erc/metu
INTERNATIONAL CONFERENCE IN ECONOMICS  IV
September 13-16, 2000, Ankara

Startegıc Environmental Policies in the Presence of Foreign Direct Investment

M. Özgür Kayalıca (University of Essex, UK)
Sajal Lahiri (University of Essex, UK)

Abstract  

We develop a partial equilibrium model of FDI and analyse the interaction between the environmental standards and FDI. We begin our analysis with two firms (one from each country) which compete to export a homogeneous good to a third country. The firm located in country 1 is foreign owned while the firm located in country 2 is owned by domestic producers.We then extend the model to allow the number of foreign firms to be endogenous. The FDI equilibrium is determined by equating the profits of the foreign firms to an exogenous level representing the reservation level of profits which the foreign firms could obtain if they invested in alternative countries. Pollution occurs during production by both types of firms, and both firms possess a technology for abating pollution they generate. The governments in the two countries can force the firms to decrease the level of pollution they generate through quantitative restrictions on pollution. Any quantity restrictions on pollution affect country 1 welfare through effects on employment and pollution, while country 2 is affected through change in the profits of the domestic firms as well as employment and pollution. Using the specification above, we examine the equilibrium levels of quantity restrictions on pollution when the governments act in a non-cooperative and cooperative fashion. We find that the non-cooperative equilibrium always generates a higher level of pollution per unit of output. Furthermore, it is found that starting from the non-cooperative equilibrium, a small uniform reduction in the pollution allowance is strictly Pareto-improving. When the number of foreign firms is exogenous, the FDI host country always applies stricter environmental regulation. However, under free entry and exit of foreign firms, the FDI host country may apply lower standards under both non-cooperative and cooperative equilibrium.

Economic Research Center
Middle East Technical University
06531 Ankara Turkey
Phone: + 90 312 210 3044, 210 2003
Fax: +90 312 210 1244
e-mail: metuerc@metu.edu.tr