUVRPHVLWXDWLRQVLIWKHQXPEHURI¿UPVLVKLJKHU
WKDQWKHIRUHLJQWKHQWKHJRYHUQPHQWVDFUL¿FHVWKHXWLOLW\RIWKHFRPSDQLHVDQGWKH
FRQVXPHUV EHQH¿W LQ H[FKDQJH IRU WKH WD[ UHYHQXHV IURP WD[ SROOXWLRQ ZKLOH WKH
government of the foreign country subsidizes, so that in the long term market sizes
are balanced and 2) if the number of local and foreign companies is similar, both gov-
ernments subsidize or otherwise exempt the taxes to their companies, thus, it favors
at the same time, both producers and consumers in both countries, in exchange for a
negligible increase in pollution levels.
,QWKHVHFRQGFDVHWKHPDUJLQDOGLVXWLOLW\RISROOXWLRQLVVLJQL¿FDQWKHUHZHFDQ
consider two scenarios: l) if the number of local companies in the country is greater
than the number of companies in the foreign country, then the government values the
effect adverse of the contamination and imposes to their companies a tax that will
increase in proportion to the magnitude of the marginal disutility for pollution and 2)
if the number of local and foreign companies is similar, both governments tax their

251
 RESEARCH ISSUES ON INTERNATIONAL ECONOMIC RELATIONS

companies in order to reduce the impact of pollution in their respective countries.

Finally, both policies coincide in the case of that the marginal disutility is very
high, prioritizing the negative effect of pollution on the other components of the wel-
fare function. In the case of quotas, minimizing the amount of emissions, and in the
case of taxes, imposing a high tax that discourages companies to pollute. Now, when
the marginal disutility is not high enough, the policies applicable in the case of quotas
and taxes are different. In the case of the quotas, these depend on their relationship
with the size of the abatement cost (with de marginal disutility), but in the case of
WD[HVGHSHQGVPDMRULW\RQWKHQXPEHURI¿UPVH[LVWLQJLQHDFKFRXQWU\
From this way, the proposed model emphasizes the importance of establishing
strategic rational environmental policies to act in two ways: on one hand, strengthen
WKHFRPSHWLWLYHQHVVRI¿UPVDQGWKHH[SHFWHGEHQH¿WVIRUFRQVXPHUVDQGDWWKHVDPH
time select the regulations that conduce to development sustainable of the economy;
harmoniously integrated elements in the welfare function of the countries.

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