Strategic environmental policy under free trade withtransboundary pollution

We analyze the effects of free trade on environmental policies in a strategic setting withtransboundary pollution. Trade liberalization can result in a race to the bottom in environmentaloutcomes, making both countries worse off. With command and control policies(quotas), there is no race to the bottom. However, with internationally tradable permits, unlesspollution is a pure global public bad, there is a race to the bottom in environmental policy.In our model carbon leakage alone, and not a terms of trade motive, drives countries to relaxdomestic environmental policy. Quantity-based tools strictly welfare-dominate price-basedtools under free trade.[...]