Trade Wars and Trade Talks Revisited: An extension of the Grossman-Helpman Model (1995)

This paper extends the Grossman and Helpman (1995) model to include environmental regulations, assuming perfectly competitive markets. The politically motivated government uses trade and environmental policies to regulate trade flows (either non-cooperatively through trade wars or through cooperative bargaining as in case of trade talks) and the use of the sector specific environmental resource in the production of the traded good, respectively. Results show that trade wars can be more pronounced when the polluting good traded is subject to environmental regulations in the country of origin. Despite being politically inclined, policy makers may also face a trade-off from trade policies chosen that have several implications on welfare gains/losses from environmental taxes vis-á-vis the improvement/deterioration in environmental quality. The net gain/loss from environmental regulations would thus be an additional factor influencing the trade policy adopted by a nation besides gains/losses from voting support, deadweight loss from price distortion and terms of trade gains/losses. Furthermore, there arises an additional layer of distortion in trade policy when political action groups cannot directly observe the true type of the regulator, i.e., whether he/she is highly corrupt or not. Incomplete knowledge about the degree of benevolence of the regulator causes an upward distortion in trade policy compared to the former case, except for a scenario where the regulator is purely benevolent.