Trade, Spatial Separation, and the Environment

We develop a simple two-sector dynamic model to examine the effects of international trade in the presence of pollution-created cross- sectoral production externalities. We assume that the production of 'Smokestack' manufactures generates pollution, which lowers the productivity of an environmentally sensitive sector ('Farming'). As a result, the long run production set is non-convex. Pollution provides a motive for trade, since trade can spatially separate incompatible industries. Two identical, unregulated countries will gain from trade if the share of world income spent on Smokestack is high. In contrast, when the share of world income spent on the dirty good is low, trade can usher in a negatively reinforcing process of environmental degradation and real income loss for the exporter of Smokestack.