Trade, Environment, and Welfare in a Model of Monopolistic Competition

In a North-South model of trade in which the market structure is monopolistically competitive, though North's attempt to reduce pollution creates a 'pollution haven' in South, its terms of trade improve and total number of varieties produced in the world economy may increase. The paper distinguishes between the direct and indirect welfare effects of North's environmental policy. While the direct effect on welfare is due to abatement, indirect effects are results of the policy's impact on prices, wages, outputs and varieties. A complex set of forces operate to determine indirect welfare effects of a tax or tariff on a pollution-causing raw material: the crucial factors are price elasticity of demand, elasticity of substitution between labor and raw material, South's trade orientation and the dependency ratios. An optimally chosen pollution tax directly hurts but indirectly benefits South. The indirect welfare effect of a tariff is similar to that of a pollution tax. However, a positive optimum tariff may not exist, in which case North's optimum policy would be free trade.