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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. 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