Trade, Emissions, and Regulatory (Non-)Compliance: Implications of Firm Heterogeneity

This paper provides the implications of firm heterogeneity for the global environment and trade liberalization in a trade model with endogenous markups and regulatory non-compliance. We show that firms with heterogeneous productivities respond differently to a uniform environmental regulation (emission taxation), which changes the market competition structure within a country and across countries, and disentangles the interaction effects of environmental regulations and trade liberalization. In autarky, raising emission tax generates an average productivity gain and favors efficient firms in the sense that they can expand output but may produce more emissions via non-compliance to escape the regulation and maintain competitiveness. In a symmetric two-country open economy, trade liberalization can break the trade-off between output and environment, not only increasing worldwide output but also decreasing global pollution emissions. Under asymmetric environmental regulations, a unilateral increase in the emission tax decreases average productivity in this country if openness to trade is substantially high, which contrasts with the e§ect under autarky. Our welfare analysis shows a U-shaped relationship between the optimal emission tax and openness to trade regardless of whether under tax harmonization or tax competition. Trade liberalization unambiguously decreases global pollution emissions under tax harmonization but it may increase global pollution emissions under tax competition.