Externalities, international policy cooperation and systems competition

Generally, the primary goal of international policy cooperation is to prevent nations from pursuing mutually harmful policies. This paper states this imperative more precisely. Assuming that the primary goal of national economic policy is to internalise externalities, production possibility frontier (PPF) expanding and PPF-contracting internalisation policies are distinguished. In a simple general equilibrium framework, Pareto-inefficient internalisation policies are modelled. The model shows that a country's natural response to another country's Pareto-inefficient PPF-expanding or PPF-contracting internalisation policy is to adopt the same policy. This leads to an alternating process of policy responses until a new equilibrium is reached. In a process of PPF-expanding (contracting) internalisation policies, the individual nation improves (worsens) its aggregate welfare level with every policy response. Consequently, only Pareto-inefficient PPF-contracting internalisation policies may qualify for international policy cooperation while PPF-expanding internalisation policies make the case for systems competition.