Environmental regulation and intra-industry trade

The paper analyses complex interactions between intra-industry trade (IIT) and environment by extending Krugman's model of monopolistic competition and trade. It is found that an increase in exogenous environmental tax by a country leads to a fall in its output (the scale effect) and aggregate pollution, and an increase in its number of varieties (the selection effect). With IIT, if Home is a net exporter, an increase in its environmental stringency leads to a negative scale effect, which reduces its export demand and raises its import demand. In contrast, a positive selection effect reduces its import demand. However, the first-order scale effect on exports dominates the second-order effect on imports, implying a rise in Home's share of IIT with Foreign. The opposite holds true when Home is a net importer. Furthermore, the impact of a rise in environmental tax on aggregate welfare comprises the following counteracting effects: a negative scale effect, a positive selection effect, a lower level of aggregate pollution and a higher environmental tax revenue in autarky, and two additional effects, namely, changes in the level of exports and imports, under free trade. The overall change in aggregate welfare, in both autarky and free trade, is in general ambiguous.