Environment, Welfare and Gains from Trade: A North-South Model in General Equilibrium

The effects of environment on trade and welfare are analyzed in a modifiedHeckscher-Ohlin framework using a quasi-homothetic preferences to account for differences incountries' expenditure shares on health. Three types of pollution, local-disembodied, global-disembodiedand embodied, result as a by-product of inputs used in production. For each case,the Walrasian, Pareto optimal and the Regulators' problem are analyzed. The optimal tax isshown to improve each country's welfare if the country is small in the world market. Otherwise,changes in the terms of trade may cause one country to be made better off at the expense of theother. Interdependence for the global-disembodied case is explored using a one-shot Nash game.For the embodied pollution, taxing the polluting input only can cause a decline in welfare whenthe polluting input is intensively used. Instead, a tax on the polluting input in combination witha subsidy to the non-polluting input is optimal. In general, the results suggest compensatorypayments may be required to encourage abatement policies. Contrary to other approaches, anabatement policy does not necessarily decrease a country's comparative advantage, i.e., reduceexports of the polluting sector.