Trade Liberalization and Optimal Environmental Policies in Vertical Related Markets

This paper establishes a symmetric two-country model with vertically related markets. In the downstream market, there is one firm in each country selling a homogeneous good, whose production generates pollution, to its home and the foreign markets a la Brander (1981). In the intermediate good market, there is also one upstream firm in each country, supplying the intermediate good only to its own country’s downstream market. The upstream firms can choose either price or quantity to maximize their profits. With this setting, the paper examines the optimal environmental policy and how it is affected by the tariff on the final good. It is found that, under free trade, the optimal final-good output with imperfect intermediate-good market will have the same output level as that with perfect intermediate-good market after imposing the optimal emission tax. The optimal environmental tax is smaller and the optimal environmental policy is less likely to be a green strategy under trade liberalization if the market structure in the intermediate good market is imperfect than perfect competition. On the other hand, the optimal environmental tax is necessarily higher if the upstream firm chooses price than quantity. Moreover, the optimal environmental policy is less likely to be a green strategy under trade liberalization if the upstream firms choose quantity than price to maximize their profits