Trade Liberalization and Optimal Environmental Policy in a Vertically Related Market

This paper studies the effects of trade liberalization on the optimal environmental policy, domestic pollution, and welfare in the pres-ence of an intermediate good market. In the import model, there is a monopoly in the domestic intermediate good market. One domestic downstream firm generates pollution during production and com-petes against one foreign firm in the domestic downstream market. When the domestic environmental tax is endogenous, the presence of the intermediate good market increases the reduction of the optimal environmental tax caused by trade liberalization. Moreover, trade lib-eralization increases the domestic pollution and may lower domestic welfare. No matter whether the intermediate good market is monop-olistic or perfectly competitive, under the optimal environmental tax the effects of trade liberalization on domestic pollution and welfare stay the same. Compared to the import case, under the intra-industry trade (IIT) model the optimal environmental tax may increase after trade liberalization. Although trade liberalization may increase the pollution tax rate, it always increases the environmental damage