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Pollution Haven Effect with Heterogeneous Firms
Hongliang Zhang
Department of Agricultural and Resource Economics
Oregon State University
[email protected]
Selected Paper prepared for presentation at the Agricultural & Applied
Economics Association’s 2013 AAEA & CAES Joint Annual Meeting, Washington,
DC, August 4-6, 2013.
© Copyright 2013 by Hongliang Zhang. All rights reserved. Readers may make verbatim copies
of this document for non-commercial purposes by any means, provided this copyright notice
appears on all such copies.
Pollution Haven Effect with Heterogeneous Firms
Abstract:
I developed a heterogeneous firm model to examine pollution haven effect within the
industry. Environmental regulation reduces the number of domestic firms in the industry by
forcing the least productive firms out, and shifts the domestic firms into the foreign country.
Although there are resource allocations between firms, total welfare is decreasing due to the
stringency of regulation. The impact of environmental regulation on the competitiveness is
dependent on the relative size of abatement cost to marginal production cost and regulation
regimes.
Keywords: Heterogeneous firms, Pollution Haven Effect, Environmental regulation
1. Introduction
Shifting the environmental regulation authority from states to federal government in
1970s caused great concerns about the relationship between regional/national
competitiveness and stringencies of environmental regulation. Researchers since then
started to test the hypothesis that tightening up pollution standard may have a negative
impact on plant decisions and trade flow, i.e., pollution haven effect.
The earlier research showed that environmental regulations have no impact on
plant location decisions (Levinson 1994; Gary 1996). But the effects of environmental
regulations on trade flow are controversial: most studies found little or no effect of
environmental regulations on the migration of pollution-intensive industries across
countries (Leonard 1998; Tobey 1990; Low and Yeats 1992; Walter 1982; Kalt 1985;
Mani 1997); some found significant displacement of pollution intensive sectors to
developing countries (Birdsall and Wheeler 1993; Hettige et al. 1992; Robin 1988; van
Beers 1997); a few concluded a positive relation between pollution regulations and
competiveness (Porter 1995; Ratnayake 1998).
The earlier estimates are likely biased because they assumed exogenous pollution
regulations and overlooked unobservable heterogeneity across countries by relying highly
aggregated state-level industry data. Later studies found environmental regulations had a
negative impact on industries’ competiveness (Henderson 1996; Greenstone 1998;
Becker and Henderson 2000; Levinson 2002) by relying on county-level industry data.
Recent studies used nonparametric methods and also supported the pollution haven
hypothesis (List 2003; Henderson 2007).
However, most international trade studies test the pollution have hypothesis assuming a
representative firm. The intra-industry analysis of firms’ reaction to environmental regulations
on export decisions does not exist.
In this paper, I extend the model in Helpman, Melitz and Yeaple (2004) to investigate the
role of environmental regulations in heterogeneous firms’ decision in export and foreign direct
investment (FDI). I show that pollution haven effects reduce the number of firms staying in the
industry and encourage more firms investing in a foreign country with loose environmental
regulations due to scale effect and composition effect, which are similar to the extensive margin
and the intensive margin in Chaney (2008).
The remainder of this paper is divided into four sections. Section 2 presents a closedeconomy model with heterogeneous polluting firms. Section 3 derives a two-country openeconomy model about export decision. Section 4 discusses pollution haven effects with
heterogeneous firms under different environmental regulations. Section 5 concludes.
2. Closed Economy
Following Melitz (2003), consider a closed economy with L consumers, each supplying
one unit of labor.
Preference and Demand
We assume there is only one differentiated “dirty” good, whose production generates
pollutants. All consumers share the same CES utility function over a continuum of varieties
indexed by ω.
(1)
∫
( )
where
represents the number of available varieties. =1/(1-ρ)>1, the elasticity of substitution
between any two varieties, is assumed constant.
The demand for each variety by Dixit and Stiglitz (1977) is given by
(2)
( )
( )
( )
∫
where I denotes aggregate expenditures spent on the good.
Production
We assume labors are inelastically supplied in the economy. Every firm is
uncertain about its productivity and faces a fixed entry cost
After entry, every firm incurs a fixed production cost
before starting production.
and a marginal production cost ,
randomly drawn from a distribution ( ). In addition, every firm under environmental
regulation incurs a fixed abatement cost
and a marginal pollution abatement cost,
proportional to its marginal production cost. The cost function is given by
(
(3)
)
.
Then, the monopolistic price for each variety is given by
(4)
( )
(
)
where w is the wage rate normalized to one.
Let
(5)
( )
(
)
, and then yield the maximized firm profit
(
)
(
(
Equilibrium
)
)
.
,
Firms staying in the industry with marginal production cost
are indifferent between
production and exiting if their profits are equal to zero. This results in the zero cutoff profit
condition (ZCP):
( )
(6)
(
)
.
All firms with marginal cost below continue to produce and earn positive profits while
firms with high marginal cost above are forced to exit.
Before entry, the net expected return of production is ∫
( )
( )
. In the long run,
free entry will drive down the net expected return to zero, leading to no entrants. This results in
the free entry condition (FE):
(7)
∫
( )
( )
.
Then, the unique equilibrium, B and c, can be solved out by combining (6) and (7).
3. Open Economy
Export and FDI
After starting production, firms can choose whether entering the foreign market or not.
We assume there are two ways to serve the foreign market: produce in the home country and
export goods abroad, facing an additional fixed export cost
cost (
and a marginal iceberg transport
); directly invest in the foreign country and build new plants there, incurring a fixed
FDI cost —including the cost of entering the foreign market and building plants—but saving
transport cost and pollution abatement cost compared to export.
Every firm’s monopolistic prices for domestic market,
( ) and
export and FDI,
(8)
( )
(
)
( ), are given by:
(
)
( ), and foreign markets under
(
( )
)
( )
( )
( ),
which yield the maximized profits level from domestic market,
( ) and
and FDI,
( )
(9)
( ):
(
)
(
( )
( ), foreign market in export
( )
)
.
Equilibrium
As in the closed economy, the zero cut-off profit condition in the open economy
gives:
(10)
(
)
(11)
( )
(12)
( )
(
)
(
)
The free entry condition of two-countries in the open economy is:
(13)
∫
(
)
( )
The equilibrium,
( )
∫
,
,
( )
∫
( )
( )
, and , can be solved out using equation (10)-(13).
4. Impacts of Environmental Regulation on Export/FDI Decision
Command and Control Policy
.
Each firm in the county with non-attainable status is required to install the same best
available abatement technology. They incur the same fixed overhead abatement cost , and
constant marginal abatement cost θ.
Figure 1: Impact of environmental regulation under command and control policy
Let
,
and
denote the cut-off without environmental regulation, and
,
, and
denote the cut-off under command and control policy. Equation (10)-(12) reveals that incurring
abatement cost induces a high cut-off productivity level (
). The least productive firms
cannot afford abatement cost and thus exit. Also, more firms are selected into the foreign market
(
), of which more firms choose FDI due to relative abatement cost between home
country and foreign country (
) under unilateral pollution regulation.
The impact of tightening up environmental regulation can be divided into four categories
by comparative statics.
1) Scale effect:
The stringency of environmental regulation reduces the number of firms staying
in the industry and thus less birth of new entrants, which lower the competitiveness of
home country/region. If this scale effect was large enough, all firms would directly invest
in the foreign country, and no firms left in the domestic markets. All demands for the
home domestic market would be satisfied by imports from the trade partner.
2) Composition effect:
The stringency of unilateral pollution regulation results in another effect—
composition effect. It is more profitable to choose FDI instead of export due to lack of
pollution regulation in the foreign country. Therefore, after survival more firms are
selected into FDI and fewer firms choose to export, which leads to a shift of the pollution
intensive industry to other clean countries and regions. If this composition effect was
large enough, the whole industry would move out. Scale effect and composition effect are
similar to the extensive margin and the intensive margin in Chaney (2008).
In sum, tightening up pollution regulation not only lowers the competiveness of
home country/region, but also causes environmental quality degradation in the clean
areas, which are mostly located in the developing countries.
3) Technical effect:
Assume the distribution ( ) of marginal production cost takes a form of Pareto
distribution, then
(14)
where
( )
( )
(
,
firms in the industry.
is a parameter indexing the dispersion. A higher
implied less productive
The technical effect is captured in the free entry condition. Due to the exogeneity of
marginal production cost distribution, technical effect is zero in this model. If pollution
regulation can induce technology innovation (Porter 1995) or there is a learn-by-doing or
learning-by-investment in the long run, technical effect will be positive, indicated by
.
4) Substitutability between trade policy and environmental policy:
There is a substitution relationship between trade policy and environmental policy
implied by
. Trade liberalization can cause the similar effect as tightening pollution
regulation. The process of freeness is also a greening process in some aspects.
Alternative Environmental Regulation Regimes
Effluent Tax
There are two types of incentive-based abatement policy. Effluent tax is one of them.
Each firm faces a fixed emission charge rate
without fixed overhead abatement cost,
. Compared to command and control policy, scale effect is smaller but composition effect
is the same. More firms stay in the industry and more firms specialize in the domestic markets.
Among firms serving the foreign markets, the rate of firms with FDI is rising.
Permits
The environmental regulation administration may release permits to firms. Typically,
permits are proportional to their emission and output, and firms are responsible for emission
reduction of the part above the permits. It is equivalent to implement an effluent tax
( ).
But this “tax” is no longer constant for every firm due to two contrary effects.
One is coming from the size of each firm. It is easier to identify and monitor bigger firms’
emission and performance, so the agency starts implementation from the bigger firms. Small
firms are forced to implement later due to their non-point attribute. Bigger firms with
higher productivity incur higher marginal abatement cost,
. This leads to more
entry of small firms and downsizing of bigger firms. The biggest firm will migrate into
the areas with loose pollution regulation first.
Political lobby is another factor. The typical outcome of lobbying is that existing
and large firms gain more free permits in the initial permits allocation. Under
grandfathering, new entrant and small firms incur higher abatement cost,
. This
will lower and delay new entrants, extending the longevity of existing firms.
The actual relationship between emission and productivity is a mixture of two
effects, which need an empirical test.
Tradable Permits
The other incentive-based regulation policy is to establish a market for permit
trading. Permits could be transferred from a firm with lower marginal abatement cost to a
firm with higher abatement cost. The market transaction determines the price of emission,
which decrease marginal abatement cost for every firm
( )
( ).
In sum, incentive-based regulation polices lower every firm’s marginal abatement
cost and thus increase the efficiency of pollution regulation.
Relaxing Model Specification
Environmental regulation increases the cut-off level for both domestic market and
foreign market. Least firms earn no longer positive profits and exit, and more productive
firms are selected into FDI. Due to resource reallocation from less productive firms to
more productive firms, the average profit of the industry is increasing, no matter how big
pollution abatement cost is.
This result is coming from the implicit assumptions in Melitz (2003). First,
environmental abatement cost does not shift the free entry condition. Actually, the productivity
level for every firm is lower due to abatement cost after regulation. The range of the distribution
( ) goes up. The average profit could be lower or constant if the free entry condition curve is
changed.
Figure 2: Average profit with environmental regulation
Second, firms’ productivity could be infinite. No matter how large the marginal
abatement cost is, the most productive firm can cover the cost and still earn an infinite positive
profit. However, this is untenable. If we limit the productivity in a certain range, a relatively
large abatement cost drives the most productive firm into unproductive, leading to a zero profit
for the most productive firm and a zero average profit for the industry.
Finally, there is only one good in this model. Substitutability only exists among varieties
within one good. Lack of substitutability at the good level causes an inelastical demand for dirty
good and a fixed markup.
Therefore, in order to gain the conclusions in this paper, it requires that we either
assume marginal abatement cost only accounts for a small percent of production cost or
relax the model specification. I will show the results under another model specification.
Two Goods and Endogenous Markup
In Melitz and Ottavio (2008), the cut-off level in country is given by
(15)
where   2(k  1)(k  2)(cM ) k f E is a technology index.
It is easier to derive that:
(16)
e
dcDl cM
k

 1.
l
dcM cD k  2
From equation (16), the elasticity of the cut-off level with respect to the upper
limit marginal cost (lowest productivity) is less than one. This implies that every unit
increase in the upper bound of the distribution will induce less than one unit increase in
the cut-off level. Thus, after imposed θ units of marginal abatement cost, the cut-off level
rises by less than θ units. Based on equation (16), the ultimate cut-off level is increasing
after pollution regulation.
The welfare in country l can be written by:
(17)
Ul  1
1
k 1 l
(  cDl )( 
cD ) .
2
k 2
According to equation (19), there is a negative relationship between welfare and
the cut-off level. Environmental regulation increases the cut-off level and leads to a
welfare loss.
5. Conclusion
I developed a heterogeneous firm model to examine pollution haven effect within the
industry. Environmental regulation reduces the number of domestic firms in the industry by
forcing the least productive firms out, and shifts the domestic firms into the foreign country.
Although there are resource allocations between firms, total welfare is decreasing due to the
stringency of regulation. The impact of environmental regulation on the competitiveness is
dependent on the relative size of abatement cost to marginal production cost plus regulation
regimes.
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