Environmental Labeling and International Trade

This paper studies how voluntary environmental labeling programs affect consumer welfare and international trade in an open world economy. I develop a two-country model with differentiated products and imperfectly-informed consumers. Consumers in both countries are concerned about the environmental characteristics of goods, but cannot discern these characteristics unless goods are labeled. Firms in each country differ in their abilities to develop “clean” technologies, but the distribution of technological ability is superior in the home country. Consequently, the proportion of firms that have sufficient incentive to upgrade their technology in response to a labeling program is greater there. I first consider the circumstance in which the home country employs a voluntary labeling program, which certifies products that satisfy a minimum standard of environmental quality, while the foreign country lacks such an institution. I show that the home country’s terms of trade are increasing in the standard. It follows that the standard set unilaterally by the home country is greater than the standard that would be chosen by a world welfare maximizing authority. Also, I show that the volume of trade is lower under the home country program than if the labeling standard were chosen by the world authority. The volume of trade and foreign welfare, however, are greater under the home country’s program than if there is no labeling program at all. Next, I consider the possibility that both countries utilize labeling programs and assume labeling standards are set non-cooperatively by the two labeling authorities. I show that the home and foreign country standards are strategic complements, and hence an exogenous increase in the choice of labeling standard by one country will lead to an optimal choice of a greater labeling standard by the other. The paper concludes with a discussion of the global inefficiencies that result from the non-cooperative setting of environmental labels and their policy implications.