Foreign Direct Investment and the Choice of Environmental Policy

We use an oligopoly model of intra-industry trade to examine the implications of foreign direct invest-ment for the pollution haven hypothesis and environmental policy. Countries which lower environmental standards to be more competitive in world markets generate pollution havens if environmental policy is xed. However, if FDI is a viable option as a mode of entry, pro\u85t-shifting considerations weaken in favour of environmental considerations and FDI-recipients tighten environmental policy, weakening the pollution haven hypothesis by reducing incentives to relocate production. Interestingly, FDI may still occur in spite of the stricter standards in order to level the playing \u85eld. We derive conditions under which the FDI-receiving country has an incentive to manipulate its environmental standard to prevent or attract FDI, potentially eliminating or creating pollution havens. Without manipulation of standards, FDI leads to improvements in world pollution levels. However, when countries manipulate their standards, FDI can lead to a dirtier environment if the two countries are substantially di¤erent in their valuation of environmental damages