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Chapter 13
Trade and the Environment
Overview
We begin the chapter with two provocative questions. First, is free trade anti-environment? We
argue that it is not. There is no reason to think that trade generally promotes production or
consumption of products that cause large harm to the environment. Surprisingly, the incentive to
relocate production into “pollution havens” is usually small. Trade tends to raise world
production and incomes. While some environmental problems become worse as production and
income rise, others become less severe, in part because protecting the environment is a normal
good. Figure 13.2 provides estimates from the trade liberalization of the Uruguay Round, for the
composition and combined production and income effects. The overall environmental effects are
generally small.
Second, is the World Trade Organization anti-environment? WTO rules recognize
environmental-protection exceptions to its general thrust toward free trade, but the WTO also
worries that restrictions that governments claim to be necessary to protect the environment are
pretexts for common protectionism. A country can impose product standards to protect the
environment, but the standards must apply to all consumption, not just imports, and the standards
must be based on scientific evidence. In another area the position of the WTO seems to have
evolved with recent rulings. The WTO now seems to be willing to permit countries to limit
imports because they are produced in foreign countries using methods that the importing country
considers to be damaging to the environment, but at the same time the WTO has imposed strict
requirements to minimize the use of such policies as subterfuge for limiting imports for
nonenvironmental (protectionist) reasons. The box “Dolphins, Turtles, and the WTO,” the fourth
in the series on Global Governance, discusses cases that show the changes in WTO rulings.
Adverse environmental effects like pollution are negative externalities, distortions that lead to
failures of the market to be fully efficient. The specificity rule introduced in Chapter 10 is a
handy guide to government policy to address negative environmental externalities. In fact, there
are two types of government policy that can directly attack the distortion—imposing taxes and
subsidies, or changing property rights. As in Chapter 10, we usually use the tax-and-subsidy
approach.
The specificity rule says to use the direct approach; for instance, tax pollution directly. If this is
not possible, then the specificity rule says to select the tax or subsidy that is as close as possible
to the act creating the pollution. An additional complication is that the source of the pollution can
be our own country’s activity, another country’s activity, or the entire world’s activity. If our
country cannot achieve an international agreement, we may be left to take our own policy action,
even though the source of much of the problem is foreign activity. In this case trade barriers
could be a second-best policy that can enhance well-being. Figure 13.3 is a useful summary of
the main conclusions that can be drawn for the various possible cases.
In our formal analysis we begin with the case in which pollution caused by an activity within the
country has effects only on this country. We use tools similar to those that we developed in
Chapter 10. If the country simply allows the pollution to occur, with no government policy to
limit the negative externality, we show that free trade can make the country worse off, and that
the country can export the wrong products. This occurs because of the marginal external costs, in
our example resulting from pollution that accompanies domestic production of the export good.
A government policy that taxes pollution or production that causes pollution (or that establishes
suitable property rights) can reverse these effects, assuring that the country exports and imports
the appropriate products and gains from free international trade.
Domestic producers subject to the pollution-related tax may complain that other countries,
especially the countries that become the suppliers of the country’s imports, are not imposing a
comparable pollution-related tax on their firms. They may complain that the foreign firms are
engaged in “eco-dumping.” From the perspective of the importing country, lax foreign controls
should not matter to its well-being, as long as the foreign pollution does not affect it.
The analysis of transborder pollution raises new issues. We use the example of production
activity in one country that pollutes a river flowing into a neighboring country. The best solution
would balance the gains to the polluting country from dumping waste into the river with the costs
of pollution to the receiving country. Generally, this best solution is less pollution than the
amount that occurs with no government policy, but more than zero pollution. However, the
government in the polluting country may resist imposing a pollution tax (or some other way to
limit pollution by its firms), because it bears the national costs while the other country gets the
national benefits. If international negotiations fail, what should the receiving country do? It
cannot tax the foreign pollution or even the foreign production that causes pollution. If the
receiving country imports the product from the polluting country, it could try to reduce the
foreign production and pollution by restricting its imports. The country will gain if its benefits
from lower foreign pollution exceed the usual deadweight losses of protection. (If instead the
receiving country is an exporter of this product to the polluting country, it could subsidize its
exports.) However, the WTO generally interprets its environmental exceptions narrowly, so it is
not clear that the WTO would uphold the import restriction (or export subsidy), if the polluting
country complained to the WTO.
The difficulty of addressing transborder pollution is also shown through a discussion of the slow
progress that NAFTA has made in attempting to ameliorate environmental problems along the
Mexico-U.S. border.
Some environmental problems are global—the whole world’s economic activity imposes an
external cost on the whole world. Each country might be willing to make some effort to reduce
its own pollution, because it recognizes that its own activities have some adverse effect on itself.
But each country on its own would not decrease enough, because it would not recognize the
costs that its pollution imposes on other countries. Yet the world, and most countries, would be
better off if the countries cooperated to reduce the pollution more. Such global agreements are
difficult to achieve, because of disagreements about the how serious the problem is, the incentive
to free-ride, and the difficulty of enforcement.
The chapter concludes with four examples of global environmental problems. The Convention on
International Trade in Endangered Species of Wild Fauna and Flora (CITES) attempts to prevent
extinction of species by restricting or banning commercial trade in threatened species. It has been
reasonably effective. But it may need to shift toward encouraging sustainable use of many
threatened species, through economic management of the species for commercial uses.
Overfishing is an example of the tragedy of the commons. It does not threaten extinction for
most species, but rather it results in fish catches that are smaller than they could be. We pay a
global cost (recently estimated to be $50 billion per year) for our inability to conclude effective
international agreements to prevent overfishing.
Release of chlorofluorocarbons (CFCs) has resulted in ozone depletion. The Montreal Protocol,
signed in 1987, is an example of an effective international agreement. It began with restrictions
on trade in CFCs and has spread to reduction of production of CFCs. It has been successful in
replacing CFCs with less harmful alternatives, and concentrations of CFCs in the atmosphere are
now slowly declining.
The buildup of carbon dioxide and other greenhouse gases in the atmosphere, and the likelihood
that this is causing global warning, is perhaps the largest global environmental challenge. We
cannot use science to predict exactly how much global warming will occur. The scientific
uncertainty probably argues for taking moderate steps as “insurance” while awaiting better
information. However, three palatable policy options—removing energy subsidies, planting new
forests, and waiting for scarcity to raise the prices of fossil fuels—would have effects that are too
small to help much. Furthermore, the specific problem is clearly not international trade in fossil
fuels or other sources of greenhouse gases. The problem is the worldwide activity, especially
burning fossil fuels, that releases greenhouse gases.
Actual global negotiations and agreements to reduce greenhouse gas emissions have been
disappointing so far. In the Kyoto Protocol, many industrialized countries made commitments to
reduce their greenhouse gas emissions, but developing countries have refused to make any
commitments. The Protocol came into effect in 2005, but the United States and Australia decided
not to ratify it. (Australia ratified in 2007.) The effects of the Protocol’s first phase were small.
Some ratifiersdid not meet their emissions targets. Emissions increased in the United States and
in many developing countries.
The chapter concludes with the presentation of the results of a recent IMF study that estimates
what a sensible global approach to global warming would look like. A policy response consistent
with the specificity rule is to tax consumption (or production) of fossil fuels on a global scale.
The IMF concludes that such a global approach could stabilize greenhouse gas concentrations at
a reasonable level with only modest costs in terms of foregone production of regular products
(results summarized in Figure 13.6). The economics are promising, so the challenge is
negotiating such a global agreement.
Tips
The material of this chapter lends itself to additional examples. The instructor can introduce extra
material in lecture, in class handouts, or in additional readings. Some examples include the threat
to the marine population of the Galapagos, water quality and air quality along the Rio Grande,
the U.S. diversion of water in the Colorado River before it gets to Mexico, the paper mills in
Uruguay that have been opposed by Argentina, dams on the Mekong River, the drift of air
pollution from China to South Korea and Japan, and overfishing of tuna (especially bluefin tuna).
As interesting examples are included in the discussion, we recommend keeping economic
principles in full view. It is useful to remind students that:
incentive distortions and imperfect property rights are crucial causes of environmental
problems, whether these problems are international or not;
there are two basic policy approaches—the (Pigovian) tax-and-subsidy approach, and the
(Coasian) property-rights approach;
we keep discovering new uses for the specificity rule introduced in Chapter 10; and
this rule almost never recommends trade policy as a first-best approach to environmental
problems.
An instructor may want to consider an assignment in which students (working individually or in
groups) report on a country’s environmental problems and policies or report on an international
environmental issue.
