Carbon Leakage: The Role of Sequential Policy Setting

We analyze non-cooperative environmental policy when the only strategic interac-tion between countries is through bilateral transboundary pollution, i.e., countries areclosed or small open economies. When countries set pollution taxes simultaneously,there is no carbon leakage. However, in the sequential-move game, the leader sets itspollution tax lower than the marginal damage from own pollution and lower than thatin the simultaneous-move game, while the follower sets its tax higher than that in thesimultaneous-move game. The only motive behind the leader's underregulation of ownpollution is to reduce the incidence of transboundary pollution from the follower, i.e.,to reduce carbon leakage. Aggregate pollution is higher in the sequential-move gamethan in the simultaneous-move game if pollution is a pure global public bad.[...]