Is environmental regulation the answer to pollution problems in urbanizing economies?

This paper seeks to better understand the persistent environmental problems in urbanizing economies. We examine the effectiveness of environmental policy in an economy with agglomeration economies and endogenous firm relocation and entry/exit. We show that, although environmental regulation is effective in the short run, in the presence of agglomeration economies, spatial relocation of firms in response to environmental regulation can undermine the effectiveness of regulations, rendering them less effective or even ineffective. In fact, we show that regulation might even be counter-productive, i.e., exacerbate environmental problems, at certain stages of development. We present initial empirical evidence in the context of water pollution in China that demonstrates the importance of agglomeration economies in determining the impacts of environmental regulation.