Do National Borders Matter? Intranational Trade, International Trade, and the Environment

Transcription

1 Do National Borders Matter? Intranational Trade, International Trade, and the Environment Carol McAusland University of British Columbia Daniel L. Millimet y Southern Methodist University & IZA October 4, 2012 Abstract We develop a theoretical model identifying channels through which trade impacts the environment. First, trade decouples some of regulation s costs from its bene ts, prompting demand for stringent environmental regulations. Second, trade provides consumers with access to new varieties of goods; the associated income (substitution) e ect raises (lowers) demand for strict regulation. The model predicts (i) international trade to be more environmentally bene cial than intranational trade due to a stronger decoupling e ect, and (ii) both intra- and international trade to be pro-environment unless substitution e ects are su ciently strong. Using data on intra- and international trade for the US and Canada, along with several environmental outcomes, we nd robust evidence that international trade has a statistically and economically bene cial causal e ect on environmental quality, while intranational trade has a harmful impact. This pattern is consistent with a moderate-sized substitution e ect along with a stronger decoupling e ect of international trade. JEL: F14, F18, Q56 Keywords: Bilateral Trade, Pollution Food and Resource Economics, Faculty of Land and Food Systems, University of British Columbia, 2357 Main Mall, Vancouver, BC V6T 2L7, Canada. Phone: ; carol.mcausland@ubc.ca. y The authors are grateful to the International Council for Canadian Studies for grant support, and Jayjit Roy, Ling Yee Khor and Alice Li for excellent research assistance. The authors also thank Dan Phaneuf, two anonymous referees, Per Fredriksson, Arik Levinson, and seminar participants at Harvard, Yale, UBC, SMU, the 2008 CEA meetings, UCSB s 10 th CalWorkshop, and the Rocky Mountain Empirical Trade Workshop for valuable comments. Corresponding author: Daniel L. Millimet, Department of Economics, Box 0496 Southern Methodist University, Dallas, TX Phone: ; Fax: ; millimet@smu.edu.

2 1 Introduction In 2007, 14 trillion dollars worth of goods crossed international borders. 1 Internal trade (i.e., trade between regions within a country) is also a primary component of economic activity. In this paper, we seek answers to several questions. What is the impact of this ow of goods on the environment? Does trade have a causal impact on emissions? Does it matter whether trade occurs between countries or between regions in the same country? In other words, do national borders matter in the trade-environment debate? To answer these questions, we introduce environmental regulation into the canonical Krugman (1980) model of monopolistic competition with increasing returns to scale and Spence-Dixit-Stiglitz preferences for di erentiated goods. We then test the predictions of our model using data on within- and between country trade for the U.S. and Canada. Theoretically, the Krugman (1980) model is appealing because it explains an important stylized fact: for most industrialized countries, intra-industry trade is the dominant form of trade. That is, for many products, each country is both an importer and an exporter. 2 Empirically, focusing on US-Canadian trade is also appealing. The US-Canadian border is the busiest international border, with bilateral trade between these two countries averaging CDN$1.7 billion per day. In 2010, Canada was the primary trading partner for the vast majority of US states. 19% of US exports are to Canada; 15% of US imports originate in Canada. Internal trade is also plentiful: in 1997, for example, US intranational shipments were $10.7 billion per day. 3 Our simple model reveals new insights about how a region s trade intensity de ned as the sum of its exports plus imports divided by its national income impacts local preferences for environmental regulation. Trade in di erentiated goods grants consumers access to increased variety, which has income and substitution e ects akin to outright improvements in per capita income and price changes. The income e ects are straightforward: for consumers who love variety, an increase in the range of product varieties available is a windfall. Broda and Weinstein (2006, p. 582) calculate the income-equivalent of the welfare gains from increased variety: US welfare is 2.6 percent higher due to gains accruing from the import of new varieties. Notably, these are annual and ongoing, not one time, bene ts. Feenstra and Weinstein (2010) estimate that the increase in varieties available in the US due to trade has lowered the merchandise price level by 3.7%. Klenow and Rodríguez-Clare (1997) nd that ignoring the bene ts from increased variety (i.e., considering only income gains) can underestimate the bene ts from trade liberalization anywhere from 33 to 80%. Intuitively, variety-gains from trade should impact environmental regulation in a manner similar to 1 WTO. International Trade Statistics , p Over the period, intra-industry trade accounted for more than 50% of total manufacturing trade for twenty-one out of the twenty-nine OECD countries. For Canada and the United States, rates of intra-industry trade over this period ranged between 73.5% and 76.2%, and 63.5% and 68.5%, respectively (OECD 2002, p. 161). 3 Authors own calculation based on data from Statistics Canada, CANSIM, Table (summarized at US Census ( and Bureau of Transportation (description available at 1

3 straight income gains: citizens redistribute their windfall gains so to get more of everything they enjoy, including environmental quality. However, improved access to variety also changes the relative value of consumption. The greater the variety of consumer goods, the more valuable is the marginal unit consumed, with implications for the marginal rate of substitution between private consumption and the environment. We refer to these as trade s variety-induced income and substitution e ects. 4 Trade also changes how the regulatory burden is distributed. Tightening local environmental regulation raises production costs. Factor owners bear some of these costs via lower factor returns, while remaining costs are passed on to consumers via higher prices; regulation also reduces the variety of locally-produced goods. The impact on local consumers of these price hikes and supply contractions is not xed, but rather depends on how intensely the region trades. In regions that import actively, the majority of goods in a household s consumption basket is produced abroad. Since the price of these imported goods depends on foreign supply conditions, overall consumption will be relatively una ected by changes in local environmental regulation. Moreover, in actively exporting regions, much of consumers share of the regulatory burden falls largely on foreigners. In e ect, trade partly decouples consumer welfare from the costs of local regulation, leading to stricter environmental regulation in states that trade intensely. Importantly, the strength of the decoupling e ect depends on who a region trades with. We illustrate this principle by building a simple two-region model and then examining how changes in each region s factor supply a ects trade volumes and demand for environmental quality in turn. We consider two variants of the basic model. In the rst scenario trade is between two autonomous regions with distinct environmental policies. In the second scenario the two regions are restricted to have the same policy, as per states or provinces governed by the same federal environmental policy. Comparing the predictions of these two models reveals an important channel through which the identity of a region s trade partner matters. Suppose, for example, that a state s trade partner is in another country; supply conditions in the trade partner are outside the jurisdiction of local regulators. This is not necessarily the case, however, if the trade partner is another state within the same country; many rules governing pollution in Canada and the US are set at the national level, often coming as the result of laws passed by federal lawmakers. As such, the price and variety of goods imported into Alberta from, say, Ontario, are not independent of the regulations impacting Albertan producers. Thus, the extent to which trade decouples consumption from regulation is substantially weaker for intranational trade, suggesting that the ceteris paribus e ect of intranational trade on the environment will be smaller than of international trade. We test our hypotheses using data on interstate commerce, interprovincial commerce, and international trade between US states and Canadian provinces in 1997 and We use this data to construct measures of intra- and international trade intensity for each state and province. We then assess the causal impact of 4 Variety induced income and substitution e ects have been overlooked in previous research on trade and environment for a variety of reasons. Many authors simply assume traded goods are homogenous. Meanwhile, models with di erentiated goods tend to assume the number of varieties is xed exogenously, and/or assume subutility from di erentiated goods as a class is logarithmic, thereby causing income and substitution e ects to cancel exactly. 2

4 each type of trade on several measures of environmental quality. Following Frankel and Rose (2005) and Chintrakarn and Millimet (2006), we control for the potential endogeneity of trade utilizing an instrumental variables (IV) approach. The instruments are derived from a rst-stage gravity model of bilateral trade ows. In e ect, the technique utilizes across-state/province variation in trade arising from its geographical determinants (e.g., proximity to other states/provinces, adjacency, etc.) to identify the causal e ect of greater trade on environmental quality. As in Frankel and Rose (2005) and Chintrakarn and Millimet (2006), we also allow income to be endogenous as well. Our results are striking. First and foremost, we nd robust evidence that international trade intensity lowers toxic releases: in most speci cations trade has a statistically and economically signi cant negative impact on emissions. Moreover, consonant with the mechanism underlying the theoretical model, we also nd robust evidence that international trade intensity promotes green voting by federal lawmakers in the US. Second, and also consistent with our theoretical predictions, we nd that intranational trade is less bene cial for the environment than international trade; in fact, in nearly all speci cations we nd intranational trade to be harmful to the environmental. This pattern of results is fully explained by the theoretical model. Our research contributes to the trade and environment debate along many dimensions. First, as in Antweiler et al. (2001), Damania et al. (2003), and others, we develop an explicit theoretical model for the purpose of generating testable hypotheses concerning the environmental impact of trade. Unlike others, our empirical analysis is motivated by a model of imperfectly competitive rms, di erentiated products, and intra-industry trade, all important features of modern trading economies. Second, while the use of trade intensity as the covariate of interest in empirical tests of trade and environment relationships is accepted practice, to the best of our knowledge none of the theoretical models used to motivate these previous empirical analyses have explicitly considered the role of trade intensity. Instead, trade intensity is generally employed as a proxy for trade frictions. Our theoretical model, on the other hand, identi es an explicit functional relationship between trade intensity and environmental regulation, uncovering speci c channels through which trade intensity a ects incentives to adopt strict environmental regulation. This turns out to be crucial when estimating the causal e ect of intranational trade. Our theoretical model builds on insights from the literature on tax exporting. Like Gordon (1983), Lockwood (2001), P üger (2001), and Hau er and P üger (2004), we nd that governments in open economies have an incentive to ignore regulatory costs born by overseas consumers. In our model, this tax exporting induces governments to tighten emission caps in response to exogenous increases in trade intensity. 5 Finally, our analysis provides important, but previously ignored, evidence vital to the trade and envi- 5 Comparing emission taxes in closed and open economies, P üger (2001) similarly nds that openness can lead to stricter regulation via consumer price spillovers. Unlike P üger 2001, in our model global product variety is endogenous, allowing for spillovers in terms of variety as well as price. 3

5 ronment debate; a debate that Taylor (2004, p. 1) argues constitutes one of the most important debates in trade policy. The debate has not been resolved in large part due to the inability to identify the causal impact of trade on the environment; simple associations may mask the causal e ect due to problems of reverse causation or omitted variables. For example, while Antweiler et al. (2001) nd trade is associated with lower pollution concentrations, Ederington et al. (2005) and Levinson and Taylor (2008) nd abatement costs negatively impact net exports. Frankel and Rose (2005) o ered a signi cant breakthrough by applying an IV approach based on a gravity model of trade to a cross-country sample. The authors nd, as in Antweiler et al. (2001), that trade is, at worst, environment-neutral and may in fact be pro-environment. Despite the advance o ered in Frankel and Rose (2005), one potential criticism of their analysis is that the use of cross-sectional data across a diverse set of countries, from a wide array of sources, makes the data suspect. For example, di erences across countries in the measurement of trade levels and/or environmental degradation, or di erences in the level of governmental honesty, may mask the true causal e ect of trade on environmental quality. To circumvent this potential shortcoming, Chintrakarn and Millimet (2006) revisit the analysis in Frankel and Rose (2005) using data on intrastate shipments from the US and statelevel measures of pollution. Using the same IV procedure, the authors seek to replicate the ndings in Frankel and Rose (2005) using data from one country (the US) to ensure consistency. The results are consistent with Frankel and Rose (2005). In light of this, it might seem as if the trade and environmental debate has been resolved. Unfortunately, the measure of trade intensity employed in Chintrakarn and Millimet (2006) is not consistent with the theoretical measure of trade intensity highlighted by the model we present here. Moreover, even if the ndings in Chintrakarn and Millimet (2006) prove robust to this change, for their analysis to extend from intranational to international trade, one must assume that intra- and international trade have the same environmental impacts; in other words, that state and national borders play the same role in the trade and environment relationship. However, there is no existing literature exploring this issue. This paper lls this gap, o ering, to our knowledge, the rst rigorous analysis of the environmental e ects of intranational versus international trade. 2 Theoretical Model 2.1 Preliminaries Consider a country, Home, that engages in free and frictionless trade with a Foreign trade partner (Foreign); values for Foreign are denoted with asterisks. Home is endowed with a generic input H that is used to produce a di erentiated product. We refer to the input H as human capital, although other interpretations are equally valid. Home has S identical citizens (and so each owns H=S units of human capital). Let w measure the rent paid per unit of human capital; we often refer to w as the wage. Let e denote emissions per unit of nal output. We assume production technologies in Home and Foreign are identical, each 4

6 exhibiting increasing returns to scale. The total cost for a rm producing y(i) units of variety i equals [a(e) + b(e)y(i)]w. a(e) and b(e) measure xed and variable input requirements; we assume it takes more inputs to design and use clean production processes, hence a(e) > 0 > a 0 (e) and b(e) > 0 > b 0 (e). For brevity we will regularly suppress arguments, writing a(e) as a and b(e ) as b, for example. For simplicity, we assume these functions are isoelastic: a a0 e a > 0 and b b0 e b > 0, where a and b are constants. In our analysis, we assume Home s emission intensity is determined by government policy; Foreign emission intensity, e, is taken as exogenous throughout our analysis. 6 De ne the mass of varieties produced in Home and Foreign as N and N. We assume consumers have Spence-Dixit-Stiglitz (SDS) constant elasticity of substitution preferences over the range of di erentiated products. An individual s utility from consuming the global range of varieties is a monotonic transformation of Z C = c(i) i2n[n (1) where c(i) is a consumer s consumption of variety i and 2 (0; 1) is a parameter. For any variety i, Home consumption c(i) equals local production y(i) less exports, all divided by S; in the case of imported goods, local production is zero while exports are negative. We can interpret C as a Home consumer s variety-adjusted consumption. Because production exhibits increasing returns to scale and consumers love variety, each rm produces a single unique variety; thus, N and N also measure the mass of rms. Given (1), consumer demands are as follows: where GDP = wh is national income and is the price-variety index. c(i) = Z P GDP=S p(i) 1 1 P 1 j2n[n p(j) 1 1 P is increasing in the price of any individual variety and decreasing in the number of varieties available. As is usual in models with SDS preferences, each rm has zero mass and faces identical isoelastic demand. Home and Foreign rms maximize pro ts by charging respective prices (2) (3) p(i) = wb and p(j ) = w b : (4) Firms are symmetric. We assume free entry, implying zero long-run pro ts: [a + by(i)] w = p(i)y(i). Substituting for p(i) using (4) and collecting terms implies y(i) = a b 1 for i = 1; : : : ; N: (5) 6 That is, we assume Foreign is policy inactive, even when conducting comparative statics such as changes in Foreign factor endowments. An analysis of a policy game played between two large, policy-active countries is beyond the scope of this paper and is left for future work. 5

7 By symmetry, yj = a b 1 for j = 1; : : : ; N : Since equilibrium prices and outputs are identical for each rm within a country, we omit arguments (i) and (j ) from here forward. yields Full employment requires N[a + by] = H. Substituting for y using (5) and similarly for Foreign N = 1 a H; N = 1 a H : (6) We assume factor prices equilibrate so as to maintain balanced trade; i.e., the value of Home s exports, X = pn w H p 1 1 P 1, equals the value of its imports M = p N wh p 1 1 P 1 : (7) Utilizing P = P, substituting in for p, p, N and N using (4) and (6) and isolating terms indicates that any pair w and w satisfying w w = a a 1 b (8) satis es the balanced trade condition. Without loss of generality, we can normalize w = b 1 a 1 b (9) and thus write the factor price in Home as a function of Home variables alone: Substituting for factor prices in (4) gives prices p = 1 w = 1 a 1 b : (10) b 1 and p = 1 a b 1 : (11) Finally, substituting (2) and (3) into (1) and collecting terms gives variety-adjusted consumption as a function of aggregate income and the price-variety index: wh C = : (12) SP We introduce the following measure of Home s trade intensity, T, de ned as Home s total trade as a fraction of income: T X+M GDP. Invoking the balanced trade condition, M = X, substituting for M using (7), and rearranging terms gives T X + M = 2[1 ] (13) GDP where Np 1 P 1 = 1 + H H a 1 a 1 b a b 1 : (14) We can interpret as Home s share in (price-adjusted) global variety. Note from (13) and (14) that, holding e constant, is decreasing (and hence T is increasing) in H. This is consistent with empirical research that nds countries with large neighbors tend to trade more intensely. 6

8 Rearranging (14) and substituting into (12) yields an expression for Home s variety-adjusted consumption expressed solely in terms of local variables and trade intensity: wh h i C = Np 1 T 1 1 S 2 1 : (15) 2.2 Pollution and Policy Choice As many pollutants are regulated via direct controls, we assume e is set directly by a government regulator. Speci cally, we assume the regulator chooses e to maximize W, the sum of Home citizens utilities, where u, and D are de ned as follows. W = S[u(C) D(Z)]; (16) u is a positive, increasing and concave function of variety-adjusted consumption C. The following u de nition will be useful in subsequent sections: 00 (C)C u 0 (C). is the elasticity of the marginal rate of substitution between C and Z with respect to changes in C. We can interpret as measuring the rate at which households become sated with private goods (C) relative to the environment. 7 D measures pollution damage; D is a positive, increasing, and convex function of emissions Z = eny: We assume emissions and pollution are synonymous and that pollution has no transboundary component. is a shift-parameter re ecting sensitivity to pollution and is discussed further in section 3.1. Substituting in for equilibrium values of y and N using (5) and (6) yields Home emissions as a function of Home s emission policy: Z = e H: (17) b Di erentiating (16) with respect to e and converting to percentage changes denoted by hat notation, whereby ^e = de e for example gives dw de = S e [ u0 (C)C ^C ^e {z } consumption response D 0 (Z)Z ^Z ]: (18) {z ^e } emission response The latter term in (18) measures the emission response. Allowing dirtier production techniques raises the amount of pollution to which households are subjected: The other term measures the consumption response: on local environmental regulation. Di erentiating (12) gives " # ^C ^e = ^w ^P ^e ^e ^Z ^e = 1 + b > 0: (19) ^C ^e measures how tightly consumption levels depend 7 Concavity dictates the sign of but not its size. For example, when u(c) = C1, = and concavity imposes no restrictions on other than that is positive. 1 (20) 7

9 indicating that regulation impacts households via their factor returns and the price index. Allowing production to be more emission intensive renders human capital more e ective in each of its possible employments designing and producing goods thereby raising nominal factor prices: where we de ne (1 ) a + b > 0. ^w ^e = (21) Changes in P can be decomposed into changes in the price of individual goods and in the range of varieties available: di erentiating P using (3) yields ^P ^e = " 1 # ^N ^e + ^p^e : (22) The e ect of regulation on unit prices is ambiguous; although relaxing environmental regulation raises factor costs, it also reduces the inputs needed to design or produce goods: ^p ^e = (1 )[ a b ]?? 0: (23) If unit-input requirements are more environmentally sensitive for production than for design (i.e., b > a ), then the productivity increase dominates the wage hike, Home rms experience a fall in their marginal costs, and prices fall in response to less stringent standards. However, if a > b, then factor prices will rise faster than productivity along the assembly line, driving prices higher. Although this possibility is theoretically interesting, we believe a priori that design costs are generally no more sensitive to environmental regulation than are production costs, and so assume b a without further apology. Relaxing regulation also leads to more varieties being produced. Firms xed costs include the costs of developing processes satisfying environmental regulations. To the extent that more design-related inputs are needed when regulation is strict, loosening regulation frees up productive resources for use by new entrants, raising the number of varieties produced by Home: ^N ^e = a > 0: (24) We can now calculate the net e ect of an increase in e on the price-variety index; substituting into (22) using (13), (23), and (24) gives ^P ^e = 1 = 1 1 T < 0: (25) 2 Notably, when is small, the link between Home s emission cap and the global price-variety index is weak: if the majority of goods in consumers baskets are produced abroad, then regulation in Home will have only a small e ect on the overall price and variety of goods available. Home s trade intensity is also correlated with the demand elasticity for Home-produced goods as a group. Integrating (2) across the mass of Home s varieties and log di erentiating with respect to the common price of Home-produced goods reveals the price elasticity of demand for Home produced goods to be 1 8 1, which is decreasing in and thus increasing

10 in Home s trade intensity. This is as one would expect: the more Home trades, the more competition its producers face and the more responsive quantity demanded is to changes in p. Combining (19), (21), and (25) in (18) yields u 0 (C)C dw de = S e + (1 ) 1 T 2 D 0 (Z) Z[1 + b ] : (26) The system formed by (26) (when set equal to zero), (6), (10)-(14), and (17) implicitly de nes Home s optimal pollution policy, e o, and equilibrium emissions. 8 3 Theoretical and Empirical Predictions 3.1 International Trade Intensity Our central question is whether greater Home trade intensity raises pollution and/or pollution intensity. Because trade intensity is endogenous, we cannot answer this question with a simple comparative static exercise involving exogenous changes in T. Instead, we must examine the impact of changes in exogenous factors, such as growth in Foreign via change in H. For example, partially di erentiating (18) with respect to H, dividing by envelope theorem gives d 2 W de 2, and invoking the de o dh = S [u 0 + ^C ^e de 2 {z } ^e f e o d 2 W decoupling eect u0 (C) dp } variety induced u 0 (C) {z } variety induced g]: (27) substitution eect income eect Foreign growth impacts Home s preferred environmental policy through three channels: a decoupling e ect, a variety-induced (VI) income e ect and a VI substitution e ect. We examine each in turn, beginning with the decoupling e ect. Foreign growth expands the variety of goods produced abroad, inducing Home consumers with their taste for varied goods to import more; Home consumers nance their expanded imports by reducing consumption of Home-produced goods. Both responses raise Home s trade intensity, which, in turn, weakens the link between local consumption and regulation. To see this mathematically, substitute (21) and (25) into (20) to obtain ^C ^e = T : (28) 2 When most of the goods in a Home consumer s basket are imported, tightening local environmental regulation has only a small deleterious e ect on Home consumers because local regulation has no e ect on the 8 The second order condition for an interior optimum is veri ed in the appendix. 9

11 price and variety of goods produced overseas. At the same time, many of the costs of local environmental regulation are passed-through to consumers overseas, making strict local regulation more attractive. 9 Because Foreign-growth raises Home s trade intensity, this growth magni es the extent to which consumers are insulated from regulatory costs and to which producers can pass their regulatory costs through to foreigners. We can see this mathematically by partially di erentiating (28) with respect to H ^C ^e = = 1 [1 ] H (29) which is negative. As a result, the increase in Home s trade intensity heightens the extent to which the costs of Home s environmental regulation are borne by di erent individuals than those bene tting from the regulation. We call this trade s decoupling e ect. The pass-through and decoupling e ects are variants of tax exporting. Gordon (1983) and Lockwood (2001) recognize that, when rms have market power, some portion of origin taxes will be passed along to foreign consumers. Ignoring the resulting negative consumer price spillover, governments have an incentive to set ine ciently strict production taxes. Examining emission taxes, P üger (2001) similarly nds consumer price spillovers can induce regulators to set ine ciently strict emission taxes. While our model does not consider taxes, the principle is the same: when a country s producers have market power over the unique goods they produce, some of the costs of complying with strict emission caps will be passed along to foreign consumers via higher prices and fewer varieties. Interestingly, consumer price spillovers do not necessarily imply that marginal abatement costs will exceed the marginal damage from pollution. As is well known from Buchanan (1968) and Barnett (1980), a Pigouvian tax can exacerbate the allocative ine ciency resulting from market power. Thus, when rms have market power, a regulator should set a second-best emission tax that is less than marginal damage; weakening emission taxes spurs supply, lowering consumer prices in turn. However, governments may be unwilling to sacri ce their local environment in an e ort to increase consumer surplus if much of that surplus is enjoyed abroad. Our model suggests governments that trade intensely are less willing to subsidize consumption via weak environmental regulation. The second channel through which Foreign growth a ects Home s preferred emission cap is the varietyinduced income e ect. An increase in the number of available varieties is a windfall for variety-loving consumers. A consumer will redistribute this windfall to procure more of everything she values, including environmental quality. This is akin to conventional income e ects: environmental quality is a normal good, and citizens demand more of it as they get wealthier. Income e ects are important in the trade and environment debate. Grossman and Krueger (1993) and Copeland and Taylor (2003) argue that trade 9 As mentioned above, an exogenous increase in Home s trade intensity also makes demand for Home produced goods more elastic, suggesting producers bear more regulatory incidence. However, in models with homogeneous monopolistically competitive rms such as ours, all producer rents are passed along to factor owners. Consequently, all changes in surplus are captured via changes in the factor price which our normalizing assumption (9) renders independent of variables other than productivity and the price-variety index P. 10

12 raises incomes, thereby fueling demand for more environmentally friendly production techniques; this is one version of the technique e ect. In our model, an increase in GDP is unnecessary; holding wh constant, an increase in variety N + N lowers P, allowing consumers to purchase the same level of C using less income, permitting Home to allocate more resources toward environmental quality. Working in the opposite direction, the emergence of new goods also has a variety-induced (VI) substitution e ect. When there are more varieties available, the opportunity cost of foregone factor returns due to environmental regulation is greater because the goods that could have been purchased are more novel. The VI substitution e ect diminishes the incentive for strict emission controls. The following proposition identi es the condition under which the pro-environment decoupling and VI income e ects dominate. Proposition 1 An increase in Foreign factor supply lowers Home s emission intensity and emissions if is su ciently large; speci cally, ^e o^ H < 0 and ^Z^H < 0 if and only if > 1 [1 ] +[1 ], where 1 < 1. Proof of Proposition 1: Substituting (28) and (29) into (27), collecting terms and converting to percentage changes gives As d2 W de 2 ^e o H^ = Su0 (C)C(1 )(1 ) [(1 )[ + (1 )] ] : (30) e 2 d 2 W de 2 < 0 by the second order condition for an interior optimum, rearranging terms implies and only if > 1 (1 ) (1 )+ : Notably, (1 ) (1 )+ < 1; hence 1 is a su cient condition for ^e o^ H arrive at comparable expressions for ^Z, log di erentiate (17) to get ^e o^ H < 0 if < 0: To ^Z = ^H + [1 + b ]^e: (31) Setting ^H = 0 and substituting in using (30) gives which is negative if and only if > ^Z H^ = [1 + b] Su0 (C)C(1 )(1 ) [(1 )[ + (1 )] ] e 2 d 2 W de 2 (1 ) +(1 ). As is evident from (27), the pro-environment VI income e ect of a growth-led increase in varieties dominates the VI substitution e ect if and only if > 1. However, even if < 1, Foreign growth may still improve Home s environment because the growth raises Home s trade intensity, which has a pro-environment decoupling e ect. As indicated in Proposition 1, the VI-income and decoupling e ects dominate unless the VI-substitution e ect is strong, i.e. if and only if < 1. As one would expect, 1 is decreasing in : when goods are better substitutes (i.e., large), Home is less able to pass-through regulatory costs to foreign consumers, shrinking trade s decoupling e ect and making trade less likely to bene t Home s environment. Growth in Home s own factor supply also has decoupling, income and substitution e ects. For starters, an increase in H raises the number of varieties produced at home. This has VI income and substitution 11

13 e ects just like those arising from Foreign-growth. Contrary to Foreign-growth, an increase in H intensi es the link between consumption and regulation in Home. As the number of varieties produced at home rises, Home s consumers nance purchases of the new goods by curtailing consumption of other goods, including imports. Home s trade intensity falls as a consequence, tightening the link between regulation and consumer welfare in Home. Finally, local factor accumulation also expands Home s pollution base, raising the marginal damage from additional emissions and expanding the scope of Home regulation, both of which argue in favor of stricter regulation. In our model, the pro-regulation e ects dominate unless is very small, as outlined in the following proposition. Proposition 2 An increase in Home s factor supply lowers Home s emission intensity as long as varietyinduced income e ects are su ciently strong; speci cally, < 0 if and only if ^e o^h > D00 (Z)Z D 0 (Z) (1 )(1 ) [+(1 )] [ + (1 {z )] } (+) where 2 < 1 < 1. (All proofs from here forward are relegated to the appendix.) We note that the cuto value, 2, identi ed in Proposition 2 is decreasing in the elasticity, D 00 (Z)Z=D 0 (Z), of the marginal damage curve: when pollution damage is highly convex, Home is more likely to respond to local growth with stricter emission caps. Even though factor growth in Home may foster stricter environmental regulation, pollution levels may rise nonetheless. Proposition 3 An increase in Home s factor supply raises Home s emissions as long as variety-induced income e ects are not too strong; speci cally,: ^Z ^H > 0 if and only if < (1 )(1 ) [ + (1 )] {z 2 } (+) where 3 > 1: (32) Factor accumulation expands the scale of polluting activity. As Proposition 3 implies, this scale e ect dominates the policy response for an intermediate range of. Only if VI income e ects are su ciently strong i.e., > 3 > 1 will the scale e ect not dominate and emissions decline. Finally, we note that changes in the idiosyncratic damage-sensitivity parameter also impact regulation and emissions. Proposition 4 An increase in Home s pollution sensitivity lowers Home s equilibrium emission intensity and emissions; i.e., deo d dz < 0 and d < 0. 12

14 What do these theoretical propositions imply about the expected relationship between trade intensity and emissions? Per the preceding discussion, an increase in Home s trade intensity partially decouples regulatory costs and bene ts, suggesting greater trade intensity is pro-environment unless VI substitution e ects are su ciently strong, as per Figure 1. Thus, we o er the following empirical prediction: Empirical Prediction 1 Conditioning on a state s/province s factor supply, an exogenous increase in own trade intensity lowers local emissions and emission intensity unless variety-induced substitution e ects are su ciently strong (i.e., if and only if < 1 ). Moreover, because changes in Foreign factor supply impact Z and e only via changes in T, we observe that Home emissions are independent of Foreign attributes conditional on Home trade intensity: Empirical Prediction 2 Conditioning on a state s/province s trade intensity, foreign factor supply is not associated with local emissions or emission intensity. However, the same cannot be said for changes in Home s factor supply and local sensitivity to pollution: Empirical Prediction 3 Conditioning on a state s/province s trade intensity, own factor supply and sensitivity to pollution are associated with local emissions and emission intensity. 3.2 Intranational Trade Intensity Our model predicts that greater international trade intensity leads to lower emissions, other things being equal, if is su ciently large. How does this compare with trade between regions within the same country? Does intranational trade intensity yield the same environmental bene ts as does international trade? Do national borders matter? Many of the rules governing industrial releases of pollutants are set by federal lawmakers. Many of these rules apply nationally, but do not extend across national borders. This means, for example, that tightening federal regulation governing emissions in Texas will simultaneously tighten regulations in Maryland, but not in Ontario. In terms of our model, it suggests Home s intranational trade partners will be subject to the same environmental regulations as Home. To assess formally the impact of this jurisdictional issue on the relationship between intranational trade intensity and the environment, we not treat Home as a state or province within a federal system. We then examine how subnational trade a ects the preferences of a federal representative from Home (e.g., a Canadian Member of Parliament or a US Senator or Congressperson) when voting for federal environmental regulations. As in the previous international trade scenario, we assume pollution is purely local: it does not cross state/provincial borders. In contrast to the preceding subsection, the representative must now account for the fact that regulation impacts both Home and Home s domestic trade partner. To distinguish the analysis from the international trade scenario, we shall refer to Home s trading partner as Rest of Country (ROC), denoted with daggers ( y ) and to Home s policy as e. 13

15 Home s representative chooses e to solve max S[u(C) e D(Z)] subject to the constraint that e y = e. Di erentiating gives " " # dw de = S u 0 (C)C e ^w ^e ^P ^e D 0 (Z)Z ^Z # : (33) ^e As when trade crosses national borders, Home s representative balances concerns over factor prices, pollution, and the price-variety index. The di erence, however, is that tightening environmental regulation has a larger impact on the price-variety index when Home s trade partner is subject to the same regulatory standard: ^P ^e = 1, rendering the link between regulatory stringency and the price-variety index conspicuously independent of Home s trade intensity. Intuitively, if Maryland is governed by the same federal regulations as Texas, interstate trade between the two does not decouple regulatory costs and bene ts. The absence of decoupling means intranational trade only impacts federally mandated policy via the VI income and substitution e ects. Proposition 5 An increase in ROC factor supply lowers Home s preferred federally mandated emission cap if and only if variety-induced income e ects are su ciently strong; i.e. ^e H^ y < 0 if and only if > 1. Of course, when Home is a political subdivision of a federalist state, the emission cap preferred by Home s representative is not necessarily the same as that actually governing Home s producers. In practice, federal policy will re ect the preferences of members of Parliament/Congress, related committees, and, in the case of the US, the Executive branch. However, if we are willing to assume that the policy actually in force in Home moves in the same direction as Home s preferred policy, then by the chain rule, as well as the fact that Home s trade intensity is increasing in ROC factor supply, we can o er the following prediction as a corollary of Proposition 5. Empirical Prediction 4 Holding a state s/province s factor supply constant, an exogenous increase in own intranational trade intensity lowers local emissions and emission intensity if and only if variety-induced income e ects dominate variety-induced substitution e ects (i.e., if and only if > 1) Multiple States/Provinces So far we have assumed one type of pollution and one regulator. This approach is useful because it allows us to highlight previously unidenti ed channels through which trade a ects the policy preferences of an individual province/state. However, in practice there are multiple types of pollutants and multiple regulators. For example, state-level regulators impact regulatory stringency either directly through state policies or indirectly through local enforcement of federal rules. For state-level policies, trade of either type inter- or subnational will have a decoupling e ect as described in section

16 But what about pollutants that are regulated federally? When setting policy, federal regulators must take into consideration conditions in multiple states/provinces. Below we o er a series of thought experiments to explore how federal policy will be a ected by inter- and subnational trade when there are multiple provinces/states in the same federal union. We start with the case of increased international trade. As per Proposition 2, an exogenous increase in H induces Home to prefer stricter policy unless is very small. If the other states/provinces in the same union as Home also trade with that same foreign partner, then they should similarly respond to a rise in H by preferring stricter federal policy, arguing in favor of stricter federal policy in equilibrium. What if, instead, it is a domestic trade partner that grows? We do not formally solve the federal policy making game. However it is entirely plausible that an increase in H y moves equilibrium policy in the same directions as Home s preferences. Consider, for example, a game in which federal emission policy is set via majority rules, and suppose Home s trade intensity rises because of factor accumulation in another state state A within the same country. As per Proposition 5, Home s trade intensity rises and its preferred emission intensity fall if and only if > 1; the same would be true of every other state in the union except state A. State A s preferred emission intensity would also fall: as per the discussion of Proposition 2, own-growth expands the local pollution base, inducing A to prefer stricter regulation unless is very small. Informal analysis suggests that, if is high, then state A-led growth induces all states to prefer stricter policy. If instead takes on an intermediate value less than unity but su ciently larger than zero, then the preferences of state A and the remaining states move in opposite directions. In a majority rules system, we would would expect the preferences of the states other than A to prevail, suggesting that a rise in Home s trade intensity driven by growth in a domestic trade partner should lead to stricter regulation in Home if and only if > 1. We can summarize these musings as follows. In a world with multiple regulators, greater international trade will induce stricter state and federal pollution policies unless is su ciently low. Greater subnational trade will similarly induce stricter state-level policy, but will only lead to tighter federal policy if is su ciently large (i.e. greater than unity). As a consequence, while it is possible that subnational trade may well engender regulatory stringency, we expect it to be less pro-environment than international trade because it does not have a decoupling e ect on federal policy. Empirical Prediction 5 International trade intensity is unambiguously more bene cial in terms of lower emissions and emissions intensity than intranational trade intensity due to the (stronger) decoupling e ect. Moreover, if greater intranational trade intensity is anti-environment, but greater international trade intensity is pro-environment, our theoretical model posits this arises due to VI substitution e ects dominating VI income e ects, but not dominating the combination of VI income e ects and the (stronger) decoupling e ect resulting from national borders. This corresponds to 2 ( 1 ; 1); see Figure 1. 15

17 3.3 Other Considerations Per Capita Income With the exception of Proposition 4, all propositions thus far depend on the magnitude of. measures the rate at which consumers become sated by variety-adjusted consumption, which in turn determines whether VI income or substitution e ects dominate. To the best of our knowledge, there is no empirical evidence concerning the relative strength of these opposing e ects. However, we can draw inferences about the magnitude of by examining the relationship between per capita income and emissions. Proposition 6 Holding H constant, an increase in S raises Home s equilibrium emission intensity and emissions if and only if variety-induced income e ects are su ciently strong; i.e., deo ds and only if > 1. dz > 0 and ds > 0 if When Home s GDP is allocated to fewer people, per capita income and consumption are both higher. Whether this induces consumers to substitute toward (or away from) more environmental quality depends once again on the rate at which consumers are sated by variety-adjusted consumption. Speci cally, our model suggests the following: Empirical Prediction 6 Conditioning on a state s/province s GDP, an increase in population reduces per capita income, thereby raising local emission intensity and emissions if and only if > 1. As indicated in Figure 1, Prediction 6 provides a test for internal consistency of our model. Speci cally, if our empirical analysis reveals a negative e ect of population on emissions holding GDP constant, then based on our theory we would conclude that VI substitution e ects dominate VI income e ects (i.e., < 1). Given Predictions 1 and 4, we would then expect intranational trade to raise emissions, while international trade may either raise or lower pollution because of the (stronger) decoupling e ect. On the other hand, if we nd a positive e ect of population on emissions holding GDP constant, then based on our theory we would conclude that VI income e ects dominate VI substitution e ects (i.e., > 1), and more of either type of trade should reduce emissions Distance Throughout our analysis we have assumed trade is free and frictionless, however iceberg transport costs (not shown) are easily accommodated by our model. With transport costs, consumers in distant regions will pay more for, and consume less of, imported varieties. However, the set of varieties consumed will still be identical across all regions. Iceberg transport costs change few of the equilibrium conditions qualitatively. Equation (8) is an exception; when there are transport costs a closed form solution for w is unavailable. We have simulated the model numerically and nd that none of our theoretical predictions are a ected qualitatively by the presence of transport costs. Moreover, variation in transport costs has predictable e ects: states/provinces facing larger trade frictions trade less intensely and set weaker environmental policy (higher e) and su er greater pollution as a result. 16

18 4 Empirics 4.1 Econometric Model To test our empirical predictions, we utilize the following estimating equation ln(z) ict = 1 INT ER T RADE ict + 2 INT RA T RADE ict (34) + 3 ln(gdp ) ict + 4 ln(p OP ) ict + W ict + " ict where Z ict is a measure of emissions in location i (a state or province) in country c (US or Canada) at time t, INT ER T RADE and INT RA T RADE are measures of the inter- and intranational trade intensity of location i, respectively, W is a vector of controls, and " ict is the usual error term. 10 Variables included in W follow from the theoretical model: Home Factor Supply (H): the percent of individuals age 25 and over, by gender, in each state or province with a high school degree and with a college degree; the local unemployment rate (to proxy for factor utilization); land area (to proxy other factors of production); Sensitivity to Emissions (): log of the total state or provincial area in square kilometers and countryby-time speci c dummies. In addition, in light of Proposition 5, we can view the country-by-time speci c dummies as capturing ROC factor supply in addition to pollution sensitivity. Prior to continuing, two notes concerning the speci cation in (34) are worth mentioning. First, the dependent variable is aggregate releases, as opposed to some scaled measure such as releases per unit of output or per capita. However, such scaling is inconsequential since ln(gdp ) and ln(p OP ) are included as covariates; doing so simply reduces the coe cient on the scaling variable by one and leaves the remaining estimates unchanged. Second, the trade intensity variables are aggregated across industries. In principle, one might conjecture that the e ects of trade intensity (of any type) may vary depending of the industrial composition of such trade. Unfortunately, industry-level trade between U.S. states and Canadian provinces is not available (to our knowledge). However, if the e ects of trade intensity vary depending on the industrial composition of the trade, then one should interpret the instrumental variable estimates (described below) as representing the local average treatment e ects of each type of trade (see, e.g., Angrist et al. 1996). That is, 1 and 2 re ect the causal e ect of each type of trade for locations for which trade intensity is determined at least in part by the instruments Many of the predictions of the theoretical model relate to environmental regulation as well as total emissions. However, de jure regulations are numerous, exhibit little temporal variation, and are di cult to compare across countries. In addition, such regulations do not account for enforcement and thus do not capture de facto regulation. Thus, we consider emissions as the dependent variable for most of our analysis; Section examines regulation as the dependent variable. 11 In this case, future work utilizing disaggregate data or relying on alternative identi cation strategies would be useful to gauge the generalizability of our ndings. 17