Environmental Policy,North-South Trade and FDI

We analyze trade between two countries, called the North and the South. There is one firm in each country and production costs are lower in the South. To serve foreign markets firms may export or engage in FDI. Both countries set tariffs on imported goods. We find that the implementation of an environmental policy by the South may affect the location decision of the Southern firm. When only the North sets an environmental tax, firms engage in FDI if the difference in costs between the two countries is low, otherwise the South exports and the Northern firm engages in FDI. If the South also sets an environmental tax, this does not restrict FDI by Northern firm, encourages FDI by the domestic firm, reduces its environmental damage and increases joint welfare. Finally, in equilibrium the South decides to implement an environmental policy and both firms engage in FDI.