Cournot, Pigou, and Ricardo Walk in a Bar – Unilateral Environmental Policy and Leakage With Market Power and Firm Heterogeneity

Policymakers aiming for the unilateral regulation of transboundary pollutants, such as greenhouse gases, fear as a consequence rising emissions in non-regulating countries. This so-called pollution haven or carbon leakage effect is of particular concern in emission-intensive and trade-exposed sectors such as steel, aluminium or chemical production. While these industries are often characterised by market concentration, most models that study the effectiveness of unilateral environmental policies operate under perfect or monopolistic competition, ruling out the adjustment of markups and cost pass-through rates. We study the determinants of emission leakage using a two-country general equilibrium model with heterogeneous product varieties and Cournot competition. We show that firms from the non-regulating country respond to the implementation of Pigouvian emission taxes on their competitors abroad and the subsequent gain in comparative advantage by increasing markups rather than output. We find that this effect, jointly with the exit of the least productive firms, can provoke a reduction of emissions in the non-regulating country and thus increase the effectiveness of unilateral emission regulation. Consumption gains from selection in non-regulating countries are offset by the use of market power by local firms