Interacting Policies: Trade and Environment 405 This is our third result. If for some reason there is a positive tax rate on capital, a jurisdiction may in fact loosen its environmental regulations relative to what we would find in a first-best world. To summarize: if jurisdictionsicountries offer foreign firms tax-free status, it would not be in the best interest of these jurisdictions to loosen environmental regulations to attract capital. If, on the other hand, conditions are such that the jurisdiction must tax capital, we might see the complementary use of weak environmental regulations to make up for the capital taxation. In reality, we might expect positive capital taxation to exist in countries that are not excessively worried about attracting capital. It seems logical that such countries would not feel strongly enough about attracting capital that they would resort to substantial weakening of environmental regulations. ‘This is just speculation, howevers what happens in reality is an empirical question. Il. INTERACTING POLICIES: TRADE AND ENVIRONMENT In the last section we examined the competition among jurisdi the use of environmental regulations to promote that advantage. In this section we examine a similar question, though in the context of international trade policies among and between countries. In particular, we are concerned about inter- actions between a country’s policies vis-a-vis international trade and a country’s environ- ‘mental policies. Can advantage in international trade be gained through manipulation of environmental policies? In the next section we are concerned with the interplay between free trade agree- ments and environmental policy. Often environmental considerations are major imped ments to free trade agreements. Conversely, environmental regulations have sometimes been used as disguised barriers to trade, in violation of agreed free trade agreements. In the subsequent section we examine two countries involved in strategic trade. This means that the countries are large enough players in the international market for there to bbe some market power, This allows trade policy to actually be used to advantage. In this context, ean environmental policy further enhance a country’s advantage? ns for advantage, and A. Free Trade Agreements and the Environment Free trade has been a holy grail for many governments over the past few decades. The European Union started out as the European Iron and Steel Community, in the early 1950s, with a goal of establishing one market for coal, iron, and steel products. The General Agreement on Tariffs and Trade (GATT) also emerged after World War 11, with a goal of facilitating world trade. In the 1990s GATT was replaced by the World Trade Organization (WTO), though the goals remained. The North American Free Trade Agreement (NAFTA) emerged in the early 1990s and involved Mexico, the United States, and Canada. Free trade agreements are concerned with reducing tariffs and other barriers to trade ‘among member countries. Reducing tarifis is relatively easy to stipulate in an agreement; defining and reducing trade barriers is more difficult, Often trade barriers will be erected406 CHAPTER 1! HAR) INTERNATIONAL AND INTERREGIONAL COMPETITION for reasons that appear to have nothing to do with trade, yet give subtle (or not so subtle) advantage to domestic producers. The boxed example relating to the Danish Bottle Bill isa good example, The WTO has developed a fairly sophisticated set of rules to deal with disguised trade barriers. Basically, a country may not restrict imports based on the way in which the products were produced—their process and production methods (PPM). Imports can be restricted based on the characteristics of the imported product (provided the same restrictions are applied to domestic products). For instance, a ban may be placed on the import or sale of beef with detectable levels of synthetic hormones. But restricting a prod. uuct based on its PPM, when there is no detectable impact on product characteristics, is deemed a way of favoring domestic production, This leads to.« problem with some global environmental problems. In several famous cases, the United States attempted to restrict the import of seafood that was not caught in an environmentally friendly fashion. U.S. law required that tuna needed to be caught in a dolphin-safe manner and shrimp needed to be caught in a way that protected sea turtles. Although the United States did not fare well in these cases, the WTO found that provided the United States (or any other country imposing such rules) has imposed its rules to protect the environment in a fair and nondiscriminatory manner, giving other countries flexibility in how they meet the ultimate environmental goal, then such rules would not be in violation of the WTO.” Other concerns with free trade agreements involve the migration of polluting indus- tries from richer countries to poorer countries within an agreement (such as from the United States to Mexico within NAFTA). This may be a valid concern, and was discussed in the previous section in the context of pollution havens. Another concern with free trade is more fundamental, and that is that environmental degradation accompanies prosperity, and trade tends to make us more prosperous. That is a hard criticism to counter except to note that richer societies tend to be willing to devote more resources to environmental protection. Danish Bottle Bill as a Trade Barrier In an effort to encourage recycling and refilling of beer and soft drinks containers, in 1978-1981 Denmark passed several laws requiring that those ‘beverages must be sold in “returnable containers.” As a matter of definition this required that the government approve containers being used and that in practice a large proportion of containers had to actually be returned and refilled. These seem like practical rules to encourage environmentally friendly practices. ‘This law was contested to the European Commission (EC). the central administrative unit (in Brussels) of the European Economic Community (EEC), which was to become the European Union (EU). One of the central arguments was that this legislation worked as a trade barrier favoring domestic producers. Foreign producers, particularly those seeking to sell madest quantities in Denmark, faced extra burdens associated with setting up a recycling system and having its containers approved. The EC objected and the Danish law was amended in 1984 to exempt smail importers (less than 300,000 liters per annum). Digitized by ‘ARD UNIVERS Original from ARD UNI\ RSITYInteracting Policies: Trade and Environment 407 This was not the end of the story. however. The EC felt the law still constituted a barrier to trade in violation of the EEC Treaty and brought the case to the European Court of Justice. Although the Danish rules Protected the environment, the EC argued that there were other ways of Providing similar levels of environmental protection (such as gavernment- run collection recycling systems) that did not have as strong an effect en protecting domestic beverage producers. Furthermore, the fact that beverages without domestic-foreign competition (milk and wine) were exempt weakened Denmark's claim to be pursuing the rule solely for B, Strategic Trade ‘The next issue we confront is the use of environmental regulations as tools to increase the competitive advantage of domestic firms engaged in international trade.” The standard view of international trade is that any barriers to trade that a country may impose, either barriers to protect domestic industries or subsidies to exports, can make the country only worse-off as a whole (though parts of the country may obviously be made better-off). If environmental regulations are weakened, domestic firms benefit via lower costs; however, residents who must put up with the pollution are harmed even more, Overall, it is not welfare improving to weaken environmental regulations to enhance trade. This is essen- tially the same result we saw earlier in this chapter in the context of interjurisdictional competition. This result breaks down somewhat if industries within a country have market power in the global market. With market power, the overall welfare of a country can be improved ‘by subsidizing exports, although this result applies to: very specific circumstances and ‘thusis not universally true, Since weakening environmental regulations is one way of pro- ‘viding a subsidy, it might be the case that there is a real incentive to relax environmental ‘regulations. Several authors have examined this question in some detail.” Their models are quite complex, so we will sketch only a rudimentary analysis of this issue here, The basie setup of our analysis is a specific industrial sector located in two differ- cent countries. Each of these two countries has a firm in this sector that is large in the global market and thus enjoys market power. For simplicity, we will assume these firms sell to a third country. This way, we do not have to worry about the welfare of consum> crs in the two countries, only the welfare of the firms. We will first show that a subsidy to production can be in the best interest of the country offering the subsidy. The firms are assumed to engage in Cournot competition with each other, meaning that each will maximize profits taking the level of output of the other as fixed. We will then examine the subsidy implications of different environmental regulations. As is the common approach in examining a problem of this nature, we first fix the subsidies at arbitrary levels and see how the firms will respond. Knowing how firms respond to arbitrary subsidies, we can determine what the optimal subsidies are, Or, in ‘our case, the two countries will be competing against each other so we are interested in the equilibrium subsidy levels that result from the competition, Digit HARVARD UNIVERSITY ginal RD UNIVERSITY408 CHAPTER 19 INTERNATIONAL AND INTERREGIONAL COMPETITION Let the outputs of the large firm in each of the two countries be denoted by D and F, for domestic and foreign. Assume the inverse demand function for their output is P(Q) = a ~ bQwhere Q = D + F. Inverse demand is thus linear, with a and b the two positive parameters of the inverse demand function. To make things even more simple, we assume fixed costs are C, and C, while variable costs are zero. This is the simplest possible arrangement we can define. Assume that the domestic firm receives a subsidy s per unit production, Profits for the domestic firm are then given by Tl, = [a-B(D + FID +sD-C, (19.8) =(a+s-BF)D-bD-C, (19.86) For any particular level of output, F, chosen by the foreign firm, how much should the domestic firm prodiuce? Clearly, the domestic firm should produce so that marginal prof- its are zero: this will maximize profits. To do so, we use Eq. (19.8b) to generate marginal profits, which we then set to zero: MIL, = (a +5~bF) ~ 26D =0 099) which implies that D=(a+5~bF)#(2) (19.10) This is shown graphically and generally in Figure 19.4. The figure shows a series of concentric isoprofit lines. These are lines of constant profit, defined by Eq. (19.8). Each of these lines represents (FD) combinations that yield the same level of profit for the FIGURE 19.4 Best response of domestic firm to foreign output levels. Decreasing C7 profit SOS Nee Isoprofit lines for EN domestic firm "Best response” of AX domestic firm to foreign output, #Interacting Policies: Trade and Environment 409 domestic firm. These isoprofit lines indicate what profit-maximizing level of D should be chosen for any particular level of F, Fix F; the D-associated with the highest profit is the D of choice. These Ds are the “best responses” to any given level of F. The solid line in Figure 19.4 shows the best response line—the optimal Ds. This is also Eq, (19.10). Now we can do the same thing for the foreign firm, deriving its best response to dif- ferent output levels by the domestic firm. The best response lines for D and F are shown in Figure 19.5. The point at which the two lines intersect is the equilibrium, (D',F"), the Deand Flevels at which each firm is doing the best it can, given what the other firm producing, This is what is known as the Cournot equilibrium. we have ignored the subsidy level implicit in Eqs. (19.8) and (19.10). If we assume the best response lines in Eq. (19.8) are associated with a zero subsidy Ievel, 0, then what happens if the domestic country increases s to a positive number? From (19.10) we see that if we increase 5, the best response D will increase as well, for any given F. Thus the best response line for D is shifted up as shown in Figure 193 for s > 6. Note that this results in a new equilibrium, one with higher D and lower F. As would be expected, a subsidy to firm D results in lower costs for this firm and thus expanded output. It comes at the expense of output from the other firm. Profits clearly expand for firm D, but to a certain extent these increased profits are due to the subsidy that has to be financed by the general tax revenues of country D. It turns out, however, that the net profits for country D (.e., taking into account the cost ‘of the subsidy) are actually higher for a positive subsidy than for no subsidy. Thus it is in the best interest of country D to subsidize firm D* In efifeet the subsidy allows D to take ‘output and profits from F. Now suppose both countries decide to subsis more complicated, In this case, both countries the result will not increase net profits for the countries. In fact, with both countries sub- sidizing, it turns out that a negative subsidy (an export tax) maximizes net profits if both ‘countries were able to coordinate policies. The reason for this is that the two firms com- ppeting against each other produce more output than if they were coordinating output and acting asa cartel. A positive export tax will restrict output and drive the two firms closer to this monopoly cartel level of output and profit. The important point, however, is that ‘two countries competing against each other will subsidize production, and not obtain the point of maximum net profit. ze exports, This turns out to be a little ill try to impose a positive subsidy, but FIGURE 19.5 Effect of a subsidy ‘on Cournot equilibrium output levels. F", D", foreign and domestic Best response, F ‘output, no subsidy to 0; F, B, foreign and domestic output, subsidy to D. o Best response, (s>0) Best response, D(s=0)410 CHAPTER 19 INTERNATIONAL AND INTERREGIONAL COMPETITION So far, these results are not ditectly related to environmental matters. However, sup- ‘pose we have exactly the same situation except that pollution is generated in conjunction ‘with output in each country, Pollution causes damage at home (forget about transbound- ary pollution). Now assume that it is not possible to directly subsidize a domesticindustry involved in an export market of the type described above. An obvious reason for being unable to use direct subsidies is that such subsidies may violate free trade agreements. A. natural way of subsidizing the industry is to relax environmental regulations. Instead of directly paying a subsidy to the polluter, the relaxed regulations reduce polluter costs at the expense of the citizens who must endure greater levels of pollution. Consider a firm that generates pollution in direct proportion to output. We will focus on only one firm, but the setup is as above: there are two firms/countries with market power selling into a third country, Ifoutput of our firm is D, then emissions are aD. Suppose the efficient Pigovian fee is f*. Ifthe firm is subject to the Pigovian fee, its profits are fa - (D + FID-C, - aD aay If the country would like to offer a subsidy s* per unit output but is unable to do so, it can instead lower the Pigovian fee to (t* ~ s'/a) resulting in profits TI, = (a - BW + FID -C, -(t* - sa) aD la- (D+ HR D-C,-faD+ sD (9.12) ing the appropriate pollution tax is a way of granting a subsidy of s*D, The down that there will be more output than desired and more pollution.” What does all of this mean? The basic result is that subsidies can be in the self interest of a country when its industries enjoy market power internationally (but not always, as we shawed), Since direct subsidies may be difficult to pursue, subsidies in the form of lax environmental regulations may be attractive. This is somewhat worrisome in that it may be difficult to determine whether a country is being too lax in protecting the environment. Ill. TRANSBOUNDARY POLLUTION ‘The last issue we will consider is that of transboundary pollution—pollution that migrates beyond the jurisdiction with the power to control that pollution. Greenhouse gas emis- sions are a classic example. Greenhouse gases emitted in Norway contribute to climate change worldwide. Or consider acid rain pollution from emissions from power plants in the United Kingdom that may be blown across the North Sea to Sweden and Norway. How do you control such pollutants? ‘There are three basic situations that we will consider. The simplest one is two adjoining ‘countries with pollution and goods produced in one country; the pollution migrates across the international boundary and is consumed in the other country. Goods are also shipped to the victim country. One way of solving this is for the vietim to levy a tariff on imports that were produced with pollution. The question is, how well will such a countervailing, tariff work if the tariff is related to pollution damage but applied to goods imports?Transboundary Pollutien 411 The second situation is an extension of this two-country model with pollution migrating across borders. But here these two countries are involved in a plethora of inter- national transactions, including but not limited to trade in pollution-intensive goods. Is it possible that sanctions in unrelated markets can be used to drive the polluting country to generate pollution levels that are Pareto optimal? ‘The third situation involves a group of countries with a common pollution problem, The pollution problem is common in that each country pollutes and each country suffers damage from the aggregate levels of pollution. Carbon dioxide, leading to global warming, is a good ‘example of such a pollutant, Effective control of the extemality must involve international agreements, Can such agreements be effective and binding, considering the fact that there is no international supergovernment that can enforce such environmental agreements? A. Countervailing Tariffs We first consider very simple situation involving two countries. One country, the polluter, has an industry that produces a good that is exported to the other country. Unfortunately, the industry also generates pollution that is entirely exported to the other country, which we will call the victim country (for example, the factory is on the border and all the pollution blows into the victim country). To correct the pollution problem, the victim country levies a tariffon imports of the good, with the tariff equal to the total pollution damage divided by the quantity of goods being imported. Thus the tariff reve- nue the victim country collects will be exactly equal to the damage inflicted on it by the polluter country. Does this correct the problem in an effictent manner? The answer is “no,” except in very particular circumstances. Only when all of the goods produced are exported to the victim country and when marginal damage is equal to average damage from pollution could the countervailing tariff be efficient. In such a case, the victim country has complete control over the producer of the good. However, because of this, the victim country is a monopsonist and will likely levy an impart tariff, in the absence of pollution, Consequently, efficient pollution control will be difficult to establish Consider a simplification of this example. Suppose the marginal and average dam- ages from pollution are the same. Pollution is also produced in direct proportion to the amount of goods produced. This is simpler than the case of allowing abatement technology—in order to reduce pollution, output must be reduced. Also suppose that the good is consumed in the polluter country as well as the vistim country, Finally, assume that the victim country does not levy a tariff to exploit its monopsony power but only to correct for the pollution externality. Figure 19.6 shows this situation. Shown are the two markets: the polluter market (19.6a) and the victim market (19,6b). Shown is the marginal private cost of producing the good as well as the demand for the good in each of the two ‘countries, The first-best pollution policy would be a Pigovian fee of t* on all production of the good, equal to marginal damage from the pollution. This raises the marginal cost of production in both markets, as shown in Figure 19.6. Only those consumers for whom the marginal value of the good exceeds the private marginal costs (MC,,,.,.) plus the marginal pollution damage (t*) will consume the good. Sales of the goods will be q? and g; in the two countries and this will be efficient. Now suppose that such a first-best cor- rection ofthe externality does not take place, Instead, there is no emission fee in the pol- luter country, leading to output of gy. The only recourse the vistim country has is to levy a tax per unit of the good imported (¢). Ideal412 CHAPTER 19 INTERNATIONAL AND INTERREGIONAL COMPETITION oo ca oa w @ «) FIGURE 19.6 Countervailing tariff in response to transboundary pollution. (a) Polluter market; (b) victim market. t’, first-best Pigovian fee; f°, countervailing tariff levied by victims; g2,q%, first-best consumption levels, polluter and victim markets; gp, consumption in polluter market without emission fee; q:, consumption in victim market with countervailing tariff; shaded area, pollution damage with countervailing tariff t~. consumer surplus less environmental damage. As the import duty is increased, pollu- tion will decline (since output in the home country will decline) but surplus fram goods consumption will also decline. The tax is shown in Figure 19.6b, as well as the total tax revenue, (t* q,). Total damage is [¢*(q, + q,)]. This is shown in Figure 19.6. Why is this not an efficient correction of the externality? In other words, why is this not Pareto efficient? One reason is that there are consumers in the victim market who are precluded from consuming the good but for whom the value of the good exceeds the value of consumers in the polluter market. For instance, the consumer corresponding to point A in the polluter market consumes the good whereas the consumer labeled 2 in the victim market does not consume the good, Yet, the marginal value of the good for Bexceeds the marginal value for A. In fact, with an efficient Pigovian fee, consumer A ‘would not be consuming the good—the consumer's value is less than the marginal social cost of producing the good. So we see that there is room for a Pareta improvement among ‘consumers. What about the quantity of pollution? Is that efficient? Note from Figure 13.9 that the efficient amount of output (which is directly proportional to the amount of pollu- tion) is qs + qi but the quantity that will be produced with a countervailing tariff is q; + 4j- These two quantities are unlikely to be the same. Efficiency in pollution generation really requires that all consumers of the dirty good see the total social cost of their consumption. That is the basic problem with the coun- tervailing tariff. And the problem gets worse if more than two countries are involved. If there are multiple consuming countries each country will levy a tariff related to dam- ‘age in that country only, ignoring damage in other countries. Such an arrangement is unlikely to lead to efficiency, In summary, a countervailing tariff.can help correcta transboundary pollution prob- lem but is unlikely to totally correct the problem. Digitized by Original from HARVARD UNIVERSITY HARVARD UNIVERSITYTransboundary Pollution 413 B. Issue Linkage ‘The previous section assumed that the victim country would levy countervailing tariffs ‘equal to the pollution damage. Although that is one approach to dealing with trans- ‘doundary pollution, the fact is that countries deal with each other on a multitude of issues, not only economic but political and cultural as well. It may be that the victim ‘country has little ability to coerce the polluter to reduce emissions; however, the victim ‘country may have a great deal of power on a totally unrelated issue, such as involvement in a joint defense treaty." By withholding agreement on the joint defense treaty, the vietim country may be able to force the polluter to reduce pollution levels. In essence, the vietim ‘country can threaten sanctions of one sort or another against the polluter country if the polluter country dos not adopt pollution regulations to achieve, the efficient amount of pollution. This is termed “issue linkage” and is more of a pol ‘tion, so it will not be addressed further here. C. Designing International Environmental Agreements ‘We now turn to the most general of international pollution problems, one in which there are many countries contributing pollution to a common poo! that damages all countries. ‘Only an international agreement among countries can hope to solve the problem. An ‘example is the emission of greenhouse gases such as carbon The emission of greenhouse gases may lead to global climate change, such as warming and sea level rise. Tt makes no difference where the gases are emitted: the effect on the global climate is the same, However, due to climate change some countries may incur greater damage than ‘others. Some arctic countries may benefit from warming whereas some low-lying coastal countries may suffer greatly from sea level rise. The emissions of chlorofluorocarbons (CFCs) to the atmosphere, leading to ozone depletion, is another example of a global pollutant. In this ease, a treaty (the Montreal Protocol) has been forged to deal with the problem.” The basic problem in designing an effective international environmental agreement is that there is no supernational organization to enforce such an agreement. In effect, the agreement must not only be self-enforcing but it must be sufficiently appealing to all par ties involved for them to agree to it in the first place The difficulties in forging an effective international envieonmental agreement are not unlike the problems faced in constructing effective cartels. A cartel isa group of producers that coordinates its production to increase its market power and thus increase its profits. Such cartels typically cannot rely on enforcement of agreements by third parties. If the cartel consists of a group of domestic firms within a single country, the cartel is usually illegal and thus any agreement is nonenforceable in court. If the cartel is a group of countries (such as OPEC), just as with environmen- tal agreements, there is no supernational enforcement bady. Successful cartels must rely on self-enforcement, voluntary participation, and effective restrictions on out- put. The work that has been done in understanding what makes cartels work can be applied to understand what makes international environmental agreements work (or not work) Drawing on what has been learned about the operation of cartels,” it is straightfor- ward to infer what is needed for an international agreement to operate effectively. For an414 CHAPTER 19 INTERNATIONAL AND INTERREGIONAL COMPETITION international environmental agreement to work (i.e, be self-enforcing), it should have three basic characteristics: 1. Cheating and nonparticipation deterred. ‘The agreement should be structured so that countries want to belong to the agreement, even if they are free to leave, This means that not-belonging to the agreement must be seen as undesirable; furthermore, cheating while in the agreement must also be deterred. 2. Individually rational, Each country should be better off joining the agreement than not joining the agreement. 3. Environmentally improving, Pollution levels attained by the agreement should be a potential Pareto improvement over the status quo. ‘The reason for the first of these conditions is that there must be an incentive-based way of keeping the agreement together. Many countries may find it in their own inter- est to be a free-rider on an agreement, rather than undertake the obligations inherent in reducing emissions. If a set of countries tightens carbon regulations, some industries may move to nonsignatory countries and export their carbon-intensive goods back to the signatory country, not only neutralizing the environmental gain but putting the nonsignatories at an advantage. (This is known as “leakage.”) One way of deterring free-riding is for participating countries to levy import duties on goods advantageously produced by nonsignatories. A similar issue pertains to signatory countries that fail to live up to treaty obligations. Cheating on the part of signatories must be deterred with predetermined penalties that countries have an incentive to levy. The reason for the second condition is that countries that join an agreement out of anything but self-interest may not be reliable members. There may be many reasons why a country joins an agreement, including a sense of obligation or a desire to do good. But if the country is better off in the agreement than not, participation is on a much more solid footing, and much more immune to domestic political pressures to weaken participation. ‘The third condition is trivial and somewhat redundant with the second point, but some environmental agreements have a great deal of activity but very little ultimate envi- ronmental protection. ‘tis easy to contemplate an international agreement that meets two of these three cri- teria; itis quite another thing to design an agreement that meets all three conditions.” Ozone vs. Carbon Dioxide Probably the two most infamous global environmental problems of the last half century are ozone depletion and global warming. In the 1970s scientists discovered that cholorofluorocarbons (CFCs), in wide use in applications ranging from refrigerants to spray can propellants, were depleting the ozone layer in the stratosphere. This depletion was expected to lead to elevated skin cancers and other consequences of higher levels of ultraviolet radiation making its way to the surface of the earth. In 1987, the Montreal Protocol was negotiated to phase out the Production of CFCs. Nearly all countries of the world, including the United States and China, have ratified the Protocol. The Montreal Protocol is widely viewed as successfully solving the global CFC problem. Digit Original HARVARD UNIVERSITY HARVARD UNIVERSITYTransboundary Pollution 415 Global warming from the production of carbon dioxide and other greenhouse gases was recognized as an issue in the nineteenth century, though only in the last two decades has it moved front and center in the global environmental policy debate. In 1997 the Kyoto Protocol was Negotiated to reduce greenhouse gas emissions from developed countries. The target, to be achieved by 2012, is approximately 8% below 1990 levels. Although the Protocol has been ratified by enough countries for It to go into effect. the United States is not one of those. Furthermore, major emitters in the developing world (China and India) have no emission reduction obligations under the Protocol. The Kyoto Protocol is widely viewed as a first step, but in the end is an inadequate solution to the climate change problem. Many papers have been written about why the Montreal Protocol worked so much better than the Kyoto Protocol. One reason for this, disparity is simply the nature of the problems. The benefits compared to the costs associated with taking action are so much more favorable in the ‘case of CFCs, Furthermore, the Montreal Protocol achieves near-universal adherence because the industrialized countries pay to make it worthwhile for the developing world to join the protocol. No such provisions exist in the Kyoto Protocol. Furthermore. punishments for violators are stipulated in the Montreal Protocol but not the Kyato Protocol. In essence, the Montreal Protocol has the three desirable characteristics of an international environmental agreement: it is self-enforcing, itis individually rational for ail countries to join, and there are clear environmental gains.* D. The Size of International Environmental Agreements ‘To answer the question of how many countries will choose to join an self-enforcing international environmental agreement (IEA), we will construct a very simple model of an IEA.” Despite its simplicity, it will help us understand why IEAs work and also what their limitations are. The basic goal is to understand why countries might voluntarily come together to solve an environmental problem, particularly when free-riding can look very attractive. Start with N identical countries, each of which generates emissions: country i emits ¢, Furthermore, each country can make two choices: to pollute or to abate. Pollution for country i means ¢, = I; no pollution (abate) means ¢, = 0, The payoff to a country will similazly be simple: MN, —ylEe) (19.13) There are two parts to this payoff. The first part is the private payoff from polluting (e) and the second part is the damage from the pollution emitted by all countries (y [¥, ¢]). For any country, abatement is more costly than polluting. If the country pollutes, the private payoff will be 1; if it does not pollute, the private payoff will be zero. (Units have been normalized se that the private payoff is either 0 or 1.) Thus the first term is e, which will be 0 if the country abates and 1 if the country pollutes. The damage from pollution Digitized t Original from ‘ARD UNIVERSITY