International Trade and Environmental Cooperation among Heterogeneous Countries

We examine the impacts of trade liberalization and border tax adjustment (BTA) on the incentives of heterogeneous countries to cooperate when regulating emissions of a global pollutant. We consider an oligopoly model of trade between two countries, North and South, where production generates transboundary pollution and the pollution damage parameter is higher in the North. Each country imposes a pollution tax on its domestic firm, where the tax rate can be chosen either cooperatively or non-cooperatively. We analyze the sustainability of environmental cooperation between the countries within an infinitely repeated game framework using trigger strategies. While the North has a stronger incentive to cooperate than the South, we find that an increase in the degree of heterogeneity between the two countries in terms of their pollution damage parameter reduces the likelihood of cooperation between them. Trade liberalization increases both the global gains from cooperation as well as the likelihood of cooperation between the countries. Further, we consider the use of a border tax adjustment under non-cooperation, where the North imposes a tariff on imports of the polluting good from the South, and the tariff rate reflects the difference in pollution tax rates across the two countries. We find that imposing the BTA makes the North less likely to cooperate, while the South is more likely to cooperate provided the countries are sufficiently heterogeneous.