Environment, Welfare and Gains from Trade: A North-South Model in General Equilibrium

The effects of environment on trade and welfare are analyzed in a modified Heckscher-Ohlin framework using a quasi-homothetic preferences to account for differences in countries' expenditure shares on health. Three types of pollution, local-disembodied, global-disembodied and embodied, result as a by-product of inputs used in production. For each case, the Walrasian, Pareto optimal and the Regulators' problem are analyzed. The optimal tax is shown to improve each country's welfare if the country is small in the world market. Otherwise, changes in the terms of trade may cause one country to be made better off at the expense of the other. Interdependence for the global-disembodied case is explored using a one-shot Nash game. For the embodied pollution, taxing the polluting input only can cause a decline in welfare when the polluting input is intensively used. Instead, a tax on the polluting input in combination with a subsidy to the non-polluting input is optimal. In general, the results suggest compensatory payments may be required to encourage abatement policies. Contrary to other approaches, an abatement policy does not necessarily decrease a country's comparative advantage, i.e., reduce exports of the polluting sector.