The Effects of Choosing Free Trade on Endogenous Environmental Regulation and Welfare: A Model of Common Agency Government

Several studies hypothesize exogeneous environmental regulation as the primary motive for trade between two regions, often predicting a lower welfare for the region with incomplete environmental protection. Such analyses do not allow the region to adjust its environmental policy in response to a shift in the trade regime. Further, they do not allow the region to refuse free trade in the face of a welfare loss. As an alternative I propose a common agency model of government to endogenize environmental policy and the choice of trade regime. Conditions for the incomplete internalization of an environmental externality are specified, and the pollution tax in autarky is compared to that under free trade. The paper finds that moving to free trade induces a tightening of pollution policy reducing the deadweight loss from incomplete environmental regulation. This improvement occurs regardless of any price changes that accompany free trade. In contrast to the predictions from earlier articles, the adoption of free trade increases aggregate welfare. This gain occurs even when the country with incomplete environmental protection exports the pollution intensive good