Taxing Variable Cost: Environmental Regulation as Industrial Policy

Conventional wisdom has it that a country that enacts strict environmental regulations will place its firms at a competitive disadvantage. This view has been challenged recently. Some commentators argue that stricter regulation will enhance domestic competitiveness: strict regulations induce innovation. We evaluate this argument in a strategic trade model. In very special cases a strengthening of regulation may result in a shift of profits from foreign to domestic firms. This is not a general result, however. Environmental regulation should, of course, be imposed to control externalities, but it is unlikely that it will serve to generate industrial advantage.