Global Environmental Standards with Heterogeneous Polluters

Transcription

1 International Review of Eonomis and Finane, forthoming Global Environmental Standards with Heterogeneous Polluters Ting Levy* Florida Atlanti University Elias Dinooulos University of Florida Current Version: Deember 18, 2015 Abstrat: We introdue environmental quality standards into a model of intra-industry trade with heterogeneous olluters. Pollution stems from onsumtion and ollution intensity delines with rodut-seifi environmental quality. We formally analyze the effets of environmental standards and trade liberalization on intra-industry trade atterns, ollution, and welfare. Trade liberalization takes the form of lower er-unit trade osts, lower fied foreign-market entry osts, or greater number of trading artners. When onsumer referenes for environmental quality are weak (strong) relative to the environmental quality elastiity of rodution osts, firms disovering dirtier (leaner) roduts are more rofitable and engage in eorting. More stringent environmental standards or trade liberalization oliies enhane er-aita real onsumtion. The effets of these oliies on global ollution and welfare are ambiguous. JEL Classifiation: Q48, Q53 and L91 Key words: intra-industry trade; firm heterogeneity; environmental standards; environmental R&D. * Ting Levy: Deartment of Eonomis, Florida Atlanti University, Boa Raton, Florida, tlevy6@fau.edu; Tel: (352) Elias Dinooulos: Deartment of Eonomis, University of Florida, Gainesville, FL dinooe@ufl.edu; Tel: (352)

2 1. Introdution The neus between trade and the environment has generated an intense aademi and oliy debate. 1 Desite the large body of theoretial and emirial literature, the hannels through whih international trade influenes environmental quality are not well understood. Consider, for instane, the effets of tougher environmental standards on international ometitiveness and global ollution. On the one hand, Porter (1991) and Porter and Van der Linde (1995) argue that tough environmental standards trigger environmentally friendly tehnologial innovations that may redue global ollution and enhane international ometitiveness. On the other hand, Palmer et al. (1995), iting survey evidene argue that the osts of environmental regulations eeed their benefits imlying that environmental regulations harm international ometitiveness. Similar onsiderations aly to several other ontroversial hyotheses onerning the effets of globalization on the environment. Aording to the rae to the bottom hyothesis, imort ometition from ountries with low environmental standards uts ressure for less stringent environmental regulations in ountries with high environmental standards; the ollution heaven hyothesis asserts that ountries with low environmental standards beome destinations of multinationals using ollution-intensive tehnologies leading to higher global ollution; and the gains from trade hyothesis states that oenness enourages growth and innovation both of whih ould imrove environmental quality. The aforementioned arguments have been develoed using traditional stati and dynami trade models generating inter-industry trade based on omarative advantage (Bovenberg and Smulders, 1995; Brok and Taylor, 2005; Chao and Yu. 2007). A few studies have addressed environmental issues in oen eonomies engaging in intra-industry trade generated by symmetri monoolistially ometitive firms (Gurtzgen and Rausher, 2000; Fung and Maehler, 2005; Haut, 2006;), or multi-ountry models with trade osts generating Riardian trade under erfet ometition (Erdogan, 2014). The resent aer studies formally the imat of environmental standards and globalization in an eonomi environment haraterized by environmental-quality heterogeneity. It is artially motivated by the global automobile industry whih onstitutes a major soure of air ollution. 2 The global automobile industry features substantial intra-industry trade and rodut-seifi heterogeneity in environmental quality. 3 1 Frankel (2009) offers an eellent overview of the literature addressing the environmental effets of trade. 2 Emissions, suh as air tois and urban smog, ontribute substantially to health and environmental degradation. Additionally, a tyial onsumer s most olluting daily ativity is ar driving. On average, eah ar generates 20 ounds of CO 2 er gallon burned leading to 6 to 9 tons of CO 2 emissions eah year. For a tyial household in the United States, vehile emissions ontribute to 51% of CO 2, followed by household alianes (26%), and heating and ooling (18%). 3 Cars with different fuel effiieny deliver different amounts of emissions. For instane, among 2014 models, Chevrolet Sark EV delivers 119 miles er gallon whereas Meredes-Benz SLS delivers 14 miles er gallon. Many ountries inluding the United States, Jaan and Germany eort and imort ars and truks from eah other. Feenstra and Taylor (2014, Table 6-4) reort that in 2012 the value of intra-industry inde for small ars was 40 erent. 2

3 Environmental standards on vehile emissions onstitute an imortant national and global oliy tool used to imrove air quality. These environmental quality standards are eressed as minimum fuel effiieny requirements in the United States or maimum CO 2 emissions in Euroe. 4 Finally, the global harater of the automobile industry has generated international ooeration leading to a global harmonized emission standard. Investment in environmental R&D is ommon in U.S. manufaturing industries and aounts for a sizable share of R&D. Sott (2003) surveys a grou of manufaturing omanies and reorts that, on average, 23.9% of firm R&D eenditures are hanneled towards environmental rojets. Moreover, over one-half of the firms artiiating in the survey indiate that environmental R&D rojets are undertaken beause of seifi environmental legislation. Goldberg (1998) onfirms this finding by arguing that Cororate Average Fuel Eonomy Standards (CAFE) regulation offers inentives to develo environmentally friendlier tehnologies and vehiles. In this aer we roose a model of intra-industry trade with heterogeneous olluters and struturally symmetri ountries to address the following questions. What determines environmental-quality heterogeneity within eah industry and the environmental ontent of intra-industry trade? Do more stringent global environmental standards lower industry rodutivity and ometitiveness? What are the effets of higher environmental standards and trade liberalization on global onsumtion-based ollution, and welfare? Following the theory of trade with heterogeneous firms, we envision a global eonomy onsisting of many struturally idential ountries with labor as the sole fator of rodution. 5 We are the first to reognize that the assumtion of struturally idential ountries is restritive and eludes the analysis of North-South environmental issues inluding national differenes in emission standards. However, this assumtion arries several advantages. First, it offers onsiderable analytial mileage and sharens the intuition of main results. Seond, the assumtion of symmetri ountries eludes links between trade and the environment that have been analyzed etensively by other studies: there are no gains from trade based on terms-of-trade hanges; there are no ross-ountry inome differenes; and there are no inentives for international fator movements. In other words, the assumtion of struturally idential ountries highlights the environmental effets of firm heterogeneity whih is missing from the eisting literature on trade and the environment. In our model, new varieties are disovered through resoure-based environmental R&D investment. Firms engage in environmental R&D in resonse to government regulations with the urose of meeting the minimum 4 In 2009, President Barak Obama announed higher emission standards requiring eah manufaturer to reah an average of 35.5 miles er gallon (MPG) by The Euroean Union has adoted the grams er kilometer ar emissions standard (EU NEDC). An et al. (2011) rovide more details on oliies assoiated with vehile emissions. 5 The literature develoing the theory of trade with heterogeneous firms inludes Melitz (2003), Melitz and Ottaviano (2008), Baldwin and Harrigan (2011), and Johnson (2012) among many others. Redding (2011) rovides an eellent literature review of theories of trade with heterogeneous firms. 3

4 environmental quality standard. 6 We view environmental R&D as a omulsory investment before any rodution materializes. We assume that firms ay a fied entry ost to invest in environmental R&D enabling them to draw an environmental quality arameter from a ommon and known distribution. Eah suessful firm learns the environmental quality level and faes an eogenous, government-imosed, minimum environmental-quality standard, suh as CO 2 emissions. If the disovered variety does not meet this standard, the firm eits the market immediately. Firms roduing roduts with environmental quality equal or greater than the government imosed standard serve the market. Additionally, we assume that the marginal ost of rodution inreases with the level of environmental quality. For instane, in the ase of ars installing lighter materials, high-quality batteries, better eletroni omonents, and using more high-skilled workers raise both fuel effiieny and er-unit rodution osts. As in Melitz (2003), suessful firms an engage in eorting by aying a fied foreign-market entry ost and inurring a er-unit trade ost. These assumtions rovide an endogenous eort utoff environmental quality level that artitions firms by eort status. The government-imosed standard serves the same urose in the resent model as the domesti fied ost of rodution in the literature on heterogeneous firms and trade. As in the ase of vehiles and household alianes, onsumtion generates ollution. The amount of ollution er variety is roortional to the quantity onsumed adjusted by the ollution intensity. The latter dereases with variety s environmental quality. In other words, firms that disover roduts with higher environmental quality ehibit lower ollution intensities. This assumtion is onsistent with evidene on ars: the 2015 Mitsubishi Mirage with fuel effiieny of 37 MPG emits 238 grams of CO 2 er mile, whereas the 2015 Chevrolet Sark EV (eletri) with fuel effiieny of 119 MPG emits lose to zero grams of CO 2. 7 In the model, firms and onsumers take aggregate ollution as given. Firms with larger revenues, enjoy greater oerating rofits, over fied and variable trade osts and engage in eorting. This redition is onsistent with evidene that within narrowly defined rodut ategories firms earning larger revenues and rofits engage in eorting. 8 One of our main findings is identifying onditions under whih leaner or dirtier roduts are traded. These onditions stem from the green elastiity whih inreases with the intensity of onsumer referenes for environmental quality and dereases with the quality elastiity of rodution osts. The ase of leaner intraindustry trade arises if onsumers ehibit strong referenes (relative to osts) for environmental quality leading to a ositive green elastiity. Firms roduing roduts with high environmental quality are larger, harge higher 6 Environmental R&D may redue the ost of abatement or redue the amount of olluting inuts used in the rodution roess, as in Bovenberg and Smulders (1995) and Xeaadeas and Zeeuw (1999). 7 See the offiial U.S. government soure for fuel eonomy information. 8 See Tybout (2003) for a survey of early emirial studies doumenting that eorting firms are larger and more rodutive. 4

5 ries, earn greater revenues, and eort their roduts; firms disovering roduts with lower environmental quality harge lower ries, earn lower revenues and serve the domesti market only. The ase of dirty intra-industry trade arises when onsumer referenes for environmental quality are weak relative to rodut osts leading to a negative green elastiity. In this ase, firms disovering varieties with low environmental quality harge lower ries, earn higher revenues and rofits and eort their roduts. As a result, the model generates eo-duming in the absene of omarative advantage and international aital movements. In other words, the model offers a novel intra-industry version of the rae to the bottom hyothesis based on self-seletion of heterogeneous olluters where ost-leadershi (as oosed to environmental quality leadershi) onfers international ometitive advantage to firms roduing dirtier and heaer roduts. We also analyze the effets of more stringent environmental quality standards and trade liberalization on er-aita onsumtion, global ollution and welfare. Trade liberalization takes the form of lower er-unit trade osts, lower fied osts of entering foreign markets, or more trading artners. Welfare is modeled as the differene between er-aital onsumtion and global ollution. We establish that a striter global environmental quality standard or any form of trade liberalization inrease er-aita onsumtion. The intuition behind this result is analogous to the standard intuition rovided by the theory of trade with heterogeneous firms: these oliies shift resoures from environmental R&D and firms serving the domesti markets to eorters. As a result, the measure of varieties available for onsumtion rises leading to a lower rie inde and an inrease in er-aita real inome and er-aita onsumtion aggregated over all available varieties. The effets of global environmental standards and trade liberalization on global ollution are ambiguous. As said, these oliies raise the number of onsumed varieties and lower the average quantity onsumed by inreasing the intensity of ometition. Pollution intensity dereases with environmental quality introduing another fator that lowers ollution. The inrease in the measure of onsumed varieties raises the etensive margin of ollution whereas the deline in quantity onsumed redues the intensive margin of ollution. As a result, the imat of trade liberalization and global standards on ollution is ambiguous. 9 This ambiguity is inherited in the welfare effets of these oliies beause welfare deends negatively on global ollution. The rest of the aer is organized as follows. Setion 2 disusses the ontribution of our aer to related studies. Setion 3 resents elements of the model and desribes the steady-state equilibrium. Setion 4 studies the effets of a more stringent environmental standard and trade liberalization on global ollution, er-aita 9 The ambiguity of trade on ollution is refleted in the emirial literature. For instane, Frankel and Rose (2005, 89) state The ase that would give an environmentalist the greater onern is CO 2. The oeffiient on oenness (measured by value of trade over GDP) is ositive and moderately signifiant imlying that trade oenness inreases ollution in this ase. Roy (2015) using a similar methodology, based on the gravity equation alied to a ross setion of ountries argues that the elastiity of ollution with reset to intra-industry trade is substantially greater than the elastiity of ollution with reset to trade oenness. Seifially, he finds that one erent hange in the inde of intra-industry trade redues CO 2 emissions by at least 5.9 erent, whereas one erent hange in trade oenness inreases CO 2 by u to 0.4 erent. 5

6 onsumtion and welfare. Setion 5 onludes. We relegate algebrai details ertaining to roofs of roositions to the Aendi. 2. Related Literature The resent aer omlements the theory of trade with heterogeneous firms ioneered by Melitz (2003) by adding two novel features. First, it establishes that in the resene of a binding rodut quality standard, the searation of firms by eort status deends on virtually all model arameters (as oosed to just trade osts and fied domesti osts). Seond, it shows that the effet of higher minimum quality standards and trade liberalization on the omonent of welfare that does not deend on ollution is benefiial. In other words, in the absene of ollution, higher rodut-quality standards imrove welfare through similar hannels to those triggered by trade liberalization. The identifiation of onditions that result in lean or dirty intra-industry trade ontributes to two strands of literature. First, the ase of lean intra-industry trade is onsistent with the Porter Hyothesis that relates striter environmental standards and to international ometitiveness (see Po (2005) and Xeaadeas and de Zeeuw (1999), among others). A reent study of the Euroean Automobile industry by Miravete, Moral and Thurk (2014) shows that the emissions oliy emloyed by Euroean regulators not only romoted the diffusion of diesel vehiles, but also inreased the rofitability of domesti manufatures by roviding Euroean automakers a omarative advantage. Using standard business terminology, the ase of a ositive green elastiity in our model orresonds to eloitation of ometitive advantage based on benefit leadershi. Seond, our aer ontributes to the debate on ollution havens and ollution duming, one version of whih states that ountries with low environmental standards or omarative advantage in ollution-intensive goods rodue dirty goods whih are eorted to ountries with higher environmental standards, or omarative advantage in leaner goods (Frankel and Rose, 2005; Frankel, 2009). Our model identifies an intra-industry trade based mehanism of ollution duming whih is indeendent of national differenes in environmental standards, fator endowments, or movements of aital to ountries with low environmental standards. In our model, in the ase of weak referenes for environmental quality, firms that rodue heaer and dirtier roduts eort them abroad in an environment of idential ountries and a binding global environmental quality standard. These firms earn higher rofits than average industry rofits (ometitive advantage) in a global eonomy with symmetri ountries in the absene of omarative advantage and differenes in national environmental standards. Finally our aer omlements Kreikemeier and Rihter (2014) who roose a model of a small oen eonomy oulated by heterogeneous firms differing in rodutivity (as oosed to rodut quality) to study the effets of intra-industry trade on rodution-generated ollution. In ontrast, our model fouses on onsumtiongenerated ollution, a global eonomy haraterized by many ountries, and the effet of minimum environmental 6

7 quality standards. As a result, we generate onditions leading to dirty or lean intra-industry trade and take into aount the effets of oliies on the measure of imorted and onsumed varieties. These features are absent from their model. 3. The Model Following the theory of trade with heterogeneous firms, we analyze a global eonomy onsisting of n 1 struturally idential ountries with n 1. As said, the assumtion of struturally idential ountries is admittedly restritive but neessary to solve the model. This assumtion, whih enhanes the analysis and sharens the intuition, has been emloyed by a large number of studies inluding the ioneering artile by Melitz (2003). It highlights the effets of environmental standards on heterogeneous olluters in the absene of omarative- advantage, international fator mobility, and inome differenes aross ountries. Eah ountry onsists of a sole industry roduing differentiated goods with labor being the only fator of rodution. The aggregate suly of labor in eah ountry, denoted by L, is fied and remains onstant over time Consumers The referenes of a reresentative onsumer are given by U Q Z. (1) Variable Q denotes er-aita onsumtion aggregated over a ontinuum of roduts and is defined by the following Diit and Stiglitz (1977) sub-utility funtion 1/ q( ) Q ( ) d. L (2) In Eq.(2), eah variety is indeed by and denotes the set of all varieties onsumed in a tyial ountry. Parameter 0 1 imlies that the onstant elastiity of substitution between any two varieties or brands is 1/ (1 ) 1. Variable q( ) denotes aggregate onsumtion of brand, and ( ) 1 denotes its timeinvariant environmental quality. Motivated by the automobile industry, we onsider environmental quality as losely related to the fueleffiieny of different vehiles as in the US CAFÉ standard. For eamle, an eletri vehile is assoiated with a large value of ( ) whereas a standard SUV ommands a low value of ( ). Parameter 0 is the onstant elastiity of onsumer s sub-utility with reset to environmental quality ( ) and measures the intensity of 7

8 onsumer referenes for environmental quality. 10 A larger value of imlies higher ereived environmental quality and greater onsumer willingness to ay for eah variety. Consumtion generates ollution. The following funtion defines aggregate ollution (summed over all varieties onsumed in a ountry) Z z( ) d, (3) where z( ) is the amount of ollution er variety onsumed and given by z( ) q( ) / ( ). (4) Pollution er variety z( ) is diretly roortional to onsumed quantity q( ); and ollution intensity er variety / ( ) is inversely related to variety-seifi environmental quality. Parameter 0 is ommon among all varieties with higher values of imlying higher ollution intensity; whereas higher values of environmental quality ( ) imly lower ollution intensity. Where 0, onsumtion does not generate any ollution and the model is equivalent to a model of trade with quality heterogeneity. Consuming varieties with higher environmental quality inreases welfare through two distint hannels: it raises utility diretly (analogous to a higher rodut quality); and redues ollution intensity resulting in a leaner environment. Based on the literature on trade and the environment, we model the seond hannel as an eternality: the reresentative onsumer behaves as though her own behavior does not affet aggregate ollution. Note that the assumtion of symmetri ountries imlies that the level of global ollution is equal to the eogenous number of ountries times the level of national ollution. As a result, issues assoiated with transboundary ollution do not arise in the resent model. Eah onsumer maimizes utility (1) taking aggregate ollution Z as given, subjet to the budget onstraint ( )[ q( ) / L] d E, where ( ) is the market rie; E is er-aita onsumer eenditure, and L is the number of onsumers in a tyial ountry. This maimization roblem yields the market quantity demanded q( ) and eenditure r( ) ( ) q( ) for variety q( ) ELP ( ) ( ) 1 ( 1) ; r( ) ELP ( ) ( ) 1 1 ( 1). (5) 10 Aording to a 2014 survey by the Consumer Reorts National Researh Center, quality, safety, erformane, value and fuel eonomy are the most imortant onsiderations for today s new-ar buyers. Consumers are willing to ay higher ries and even submit to a waiting list to urhase environmentally friendly eletri and hybrid vehiles. 8

9 Variable P is now defined as the green rie inde, that is, the standard rie inde adjusted for environmental quality 1/(1 ) 1 ( ) P d. (6) ( ) Where onsumers do not are about environmentally friendly roduts ( 0 ), the green rie inde equals the standard aggregate rie inde, as in Melitz (2003). Firm revenue r( ) dereases with rie beause eah firm faes an elasti demand urve. However, for any rie level, greener roduts enjoy greater demand and revenues refleting onsumer demand for environmental quality. Term ( ) / ( ) atures the effetive environmental quality of variety and will lay a ivotal role in the determination of intra-industry trade. The numerator desribes the onsumer valuation of environmental quality (ereived benefit) and thus the effetive environmental quality is simly er-dollar ereived environmental quality. In other words, onsumer demand for a variety with environmental quality ( ) deends on the effetive environmental quality ( ) / ( ) Workers and Firms As said, labor is the sole fator of rodution with eah worker sulying one unit of labor. As a result, labor suly is inelasti and equal to the number of onsumers L. There is a ontinuum of firms with eah firm hoosing to rodue a different variety. In eah ountry the government sets the (global) environmental quality standard, whih is denoted with. Firms must invest in environmental R&D to disover new varieties. Eah otential entrant inurs a fied entry ost fe 0, measured in units of labor, and interreted as the number of R&D researhers required to disover a new variety. After inurring the said fied ost, a firm disovers a new variety and the embedded environmental quality by drawing arameter ( ) from a general and ommonly known distribution with ositive suort. After drawing its environmental quality, a firm has to deide whether to enter the domesti and foreign markets based on government regulations and rofitability onsiderations. If the environmental quality of a newly disovered variety does not meet the global (and national) environmental standard ( ( ) ), the firm eits the market. If the new rodut meets the environmental standard ( ( ) ), the firm manufatures the rodut without inurring any fied rodution osts. We assume that the environmental standard is stritly enfored and 9

10 abstrat from omliane issues stemming from firm attemts to oneal the true value of environmental quality. 11 Manufaturing of variety entails marginal (and average) osts that inrease with environmental quality. In order to rodue q( ) units of outut, l( ) ( ) q( ) units of labor are required, where 0 is the onstant elastiity of unit-labor requirement with reset to environmental quality. Thus eah firm faes onstant marginal and average osts ( ) w, where w denotes the wage rate. For eamle, we adot the reasonable assumtion that, all else equal, resoures (and osts) required to rodue an eletri Nissan Leaf delivering 114 MPGe eeed resoures needed to manufature a Honda Civi delivering 35 MPG. For the remainder of this aer, we omit inde and use the environmental quality arameter to denote a artiular variety when this ratie does not reate notational ambiguity. Firms meeting the environmental standard serve the domesti market but fae additional osts to enter eah foreign market. Entry into a foreign market requires er-eriod fied osts f 0 measured in units of labor and er-unit trade ost 1. The latter is modeled in the usual ieberg fashion: units must be rodued in the ountry of origin in order for one unit to arrive in the destination ountry. Eorting osts are indeendent of environmental quality. Regardless of differenes in environmental quality, eah firm faes a onstant elastiity demand urve, as er Eq. (5). A firm serving the domesti market maimizes rofits by taking the measure of varieties onsumed and green rie inde P as given. Standard alulations deliver the following riing rules. A firm with environmental quality sets its domesti rie d ( ) and eort rie ( ) in eah foreign market as a onstant marku over marginal ost d ( ) / ; ( ) /, (7) where we set the wage rate equal unity ( w 1) in Eq. (7) by hoosing labor as the numeraire. A firm with environmental quality faes greater marginal osts when serving a foreign market as oosed to serving the domesti market beause 1. Firms roduing goods with higher environmental quality harge higher ries In Setember 2015, the German automaker Volkswagen was issued a notie of violation by the US EPA after it beame known that the omany had equied vehiles owered by turboharged diret injetion diesel engines with software rogramming that ativated the nitrogen oides emissions ontrols only during laboratory emissions testing. This redued the emission levels during testing below the emission levels during atual driving. Volkswagen announed lans to send more than $7 billion on fiing these emission violations. 12 Eq. (5) imlies that eah firm faes a marginal revenue funtion MR (1 1/ ) whih delines with quantity, beause / q 0, and onstant domesti and foreign marginal osts: MC and MC, resetively. Setting marginal revenue equal to marginal ost in eah market delivers Eq. (7). The downward sloing marginal revenue funtion and onstant marginal osts features ensure that the seond-order onditions for rofit maimization hold. 10

11 The onsumer willingness to ay and the market rie deend on environmental quality. The green elastiity reflets this deendene. Definition 1: Let ( ) / ( ) denote the market effetive environmental quality, where the rofitmaimizing rie ( ) is given by Eq. (7). The green elastiity ln ( )/ ln a denotes the erentage hange in effetive environmental quality ( ) brought about by one erent hange in atual environmental quality. In the resent model, the green elastiity is onstant. When is ositive (negative), the effetive environmental quality inreases (dereases) with atual environmental quality. This roerty has imliations for the attern of intra-industry trade. The quantities of a variety with environmental quality sold in the domesti and eah of n foreign markets are given by 1 ( 1) qd ( ) ELP ; q ( ) 1 ( 1) ELP. (8) Total quantity q( ) rodued by a firm deends on eort status. A firm serving only the domesti market rodues 1 ( 1) q( ) qd ( ) ELP, (9) whereas eah eorter rodues q( ) q ( ) nq ( ) (1 n ) q ( ) (1 n ) ELP. (10) 1 ( 1) d d Domesti revenue r ( ) ( ) q ( ) and revenue in eah of n foreign markets r ( ) ( ) q ( ) are given by d d d r ( ) EL( P) d 1 ( 1) ; Firm revenue deends on eort status as well and given by ( 1) d r ( ) r ( ) EL( P). (11) r( ) r ( ) I nr ( ) (1 I n ) r ( ) (1 I n ) EL( P), (12) d d where I is the indiator funtion whih equals one if the firm engages in eorting and zero if the firm serves only the domesti market; and ( )( 1) ( 1) (13) denotes the environmental-quality elastiity of firm revenue. Eq. (12) reveals that the green elastiity regulates the deendene of firm revenue (and oerating rofits) on environmental quality. Seifially, the elastiity of revenue with reset to environmental quality ln r( ) / ln is onstant and equal to ( 1), where 1/(1 ) 1 is the elastiity of substitution 11

12 between two varieties and the rie elastiity of demand for eah variety. As a result, the sign of green elastiity is the same as the sign of ln r( )/ ln. The intuition behind this roerty is as follows. Eq. (5) indiates that an inrease in environmental quantity raises the quantity demanded and firm revenue for any given rie. However, the effet of environmental quality on the otimal firm revenue is ambiguous: first, for a given rie, an inrease in by one erent raises firm revenue diretly by ( 1) erentage oints; seond, oneerent inrease in raises the rofit-maimizing rie by erentage oints (see Eq. (7)) and thus lowers firm revenue by ( 1) erentage oints beause eah firm faes an elasti demand urve. Consequently, the overall effet of environmental quality on firm revenue is ambiguous and deends on green elastiity. If, where onsumers have a strong referene for environmental quality, the green elastiity is ositive and leaner, more eensive roduts enjoy larger revenues. If, where onsumers are more about the osts of environmental quality, the green elastiity is negative and dirtier, heaer roduts enjoy larger revenues. We ontinue the analysis by stating the roerties of rofit flows. Standard alulations imly that domesti rofits and rofits from eorting are roortional to orresonding revenues. Seifially, for a firm whih meets the global environmental standard ( ), domesti rofit flow ( ) is given by ( ) r ( ) /, (14) d d and rofit flow ( ) earned from sales in eah of n foreign markets is ( ) r ( ) / f, (15) where f is the fied ost of foreign-market entry. As a result, total er-eriod rofit ( ) is given by ( ) ( ) In ( ), (16) d where I assumes the value of zero if the firm serves the domesti market only and the value of one if the firm serves all eort markets. The following lemma summarizes the basi findings so far. d Lemma 1: Ative firms harge ries whih inrease with environmental quality. If the green elastiity is ositive, then firms disovering roduts with higher environmental quality earn larger revenues and rofit flows. If the green elastiity is negative, then firms disovering roduts with lower environmental quality earn larger revenues and rofit flows. Sine eorting involves fied osts, only the larger and most rofitable firms meeting the global environmental standard serve all foreign markets. Lemma 1 states that the green elastiity determines the environmental ontent of intra-industry trade, as will be disussed later. 12

13 The amount of ollution z( ) emitted by a firm deends on eort status as well. A firm disovering a rodut with environmental quality emits z( ) z ( ) I nz ( ) (1 I n ) z ( ) (1 I n ) ELP, (17) 1 ( 1) ( 1) d d where I is the eort-status indiator funtion. The effet of environmental quality on ollution er variety is in general ambiguous. An inrease in quality redues ollution diretly, as indiated by Eq.(4), but has an ambiguous effet on quantity onsumed q( ), as established by Eq. (10). Thus, if the green elastiity is negative firms with higher quality rodue less and generate less ollution. If the green elastiity is ositive and suffiiently high, then firms with greener roduts rodue more units than firms with dirtier roduts and thus ontribute to ollution more Entry Deisions Following the ioneering work of Melitz (2003), suose that in eah ountry there are large numbers of rosetive e-ante idential entrants. A firm engaged in environmental R&D inurs fied entry ost fe 0. This initial ost allows it to draw its environmental quality arameter from a ommon and known distribution g( ) with ositive suort over (0, ) and with ontinuous umulative distribution G( ). After observing its environmental quality level, eah firm deides whether to eit the market immediately or start roduing. Countries are idential and thus every ountry sets the same environmental standard, eressed as a minimum environmental quality level 1. The global standard is stritly enfored and serves as the domesti utoff quality (rodutivity) level in the theory of heterogeneous firms. If a firm disovers a rodut with environmental quality, then the government does not allow it to enter the market. If a firm disovers a rodut with environmental quality equal to or greater than the standard, then it is allowed to enter the market and thus earns ositive oerating (and total) rofits. After learning its environmental quality level, a firm must deide whether or not to eort by inurring a fied eort ost f 0 and a er-unit trade ost 1. The eort utoff level of environmental quality determined imliitly by setting the flow of rofits from eorting equal to zero is ( ) r ( ) / f 0 r ( ) f. (18) Firms earning ositive rofits from eorting ( ( ) 0 or r( ) f) serve all foreign markets. However, whether firms roduing greener or dirtier roduts beome eorters deends on the sign of green elastiity as stated in Lemma 1. trade. The following roosition summarizes our findings regarding the environmental attern of intra-industry 13

14 Proosition 1: Firms with higher environmental quality roduts ( ) inur higher marginal osts and harge higher ries. The attern of intra-industry trade deends on green elastiity as follows: (i) If the green elastiity is ositive ( 0 ) and firms fae suffiiently high foreign-entry market osts f, then the eort utoff environmental quality level is stritly greater than the global environmental standard ( ); firms roduing roduts with low environmental quality suh as earn lower rofits and serve only their domesti market; and firms roduing roduts with high environmental quality suh as earn higher rofits and serve their domesti and all foreign markets. (ii) If the green elastiity is negative ( 0 ) and firms inur suffiiently low foreign-market entry osts f, then the eort utoff environmental quality level is stritly greater than the global environmental standard ( ); firms roduing varieties with low environmental quality suh as earn higher rofits and serve their domesti and foreign markets; and firms roduing varieties with high environmental quality suh as earn lower rofits and serve only their domesti market. Proof: Please see the Aendi. Proosition 1 highlights the role of green elastiity in determining the environmental attern of intraindustry trade. In the ase of ositive green elastiity and suffiiently high trade osts, firm global ometitive advantage stems from benefit (as oosed to ost) leadershi. Consumers have strong referenes for environmental quality, and thus firms with leaner, more eensive roduts earn higher rofits, inur both fied and variable trade osts and eort their roduts. Firms disovering dirtier roduts, harge lower ries and serve only the domesti market beause they annot ay the high trade osts of entering and serving foreign markets. In ontrast, when the green elastiity is negative and trade osts suffiiently low, the model generates dirty intra-industry trade. In this ase, onsumers are more about osts than ereived environmental benefits, generating favorable onditions for ost (as oosed) to benefit leadershi as a strategy to ahieve global ometitive advantage. Consequently, firms disovering roduts with low environmental quality harge lower ries and enjoy higher oerating rofits, whereas firms disovering leaner roduts harge higher ries and earn lower rofits. The latter annot over the ost of eorting and serve the domesti market only. As a result, for suffiiently low trade osts, a negative green elastiity generates dirty intra-industry trade. In other words, 14

15 when the green elastiity is negative, the model generates intra-industry eo-duming where the environmental ontent of trade is lower than the environmental ontent of good rodued by firms serving the domesti market only. Where the green elastiity is zero (that is, ), rofit-maimizing revenues (and rofit flows) are indeendent of environmental quality. In this seial razor s edge ase, all firms eort their roduts for a suffiiently low value of the global environmental standard; whereas, for a suffiiently high value of the global environmental standard, all firms serve their domesti markets only. This imliation is unrealisti and inonsistent with emirial studies asserting that some firms eort and others serve only their domesti markets within narrowly defined rodut ategories. We therefore fous on and analyze the ases of lean and dirty intra-industry trade. Proosition 1 generates the artition of firms into eorters and non-eorters whih deends on eraita eenditure E and the green rie inde P. These variables are endogenous. This means that the revious disussion relating the attern of intra-industry to the sign of green elastiity does not take into aount firm-entry onsiderations. In Setion 2.6, we will desribe the steady-state equilibrium onditions and establish the generalequilibrium validity of Proosition 1. Net, we analyze the entry deision of a tyial firm. Every inumbent firm faes a onstant robability of default ( 0 1) in eah eriod aused by a stohasti shok. In the resent ontet, this stohasti shok an be interreted as hanging tastes that eliminate the demand for a artiular variety. Sine firm default is unorrelated with environmental quality, the eit roess is indeendent of the distribution of the latter. The robability of drawing an environmental quality level is governed by density funtion g( ). As a result, the eante robability of suessful entry is given by 1 G( ). The density of the distribution of environmental in quality draws meeting the environmental standard, whih is denoted by ( ), is the onditional density of g( ) on the interval, defined by g( ) ( ). (19) 1 G( ) The e-ante robability that an inumbent firm beomes an eorter equal the fration of eorters and is given by 1 G( ). (20) 1 G( ) 15

16 3.4. Aggregation Aggregation rovides eressions for various omonents of e-ante rofits that are needed to establish the general-equilibrium roerties of the model. Let M denote the measure of varieties rodued, measure of eorted varieties, and measures are related to eah other as follows. M defined by M the M the measure of varieties available for onsumtion in eah ountry. These M ; M M nm (1 n ) M. (21) Let denote an inde of environmental quality of domestially rodued goods. This quality inde is 1 1 ( ) g( ) d 1 G( ), (22) where ( 1) 0 is the quality elastiity of firm revenue defined in Eq. (13). Beause 1, if the green elastiity is ositive (, 0), then has idential roerties to those assoiated with the average firm rodutivity in Melitz (2003). If the green elastiity is negative (, 0), then orresonds to the weighted harmoni mean of effetive qualities of all domestially rodued varieties, as in Dinooulos and Unel (2013). The quality inde deends on the global environmental standard and density g( ) of environmental quality. Let denote the average environmental quality of eorts, whih is defined by 1 1 ( ) g( ) d 1 G( ). (23) The average environmental quality of varieties available for onsumtion in a ountry is denoted with and defined by M nm 1 M M 1. (24) The first term inside the square brakets orresonds to domestially rodued varieties and the seond term orresonds to imorted varieties. Lemma 2: The average environmental quality of rodued varieties is stritly greater and inreases with the environmental standard ( and / 0 ). If the green elastiity is ositive ( 0 ), then the average environmental quality of eorts is stritly greater and inreases with the eort utoff environmental quality 16

17 and / 0 ). If the green elastiity is negative ( 0 ), then the average environmental quality of ( eorts is stritly smaller and dereases with the eort utoff environmental quality ( and / 0 ). Proof: Please see the Aendi. Green rie inde P, aggregate revenue R and aggregate quantity Q in any ountry may be written as funtions of the average level of environmental quality and the measure of varieties available for onsumtion M. The Aendi rovides algebrai details. P M / ; R M r ( ); 1/(1 ) d Q M. (25) 1/( 1) The market equilibrium in any ountry is isomorhi to the equilibrium with rodues a variety with environmental quality. M idential firms, eah of whih Finally, eeted revenue r and rofit earned by a reresentative firm serving the domesti and foreign markets are given by r r ( ) nr ( ) ; ( ) n ( ). (26) d d 3.5. Free Entry A firm roduing a variety with environmental quality earns oerating rofit ( ) and faes a onstant robability of death in eah eriod. Following the literature on trade with heterogeneous firms, we assume that the disount (and interest) rate equals zero. As a result, firm market value is given by t ( ) v( ) ma 0, (1 ) ( ) ma 0, t0, (27) where the seond equality is based on the roerty that environmental quality is time invariant and thus the firm earns the same rofit flow eah eriod. The firm meets the environmental standard and enters the market suessfully with robability 1 G( ). As a result, eeted net benefits of onduting environmental R&D are equal to e-ante eeted firm value 1 G( ), where / is the (e-ost) value of a suessful entrant, and is the rofit flow ( ) n ( ), defined in Eq. (26). d 17

18 Free entry into environmental R&D leads to zero eeted net benefits: eeted benefits of entry 1 G( ) must equal the fied R&D entry ost f e yielding the free-entry ondition fe 1 G( ). (28) The LHS of Eq. (28) is eeted ost of environmental R&D and its RHS is average firm rofit. Average firm rofit is therefore determined by firm default rate, fied ost of environmental R&D f e, and the global environmental standard. Ceteris aribus, a higher environmental standard lowers the robability of suessful entry1 G( ) and requires higher rofit flow to restore free-entry ondition(28). Similar onsiderations aly to the rate of default and entry ost f e : higher eeted R&D ost fe requires higher rofit flow Equilibrium At the steady-state equilibrium, the zero-rofit ondition(18), determines the relationshi between the average rofit er firm and the eort utoff environmental quality. where Combining Eq. (11) and Eq. (14) yields d ( ) rd ( ) d ( ) rd ( ) ; r ( ) r ( ) We an eress the average rofit flow, whih is defined by Eq. (26), as. (29) 1 1 G( ) f nf 1, (30) 1 G( ) is a funtion of R&D ondition where. 13 Substituting Eq. (30) into Eq. (28) yields the following zero-rofit environmental f / f F( ), (31) e 1 F( ) g( ) d n g( ) d [1 G( )]. (32) 13 The first and seond terms in the right-hand-side (RHS) of (30) are equal to the orresonding terms in the RHS of in 1 1 (26). Eq. (11) and Eq. (18) imly ( ) r ( ) / f. Substituting ( ) in Eq. (29) yields the first term in the d RHS of Eq. (30). Eq. (15) imlies. Substituting from Eq. (29), [1 G( )]/[1 G( )] and r ( ) f from Eq. (18) delivers to the seond term in the RHS of Eq. (30). d 18

19 The environmental R&D ondition determines the general-equilibrium eort utoff level. The LHS of Eq. (32) equals er-eriod eeted fied environmental R&D osts eressed in units of foreign-market entry ost f ; and F( ) equals er-eriod eeted rofits, eressed in units of foreign-market entry osts f, earned by a firm engaged in environmental R&D. It an be easily established that eeted rofits derease monotonially with eort utoff quality level if and only if the green elastiity is ositive: F / The intuition behind the sign of F( ) is as follows. Observe that er-eriod firm rofit is higher for firms serving both the domesti and foreign markets than for firms serving only their domesti markets, as indiated by Proosition 1. In the ase of ositive green elastiity, firms roduing roduts with environmental quality higher than the eort utoff level ( ) beome eorters and earn higher rofits. In this ase, an inrease in redues the likelihood that a firm will earn higher rofits by beoming an eorter and inreases the likelihood that the firm will earn lower rofits by serving the domesti market only. As a result, if 0, then an inrease in redues er-eriod eeted (average) rofits F( ). If 0, then firms roduing roduts with environmental quality whih is lower than the eort utoff level earn higher rofits and beome eorters. In this ase, an inrease in inreases the range of environmental quality generating higher rofits and redues the likelihood of lower rofits assoiated with serving only the domesti market. As a result, if 0 then an inrease in raises er-eriod average firm rofit F( ). The environmental R&D ondition f / f F( ) determines the eort utoff level as follows. e Consider first the ase of 0, where F( ) dereases with. The R&D ondition must hold at the minimum environmental standard, ( fe / f F( ) ). Thus if, then all ative firms eort and obtain maimum eeted rofits equal to F( ). If f / f F( ) F( ), then the eort utoff level is higher than the global e environmental standard ( ); firms disovering environmental quality roduts eeeding the eort utoff ( ) beome eorters; and firms with environmental quality roduts below the eort utoff level and above the global environmental standard ( ) serve their domesti market only. Similar reasoning alies to the ase of negative green elastiity. In this ase, evaluating the R&D ondition at the global standard where imlies that all firms obtain minimum e ante rofit equal to 14 Formally, the artial derivative of the RHS of Eq. (32) with reset to equals ( 1) 1 ( ) / ( ) ( ) F g d n g d imlying that sign ( F / ) sign ( ). 19

20 F(, ). In this ase, all firms serve the domesti market and there is not searation between loal firms and eorters. Sine eeted rofit inreases with in this ase, if F( ) fe / f F( ) (that is, for suffiiently high eeted entry osts f / f ), the eort utoff level is stritly greater than the global standard ( ). e Firms with environmental quality roduts higher than the eort utoff ( ) serve the domesti market; and firms disovering roduts with environmental quality between the eort utoff level and the global standard ( ) engage in eorting. Fig. 1 illustrates the general-equilibrium solution to the eort utoff level in the ase of ositive green elastiity by lotting the LHS and RHS of the environmental (zero-rofit) R&D ondition (31) as funtions of. The LHS is indeendent of and is shown by horizontal line fe / f. Fig. 1 illustrates the grah of F( ) whih is downward sloing in the ase of ositive green elastiity. The intersetion of the vertial line assing through and urve F( ) at oint A determines F( ). In Fig.1, f / f is stritly lower than F( ). As a result, the intersetion of fe / f and urve F( ) determines the equilibrium eort utoff. It is obvious from Fig. 1 that there eists a suffiiently high level of f suh that the eort utoff quality level eeeds the global environmental standard. e F( ) A f e / f Figure 1. Determination of eort utoff when 0. In the ase of negative green elastiity ( 0 ), the grah of F( ) (not shown in Fig.1) has ositive sloe and asses through oint A. Thus for a suffiiently high level f / f, suh as F( ) f / f, the e e 20

21 horizontal line is loated above oint A. In this ase, the unique intersetion between line f / f and uwardsloing urve F( ) determines the general-equilibrium value of eort utoff whih is greater than the global environmental standard. These onsiderations imly that Proosition 1 holds in general equilibrium. e Proosition 2: There eists an eort utoff level whih is unique and stritly greater than the global environmental standard ( ) satisfying equation (31) under the following arameter restritions: if the green elastiity is ositive (negative), then the ratio of eeted entry osts to foreign-market entry osts f / e f must be stritly lower (greater) than F( ). The intra-industry trade attern desribed by Proosition 1 holds in general equilibrium. The equilibrium eort utoff environmental quality level and global environmental standard determine the average environmental quality levels of eorts, domestially rodued goods, and goods available for onsumtion. Equilibrium robabilities in and are determined as well. 15 Proosition 2 identifies the onditions roviding searation between domesti firms and eorters. These onditions involve more arameters than those identified by the traditional theory of trade with heterogeneous firms. For instane, in Melitz (2003) the domesti utoff quality level d is given by setting the e-ost flow of domesti rofits equal to the fied osts of rodution d( d) f, where f denotes the fied osts of entering the domesti market. Combining this equation with (11) and (18) yields the standard ondition for the artitioning 1 of firms by eort status whih ours if and only if f f. In ontrast, in the resent model the resene of a minimum (environmental) quality standard ats as the eogenous domesti utoff quality level and imlies that several additional arameters affet the artitioning of firms by eort status. These additional arameters inlude, f e, and arameters regulating the distribution of environmental quality Effets of Environmental Standards and Trade Liberalization In this setion we analyze the effets of the global environmental standard, and the imat of three tyes of trade liberalization: an inrease in the number of trading artners n ; a redution in variable trade osts ; 15 The determination of the remaining endogenous variables suh as the measure of varieties rodued and onsumed in eah ountry, and aggregate rofits is standard and omitted here based on sae onsiderations. 16 Proosition 2 alies to markets with binding rodut quality standards indeendently of ollution onsiderations. These quality standards inlude safety and health-hazard standards alied to harmaeutials, many agriultural roduts, and onstrution materials. 21