COMMAND and CONTROL REGULATION
and the GAINS from TRADE
Joel Bruneau
Department of Economics
University of Saskatchewan
9 Campus Drive
Saskatoon, SK Canada
S7N 5A5
joel.bruneau@usask.ca
Discussion paper
May 2003
COMMAND and CONTROL REGULATION
and the GAINS FROM TRADE
Abstract:
This paper shows that deeper economic integration need not raise welfare even in
the presence of binding and effective regulation of pollution. A standard result from the trade
and environment literature is that, as long as countries implement (near) optimal pollution
targets, countries never lose from more trade. Another result is that, if a country holds the line
on emissions, then trade never lowers welfare. Both these results, however, presuppose that
regulation is efficient (incentive-based). Most current regulation is not. Rather, regulators have
preferred, and continue to prefer, Command and Control (CAC) structures to limit emissions. In
this paper I analyze whether it is still the case that gains from trade can be guaranteed under
these in-efficient regulations. They need not. Two aspects of regulation become important.
First (as in Copeland and Taylor, 2003) is whether emissions are directly, rather than in-directly,
controlled. Second is whether or not regulations are efficient. Free trade under direct
environmental control always leads to gains from trade. This holds whether targets are nonoptimal or instruments CAC. However, free trade under in-direct environmental control can
lead to losses. Institutional distortions under CAC regulation can rise with trade and offset the
traditional material gains from trade. If institutional distortions are large enough, free trade
under in-direct CAC regulation can lead to losses from trade even if targets are optimally set.
That is, even if regulators choose the appropriate targets under, say, design standards, welfare
can fall with free trade. Hence, even if we were to maintain environmental quality, welfare can
fall with trade when we use indirect CAC regulation.
JEL CLASSIFICATION:
F1 (Trade)
Q2 (Renewable Resources and Conservation: Environmental Management),
KEY WORDS: International Trade, Environmental Regulation, Gains from Trade, Command
and Control.
1
INTRODUCTION:
This paper focuses on the gains from trade in the presence of pollution externalities when
regulators use Command and Control (CAC) environmental regulations. In contrast to results
obtained under incentive-based instruments, I show that countries can lose from trade even if
targets are optimally set or if environmental quality does not deteriorate with trade. These results
are new to the literature. The focus on CAC regulation is important since most regulations tend
to be of this sort rather than incentive-based (see Helfand, 1999, 1991, and Dewees, 1983).
Previous analysis has identified three propositions relating environmental regulation and
international trade under (otherwise) competitive conditions (see for example Copeland and
Taylor 2003, Nordstrom and Vaughan 1999, Ulph 1997, Copeland 1994, Anderson 1995, Runge
1995, amongst others).
1.
Trade can lower welfare in the absence of environmental regulation. When trade expands
polluting activities, and externalities are strong enough, then the resulting increase in
pollution damages can fully offset the traditional material gains from trade.
2.
Trade with (near) optimal targets always raises welfare. Optimal Pigouvian-like regulation
will alter the pattern and intensity of trade but will not make a small open country worse off.
A problem is that changes in international markets can lead to domestic welfare losses unless
targets are re-optimized.
3.
Countries always gain from trade as long as damages do not rise with trade. Holding the
line on emissions means environmental distortions are held in check and countries enjoy the
material gains from trade without increased damages. This holds even if targets are nonoptimal (Copeland and Taylor, 2003, p 174).
The above results are almost always derived under the presumption that regulation is
imposed using incentive-based instruments. For instance, Anderson (1995) and Nordstrom and
Vaughan (1999) consider emission taxes while Copeland (1994) and Copeland and Taylor
(2003) consider both emission taxes and tradable emission permits. This distinction is important
2
since incentive-based instruments presume targets are achieved at least cost. Kalt (1985) and
Tietenberg (1990), among others, argue strongly that this is clearly not the case since actual
regulatory compliance costs often exceed the minimum by several magnitudes.
To consider the gains from trade under Command and Control instruments we need to
carefully differentiate amongst the different kinds of regulations that may be employed. First,
we can categorize environmental regulation in terms of the control of emissions. Regulators can
impose direct control over emissions or indirect control. For instance, emission permits,
whether tradable or not, place direct restrictions on the volume of allowable emissions. Firms
cannot exceed that target. Emission taxes, on the other hand, indirectly control emissions.
Regulators impose an implicit emission limit but changes in market conditions allow firms to
alter emissions as they see fit. A useful refinement is offered by Copeland and Taylor (2003).
They instruments in terms of rigid and flexible. Rigid regulations are those that do not allow the
firm to alter their emissions with changes in their market circumstances. Flexible regulations, on
the other hand, would allow emissions to change with circumstances. Direct control of
emissions, of course, would always be considered rigid. Indirect control can be either rigid or
flexible. For instance, output permits control emissions indirectly and would not, generally,
allow emissions to change. Conversely, indirect controls such as emission taxes, output taxes,
abatement subsidies, or concentration standards would be considered flexible. 1
Second, regulations can differ is in terms of their efficiency. An efficient regulation can
be defined as one that allows firms to achieve a particular emission target at least cost. For
instance, emission taxes are efficient since they allow the firm to freely allocate inputs to attain a
particular (implicit) target. Inefficient regulations, such as design standards, prescribe the way in
1
Whether a regulation is rigid, inflexible, direct, or indirect depends on the nature of the damage and abatement
technologies. For instance, if damage is due to ambient concentration levels, then regulation of concentration ratios
is both direct and rigid. This is the approach taken by Copeland and Taylor. If damage, on the other hand, is due to
accumulations of pollutants, then regulation of concentration ratios is indirect and flexible.
3
which firms must achieve targets and typically do not do so at least cost. Alternately,
inefficiency can come from an inability to target externalities directly. Hence output constraints
and output taxes are typically inefficient since they do not directly control the source of the
externality.
The table below illustrates the four possible combinations that obtain in this conceptual
matrix and some examples of respective environmental regulations. In this paper I focus entirely
on indirect and inefficient environmental regulations in a small country engaged in free trade.
See Copeland (1994) or Copeland and Taylor (2003) for an analysis of efficient regulations and
Anderson (1995) for direct and inefficient regulation.
REGULATORY APPROACH
CONTROL of EMISSIONS
EFFICIENT
•
(Incentive - Based)
INEFFICIENT
(Command and
Control)
•
DIRECT
INDIRECT
(RIGID)
(RIGID or FLEXIBLE)
Tradable Emission
Permits
Non-tradable
Emission Permits
•
Emission Taxes
•
Subsidies for Emission Reductions
•
Concentration Standards
•
Input or Output Taxes
•
Subsidies on Abatement Expenditures
•
Capped Emission Taxes
•
Output Permits
•
Design Standards
The primary message of paper is that inefficient instruments introduce institutional
distortions that can lead to net losses from trade even if regulations are optimally applied. The
expansion of institutional distortions does not arise under efficient regulation or under direct
regulation. It can occur under design standards, concentration standards, subsidies for abatement
4
equipment, caps on emission taxes, or where the costs of monitoring or collecting taxes do not
fully accrue to the firms.
This relationship between the form of environmental regulation and whether countries
gain from trade is found in only a few papers to my knowledge. Copeland (1994) considers only
efficient instruments (tradable emission permits or emission taxes) while Copeland and Taylor
(2003) consider concentration standards and emission taxes (Chapter 4). However, due to their
model assumptions, both instruments are efficient. Brander and Taylor (1997), following
Chichilnisky (1994), consider natural resource management and compare open access to private
property management.2 Another stream of literature considers strategic interactions between
countries and the choice of environmental regulation. The question posed is whether countries
have a strategic incentive to manipulate the level as well as form of environmental regulation.
None of this research, however, considers whether opening to trade is a good idea to begin with.
Dijkstra (2001), for instance, considers the choice of a tax regime or a relative standards3 regime
while Verdier (1993) compares emission standards to design standards. Similarly, Ulph (1997)
draws on previous work and provides a nice survey of the strategic arguments for choosing
between taxes and permits in the presence of market power. Ruseski (1998) considers strategic
fishery’s management and compares open access to private property management. These
strategic papers presume countries are better with trade than without.
The layout of the paper is as follows. In the first section I develop the basic model. I
consider a small open economy characterized by a perfectly competitive industry. Pollution
damages are purely local. I consider rigid control (both direct and indirect) and show that
2
Note that open access management is really a hands-off policy and is analogous to the absence of pollution
regulation. Hence countries can lose from trade in the absence of private property rights.
3
Relative Standards restrict the ratio of emissions to output: e/q ≤ K. I call these Concentration Standards after
Helfand (1991).
5
welfare never falls with trade. In section 2 I consider indirect flexible control and show how
trade can lower welfare even if targets are optimally set. I conclude in section 3.
1
GAINS FROM TRADE under RIGID CONTROL
I use an extension of the model employed by Krutilla (1999), Anderson (1995), and
Runge (1995) and presented in some undergraduate environmental economics textbooks (for
instance Hanley, Shogren, and White, 2001, p 184.). As with these authors, I take a partial
equilibrium approach and concentrate on one polluting industry only. This approach makes
sense for three reasons. First, introducing different forms of regulations adds at least one degree
of complexity. It is easier to compare instrument choice in a simpler framework as the intuition
is easier to develop, easier to convey, and more revealing. Second, most CAC regulation is
directed at particular, narrowly defined industries or products rather than at pan-economic
activities.4 Hence it appears sensible to ignore the economic spillover effects of a particular
regulation in a particular industry.5 The third reason is pedagogic. The model used here is
familiar to a broad audience and can be presented to senior under-graduate students who have
some background in trade theory and environmental theory. Hopefully this makes dissemination
of these results easier.
Abatement activities in the Krutilla, Anderson, and Runges model are, by assumption,
limited so that emissions are always proportional to output. Stricter environmental regulations
necessarily lead to lower production. However, to consider alternative regulatory modes we
need to break the direct link between output and emissions by assuming that firms have means
available to reduce emissions without necessarily reducing output. This is Helfand’s (1991)
4
For instance; CAFE rules, reformulated gasoline, catalytic converters, the use of SO2 scrubbers in electrical
generation plants, effluent limits in pulp mills, restrictions on the use and sale of particular kinds of asbestos,
handling of hazardous wastes, and trade in elephant ivory are all product or industry specific regulations.
5
On the other hand, incentive-based instruments, such as C02 trading schemes or carbon taxes, cut across broad
industry categories and so can be expected to affect both product and factor prices. General equilibrium models
make more sense when analyzing these policies.
6
approach and is at the heart of the efficiency debate surrounding CAC regulation versus
incentive-based instruments: which instrument achieves the target at least cost?
The firm’s problem is to choose output (q) and abatement (a) that maximizes profits
given the world price: MAXqa [Pq – c(q,a)]. They do so under some sort of environmental
regulations to be stipulated later.
I make two assumptions that ease a diagrammatic exposition. I first assume that
emissions are increasing in output and decreasing in abatement on a one-to-one basis: e(q,a) = q
– a. This allows me to show emissions and output on the same axis. Second, costs are separable
in output and abatement: c(q,a) = c(q) + d(a). This allows me to hold the schedule of marginal
production costs constant as I alter the level of abatement. Marginal production costs (cq) are
non-decreasing in output and marginal abatement costs (da) are no-decreasing in abatement.
Further d(0) = 0 and da(0) ≥ 0.
Pollution damages are a non-decreasing function of net emissions and affect only local
welfare. I abstract from any trans-boundary pollution problem. I will focus on production
externalities and leave it to the reader to complete the case for a consumption externality. I
assume that the level of emissions does not alter productivity within the industry. It can, of
course, lower productivity in other activities. This is captured in the damage function.
As is customary in this literature, each national government chooses its environmental
target, given the instrument regime, to maximize social surplus: consumer plus producer surplus
less environmental damage. Their selection of an emission target is implemented by an
appropriate choice under the regulatory instrument employed. For instance, they can choose the
emission tax that achieves their desired emission target. I assume full information so that there is
no difficulty achieving targets under any instrument. I also assume that regulatory costs are zero
for all instruments. This, of course, is not realistic. Each instrument will entail different sorts of
7
monitoring, implementation, and enforcement costs. These costs will play a part in the
instrument choice taken. I abstract from this dimension to highlight the difference instruments
have on market outcomes and induced institutional distortions.
1.1
Direct Control: Non-Tradable Emission Permits
Consider a perfectly competitive firm facing a given market price with holding a pre-
determined amount of non-tradable emissions permits (ē). The firm’s problem is to maximize
[Pq – c(q) – d(a)] subject to e(q,a) ≤ ē. Figure 1 can be used to illustrate the firms’output and
costs and environmental damages. For output below the target ē, marginal compliance costs are
simply cq(q,0) = cq(q): the target is non-binding so the firm does not have to abate. However, for
output above ē, the target is binding and marginal compliance costs rise to cq(q,a) = cq + da
where the level of abatement, given output q(ē), is sufficient to reduce emissions to the target (a
FIGURE 1: EMISSION CONSTRAINTS under FREE TRADE: EXPORTER CASE
MC + MAC
MC
PW
D
C
E
WORLD
PRICE
B
PAUT
DOMESTIC
DEMAND
A
MARGINAL
DAMAGE
F
CAUT=qē AUT
ē
CFT
qē FT
OUTPUT
EMISSIONS
8
= q - ē). The binding target pushes marginal compliance costs up and induces the firm to reduce
output and raise abatement. The choice of output reductions and abatement minimize the firm’s
costs of achieving the target. It solves PW = cq(q(ē)) + da(q-ē) Abatement costs are area (A+B)
while lost producer surplus is area (C). Total damages are area (F).
Now, consider an industry that exports after opening to trade. Suppose the industry is
optimally regulated in autarchy so that MAC (evaluated at autarchy output qē AUT) is equal to MD
at ē. Now let the country open to trade while holding to the same target. Output rises to qēFT
while consumption falls to CFT. Damages have not changed. The firm’s abatement costs rise by
area B since it must adhere to the autarchy emission target. Consumers lose area (D) due to the
higher prices. However, the firm’s surplus rises by area (D+E). Hence the net gain from trade is
area (E). A similar analysis holds for an importer. As Copeland (1994) notes, the quantitative
restriction on emissions ensures that trade cannot worsen the environmental damage and so any
changes in market activity must be welfare improving.
1.2
Output Constraints
Consider now an output constraint as the CAC instrument. The regulator may take this
approach if observation or abatement of emissions is not possible or too costly.6 An example
might be a limit on development in sensitive ecological areas. Here the source of the problem is
the level of human activity so reducing activity is the only reasonable form of abatement. The
firm’s problem is to maximize [Pq – c(q) – d(a)] subject to q ≤ ē. The regulator restricts
exposure by setting an upper limit on output. The firm does not abate since this is costly. We
can imagine that the firm perceives its MACs as infinite at q = ē. Note that the true social
marginal compliance cost of attaining the target ē is equal to P – MC evaluated at q = ē. and so
this instrument introduces a wedge between the social and private MACs.
6
Note that this is the analog to Anderson’s (1995) model where abatement is not possible (p 29).
9
We can now compare outcomes under permits and output constraints. This is illustrated
in Figure 2. Begin with autarchy. If we implement an emission target with an output constraint,
output is at ē rather than the qē AUT as would obtain under permits. Autarchy prices will be
higher under output constraints due to the smaller output. Note area (A). This is uncaptured
social surplus that was captured under a permit system. Hence, the output constraint is not
efficient since it creates an excess regulatory burden. It is this institutional distortion that forms
much of the basis for the move to incentive-based instruments.
FIGURE 2: OUTPUT CONSTRAINTS under FREE TRADE: EXPORTER CASE
MC + MAC
MC
PW
C
B
D
PAUT
A
DOMESTIC
DEMAND
OUTPUT
EMISSIONS
ē = qAUT = CAUT
CFT
FT
q
qē AUT
Now consider the effects of trade on welfare. We begin again in autarchy with an
optimal output constraint: ēAUT= qAUT= CAUT. Now suppose we open to trade with the world
price above the autarchy price. In the absence of regulation, output would rise. However, it
cannot due to the environmental constraint. Neither can emissions. Consumption, however,
falls. Consumer surplus falls by area (B) but producer surplus rises by (B+C). The net gain is
10
area (C). This is unambiguously positive. A similar gain can be established for the importer
case. Regulations allow firms to capture a portion of the material gains from trade but do not
worsen environmental damages. Hence countries always gain from trade under this
environmental regulation. Again, this holds even if the constraint is non-optimal. Note that the
opportunity lost is area (D). Countries do not lose from trade but clearly do not maximize the
opportunities offered by trade.
Combining these results for emission permits and output constraints establishes that free
trade under rigid environmental regulations, whether direct or indirect, never lowers welfare.
This extends the results under efficient regulation from Copeland (1994) and Copeland and
Taylor (2003). This can be stated as a proposition:
PROPOSITION 1: Assume a perfectly competitive industry in a small country is regulated through
rigid regulations (either output constraints or emission permits). Then, for any binding emission
target, welfare in the free-trade equilibrium never falls relative to autarchy.
2
GAINS FROM TRADE under FLEXIBLE, INDIRECT CONTROL
I now turn to indirect, flexible CAC instruments. I consider abatement subsidies, design
standards, and concentration standards. I show that the country may be better off in autarchy
even if environmental quality does not deteriorate or if targets are optimally applied.
2.1
Design Standards:
Regulators often use Design Standards to specify how firms must reduce emissions. For
example, regulators can specify the kinds of inputs the firm can use (unleaded fuels, low sulfur
coal), their abatement process (mandatory recycling, incineration rather than burial, catalytic
converters, scrubbers), the location of production (zoning), or their production methods
(minimum space requirements for poultry). The regulator achieves an emission target by
specifying the amount, or intensity, of abatement. Having met their abatement requirement,
11
firms have no additional restrictions on output or emissions. One can specify the firm’s problem
as MAXqa [Pq – c(q) – d(a) ] subject to a ≥ A where A is chosen by the regulator to attain an
implicit emission target.
There are two problems associated with Design Standards. First, even if the regulator
chooses the proper abatement activity, design standards will still entail excess social costs
(discussed below). Second, the restriction on choice of abatement technique will tend to raise
the costs of abatement and so raise social costs above the minimum.
We can take up the first aspect by supposing that firms are required to install the cost
efficient treatment method. Since production costs are independent of the level of abatement, the
firm’s output decision is independent of the abatement requirement. Design standards, in effect,
turn abatement into a quasi-fixed cost. The firm chooses output as if it was unregulated but
abates as required.7 This is depicted in Figure 3. The firm produces at qU regardless of the
required abatement. Hence the regulator has to specify a higher level of abatement to achieve
their emission objective than would occur under emission constraints. The abatement cost of
achieving the target is area (A+B+C+D). Area (D) reflects the excess social costs of using
design standards.8
Now consider the second problem of restricting abatement activities to a subset of
available technologies. In this case we might presume that the rigidity of the regulation increases
the costs to the firm of attaining a particular target. This is the primary argument used against
design standards (see Porter and Van der Linde, 1995, amongst others). For a given target, the
7
Equivalent to this design standard would be an emission tax that had a binding upper limit on payments. The
binding maximum means that the firm has no incentive to reduce emissions or to limit output since it offers no
reduction in taxes. To reduce emissions, or the effect of emissions, the regulator could use the tax receipts for its
own environmental programs. This sort of tax treatment could be equivalent to a cleanup fund where polluters
contribute to environmental programs but payments are not necessarily a function of individual emissions.
8
Note that social marginal compliance costs are above private marginal compliance costs. The firm’s private
marginal compliance costs are simply marginal costs (MC) since additional output does not require additional
abatement. The social marginal compliance costs include the resources used to achieve the target. This is captured
by the marginal compliance costs of firms regulated using emission constraints: cq(qU) + da(a) > cq(qU) + da(0).
12
marginal compliance costs will rotate upwards. The firm still produces as if unregulated but the
restriction on the form of abatement activities further raises costs above (A+B+C+D). This
implies an increase in the excess social costs already identified.
FIGURE 3
DESIGN STANDARDS under FREE TRADE: EXPORTER CASE
MC + MAC
D
MC
PW
E
C
B
AUT
P
A
DEMAND
CFT
ēFT
OUTPUT
EMISSIONS
CAUT = qAUT
qFT
The primary result of the inefficiency and the indirect control of emissions is that, even if
the regulator optimizes the level of emissions, the country may be better off in autarchy. This is
laid out in Proposition 2.
PROPOSITION 2: Assume a perfectly competitive industry in a small country is regulated through
design standards. Then, given optimal design standards, welfare in the free-trade equilibrium
can fall relative to autarchy if the polluting activity rises.
To establish the proposition I will show that the country can do better by banning trade
given an optimal design standard under free trade. Return to Figure 3. Consider the case where
the country is an exporter in free trade. The regulator chooses the optimal design standard given
13
world prices. The implicit target sets MAC (evaluated at qFT) equal to MD. The country has net
material gains of area (E) and excess costs of area (D). Now suppose the country holds
emissions constant but bans exports. Prices fall and the regulator can now reduce the abatement
requirement since production falls to qAUT. This reduces the excess costs of regulation to area
(B). The change in welfare is (D – B) – E. The first part is the decrease in excess burden
associated with the inefficient regulation. The second is the lost net material gains from trade.
As long as the decrease in excess costs is large relative to material gains, then moving to
autarchy raises domestic welfare. This would be the case if abatement were very costly. Once
the country bans exports, the reduction in the scale of production allows it to reduce the emission
target even further. This raises welfare even more. The corollary is that welfare can fall even if
environmental quality is maintained.
An intuitive way to see this result is to recognize that a design standard is equivalent to
an emission constraint with a fully offsetting output subsidy. The “subsidy” ensures that output
is at the unregulated level regardless of the emission constraint. However, since the market price
is independent of industry output, the “output subsidy” generates excess social costs. In
autarchy, production is smaller and so the corresponding social costs of the “subsidy” is smaller
as well. Banning trade allows the regulator to reduce the regulatory distortion and so reduce the
excess burden of regulation.9
If the country becomes an importer, given the production externality, then free trade is
always better than autarchy (not illustrated). This follows since the smaller scale of production
9
One can also consider the case where taxation or monitoring imposes some costs on society that are not borne by
the individual firm. This would occur if taxes entail costly administration or collection of fees. The imposition of
such taxes creates a wedge between private and social costs. This generates excess costs of regulations. Trade
increases the level of polluting activities and, for a given target, tends to increase the excess costs of regulations.
These excess costs will offset the material gains from trade. The net benefits of trade fall. If the excess costs are
high, then net benefits of trade might be negative. This also occurs when regulations exacerbate existing market
inefficiencies.
14
decreases the excess costs of regulation by reducing the implicit “output subsidy”. Added to this
are the material gains from trade. Hence the net benefit of opening to trade is positive. This
parallels Anderson’s result that, in the presence of an unregulated production externality, free
trade that results in imports always raises welfare. With design standards, we can add reduced
pollution damages and reduced excess regulatory burden to the material gains from trade.
The policy relevant question is whether empirically the excess costs of regulation
dominate the material gains from trade. They may. Tietenberg (1990) suggests that the costs of
CAC regulation can be up to 22 times more expensive than the least cost approach (pp 26-27).
Further, most measures of the (static) gains from trade tend to be quite small (in the range of
5%).
2.2
Concentration Standards
Concentration standards limit the emissions per unit of output (e/q) but do not directly
limit either emissions or output. This form of standard underpins much current CAC regulation
by regulating the “greenness” of a product or industry but not total emissions. For example, the
EPA’s Corporate Average Fuel Economy (CAFE) standards can be characterized in this
framework as they regulate the fuel efficiency of vehicles sold. They do not regulate how far
cars are driven hence do not control total emissions. Similarly, EPA regulations on reformulated
gasoline require conventional gasoline to be blended with oxygenates to burn cleaner. The intent
of this regulation is to reduce smog and other pollutants. Regulations are focused on the quality
of the fuel and not directly on net emissions. Similarly, restrictions on the concentration of
chemicals in industrial effluent only indirectly control pollution levels.
Under this regulation the firm’s problem is MAXqa [Pq – c(q) – d(a)] subject to e/q ≤ K.
The firm, for a given output, chooses the least abatement required to meet the concentration
constraint. The firm, however, abates at all levels of output. At high output levels the firm has
15
lower marginal compliance cost than does a firm under an equivalent emission constraint. This
is because emission permits force the firm to raise abatement one-for-one with output. With
concentration standards, abatement rises at less than a one-to–one ratio. Hence marginal
compliance costs, for a given target, are lower at higher output levels.10 Though both are
performance standards, each uses different criteria. Like design standards, concentration
standards lead to higher output than emission permits for the same target (though less output than
under design standards). Abatement is also higher (see also Dijkstra 2001).
Concentration standards generate similar, though weaker, results as design standards: a
country may be better off in autarchy even if emissions are optimally implemented or do not rise
with trade. Intuitively, concentrations standards are equivalent to an emission tax and an “output
subsidy”. This subsidy, however, does not fully offset the output effects of the emission tax and
so creates a smaller excess burden than under design standards. Excess costs also tend to be
smaller and so the potential for welfare losses is correspondingly smaller.
2.3
Subsidies:
There are two ways to introduce subsidies into this framework. The first is to assume
that the regulator pays the firm to reduce emissions below some level and does not care how this
is done. For instance, the regulator might offer a subsidy for emission reductions below the
unregulated level. The firm’s problem then becomes MAXqa [Pq – c(q) – d(a) + s(eU – (q – a))].
Notice that the only difference between this problem and that under emission taxes is the term
seU. Hence, if t = s then both generate the same output and abatement. This form of subsidy is
efficient and, like emission taxes, allows total emissions to change with changing market
To see this re-write the firm’s constraint using the fact that e = q - a as {[1-K]q – a ≤ 0}. The firm’s first order
necessary conditions imply that P = cq - [1-K]da. Since e ≥ q we have K ∈[0,1] and hence cq -[1-K] da ≤ cq - da for
a given output and emission target.
10
16
circumstances. Hence, subsidies for emission reductions can lead to net losses if they are not reoptimized after trade.
The second and perhaps more common approach is to assume that governments directly
subsidize firm’s abatement expenditures. For instance, governments might offer tax write-offs or
tax credits based on abatement expenditures or may undertake the abatement for the firm
themselves.11 Recall that abatement offers no direct benefits to the firm so without regulation,
abatement would be zero. Abatement subsidies alter this by creating a direct benefit to the firm.
The firm’s problem becomes MAXqa [Pq – c(q) – d(a) + s(a)]. The firm’s optimal choice of
abatement solves da = s. On the other hand, their optimal output remains where P = MC and is
independent of the subsidy (this follows from the seperability in costs). Hence the firm produces
as if unregulated but does abate due to the subsidy. The greater the subsidy, the less the damage
since da is increasing in a. The regulator can achieve any particular pollution target simply by
manipulating the level of the abatement subsidy. This form of subsidy is not equivalent to an
emission tax but is equivalent to a design standard. As with design standards, the country may
find that they are better off without trade.
SECTION 3: CONCLUSION
This paper argued that trade agreements that deepen economic integration need not raise
welfare even in the presence of binding, effective regulation of pollution. The form of regulation
is important. I showed that the use of Command and Control instruments in a free-trade regime
could lower welfare even if regulators use them optimally or if emissions did not rise. The
primary issue is whether emissions are directly controlled by regulation. If they are, then trade
will not lower welfare even if instruments are inefficient and/or targets non-optimal. On the
11
The subsidy need not cover all abatement costs. It need only apply to marginal abatement above some minimum
threshold for the results to follow: s(a - a0).
17
other hand, if the regulator uses inefficient instruments but does not control emissions directly,
then welfare can fall.
There are some important policy implications that follow from this analysis.
1.
We have an additional rationale for moving away from CAC regulation to incentive- based
instruments. Trade magnifies the institutional burdens inherent to CAC regulation. Hence,
to the extent that our current management structures are inefficient suggests that we have not
gained as much from trading arrangements as we could. Efficient instruments allow
regulators to maximize the gains from trade.
2.
Moving away from CAC structures will reduce the social costs of regulation and allow
regulators to tighten current emission levels. Hence we can achieve promised gains from
trade and have a cleaner environment too. Kalt (1985) and Esty (1994) make this claim.
3.
It seems sensible to control pollution directly rather than indirectly. In Copeland and
Taylor’s (2003) jargon, such a policy will be “a safe pro-free-trade position” (p 174). This
also allows the regulator to recalibrate emission targets independent of market innovations
and so can do so at prescribed intervals. With indirect control, regulators need to monitor
relevant markets and adjust targets on an ongoing basis. This is much more difficult to
accomplish and so is seldom done.
4.
If we wish to pursue more open borders, we need to know whether a concomitant reevaluation of environmental policy is a necessary condition for successful trade negotiations.
This is particularly important for poorer countries that may lack the institutional capital, or
technical and market expertise, to implement efficient management practices. Trade
agreements may need to permit developing countries greater leeway to accommodate their
inability to manage their environment properly. This can put countries in conflict given
existing trade agreements do not account for institutional inefficiencies.12 A lack of
flexibility may lead poorer countries to forego trade agreements. Alternately, trade
12
For instance, WTO rules allow countries to ban exports if it is required to protect a natural resource or local
species. The rationale behind a ban under design standards is that it reduces compliance costs and not that
protection is impossible. Hence, a trade ban could be challenged. Similarly, Chapter 11 in the NAFTA agreement
might be invoked since trade bans can impose financial losses. This problem is more acute when it is an importing
country that wishes to restrict trade. Again, WTO rules allow for import bans to protect local environments. It does
not allow for bans based on ineffective or costly regulations.
18
agreements may need to provide technical and informational transfers between developed
and developing nations relating to environmental policies if all are to benefit from freer trade.
So far trade agreements have been pursued more or less independent of their environmental
or induced regulatory effects. This approach may not be tenable.
There are two important issues not addressed in this paper. First, do these results hold in
a general equilibrium setting? I think they probably do. Copeland and Taylor (2003) show that
these hold for efficient regulations (permits and taxes). Second, how does market structure alter
the relative ranking of instruments? We know that the different instruments induce different
output responses by firms. This will alter the degree of market failure. As Verdier (1993)
shows, it may be the case that incentive-based instruments no longer maximize gains from trade.
This would weaken the motive to move away from Command and Control structures. I leave
this to future research.
19
REFERENCES:
[1].
Kym Anderson, “The Standard Welfare Economics of Policies Affecting Trade and the
Environment”, in The Greening of World Trade Issues, edited by Kym Anderson and
Richard Blackhurst, Michigan Press, Ann Arbor, 1995 (25-48).
[2].
James A. Brander and M. Scott Taylor, “International Trade between Consumer and
Conservationist Countries”, Resource and Energy Economics, 19, 1997 (267-297).
[3].
G. Chichilnisky, “North-South Trade and the Global Environment”, American Economic
Review, 84, 1994 (851-874).
[4].
Brian Copeland, “International Trade and the Environment: Policy Reform in a Polluted
Small Open Economy”, Journal of Environmental Economics and Management, 26, 1994
(44-65).
[5].
Brian Copeland and Scott Taylor, Trade and the Environment: Theory and Evidence,
forthcoming, 2003.
[6].
Donald N. Dewees, “Instrument Choice in Environmental Policy”, Economic Enquiry,
21, 1982 (53-71).
[7].
Bouwe R. Dijkstra, “Non-cooperative Instrument Choice in an International
Environmental Agreement”, Working Paper, University of Groningen, 2001.
[8].
Daniel C. Esty, Greening the GATT: Trade, Environment, and the Future, Institute for
International Economics, Washington, DC. 1994.
[9].
Nick Hanley, Jason F. Shogren, and Ben White, Introduction to Environmental
Economics, Oxford University Press, Oxford, UK, 2001.
[10].
Gloria E. Helfand, “Standards Versus Taxes in Pollution Control”, Handbook of
Environmental and Resource Economics, Jeroen C.J.M. van den Bergh editor, Edward
Elgar Publishing Ltd, Cheltenham, UK, 1999 (223-234).
[11].
Gloria E. Helfand, “Standards versus Standards; the Effects of Different Pollution
Standards”, American Economic Review, 81, 1991 (622-634).
[12].
Joseph P. Kalt. “The Impact of Domestic Environmental Regulatory Policies on US
International Competitiveness”, Harvard Energy and Environmental Policy Center
Discussion Paper E-85-12, 1985.
[13].
Kerry Krutilla, “Partial Equilibrium Models of Trade and the Environment”, Handbook
of Environmental and Resource Economics, Joeren C.J.M. van den Bergh editor, Edward
Elgar Publishing Ltd, Cheltenham, UK, 1999 (404-415).
[14].
Hakan Nordstrom and Scott Vaughan, Trade and the Environment, Special Studies 4,
World Trade Organization, 1999.
[15].
Michael Porter and Claus van der Linde, “Toward a New Conception of the
Environment-Competitiveness Relationship”, Journal of Economic Perspectives, 9(4),
1995 (97-118).
[16].
C. Ford Runge, “Trade, Pollution, and Environmental Protection”, in Handbook of
Environmental Economics, edited by Daniel W. Bromley, Basil Blackwell Ltd, 1995
(353-375).
20
[17].
Gorazd Ruseski, “International Fish Wars: The Strategic Roles for Fleet Licensing and
Effort Subsidies” Journal of Environmental Economics and Management, 36, 1998 (7088).
[18].
Alistair Ulph, “International Trade and the Environment: a Survey of Recent Economic
Analysis”, in The International Yearbook of Environmental and Resource Economics
1997/1998:a Survey of Current Issues, edited by Henk Folmer and Tom Teitenberg,
Edward Elgar Publishing Ltd, Cheltenham, UK, 1997 (205-242).
[19].
Thierry Verdier, “Strategic Trade and the Regulation of Pollution by Performance or
Design Standards”, Nota Di Lavoro 58.93, 1993.
[20].
Tom H. Tietenberg, “Economic Instruments for Environmental Regulation”, Oxford
Review of Economic Policy, 6(1), 1990 (17-33).
21