Unilateral Pollution Control

Abstract

In a two-country trade framework with uncertainty on the production costs and R&D outcomes, we analyze a unilateral policy aimed at incentivizing a domestic firm to find a clean technology. Under Bertrand competition, the optimal policy is a subsidy to domestic production. We compare the full information benchmark to the case where the firm’s R&D effort is unobservable by her government. In both informational contexts, we show the irrelevance of a tariff as a trade sanction against foreign emissions: when the goods are themselves perfect substitutes, the trade policy is a perfect substitute to the environmental policy, the latter being akin to a hidden tariff. When the goods are differentiated, we show instead that the trade policy cannot be decoupled from the environmental policy: these policies become complementary under moral hazard in innovation.

I thank Larbi Dohni, Essi Eerola, David Martimort, Michael Rauscher and the participants in the SCSE conference, Montréal, JMA, Nancy, EAERE conference, Southampton, Euresco conference, Maratea, and Montesquieu Bordeaux 4 seminar for their comments. All errors are mine.