Protectionists, environmentalists, and the formation of environmental policy in an open economy

In situations where the traditional instruments of trade policy are not available, protection for importcompeting industries can be given only indirectly. One of the candidates of giving indirect subsidies is environmental regulation. The competitiveness of a domestic industry can be improved by low emission taxes, by low environmental taxes on the consumption of the industry's output, or by low quality standards that have to be met by the goods that are produced by this industry. The paper looks at these instruments in a partial-equilibrium setting. There are a domestic and a foreign industry that produce goods that are regarded as imperfect substitutes by the consumers. Firms are price takers. The government has five policy instruments at its disposal: the emission tax rate, taxes on the consumption of domestic and foreign goods, and environmental-quality standards for domestic and foreign goods. In a first step, the small-country case is addressed. Two lobby groups that are interested in influencing environmental policies are considered: the owners of an industry-specific factor and environmentalists. The process of regulatory capture is modelled via a political-support-function approach. Two cases are distinguished. First, the lobbies capture only single policy instruments. Second, they capture environmental policy as a whole. It is seen that some counter-intuitive results turn up, and this is explained by the fact that lobbies and policy makers are interested in providing protection in the most efficient way. Then we look at the large-country case where environmental policies affect the terms of trade. It is seen that regulatory capture may lead to welfare gains since lobbies sometimes happen to internalise part of the external effects arising in the international policy game.