Trade and the Environment: The Role of Firm Heterogeneity

In this paper, we derive a new effect of trade liberalization on the quality of the environment. We show that in the presence of heterogeneous firms, the aggregate volume of emissions is influenced by a reallocation effect resulting from an increase in the relative size of more productive firms. The relative importance of this reallocation effect and the scale effect well‐known from the literature is affected by the emission intensity at the firm level. Domestic emissions decrease as a result of a unilateral tariff reduction if and only if firm‐specific emission intensity decreases strongly with increasing firm productivity. As a result of the induced change in foreign emissions, domestic pollution can increase even if domestic emissions decrease.