A Tale of Two Externalities: Environmental Policy and Market Structure

This paper examines the two externalities that a country's environmental regulation imposes on other country's welfare: an environmental externality, due to transboundary pollution, and a competitive advantage externality, as regulations affect domestic firms' abatement costs, which impact the profits of their foreign competitors. We first analyze the emission standards that countries independently set under different market structures and then compare them with the standards set under international environmental agreements that internalize one or both types of externalities. The paper hence disentangles the effect of each externality. We show that firms’ profits increase when countries participate in international treaties if the environmental damage from pollution is relatively low and such pollution is not significantly transboundary. We hence demonstrate that international environmental agreements can serve as cooperative devices firms use to ameliorate overproduction and increase profits, without the need to form collusive agreements.