Environmental regulation: An incentive for foreign direct investment

Abstract: Empirical evidence has so far failed to find firm support for the Pollution Haven Hypothesis that lenient environmental regulation attracts investment from polluting firms. In this context, this paper investigates the incentive effects of environmental regulation on foreign direct investment and market competition. We show that a firm may want to relocate to a country with stricter environmental regulation, when the move raises its rival’s cost by sufficiently more than its own. We model a Cournot duopoly with a foreign and an incumbent domestic firm. When the foreign firm moves to the home country, the domestic government will respond by increasing the environmental tax rate. This may hurt the domestic firm more than the foreign firm thus making it profitable for the foreign firm to relocate rather than to export