International outsourcing, environmental costs, and welfare

This paper explores the welfare consequences of international outsourcing in the presence of resulting environmental damage in a three-stage model of North-South trade. In stage 1, outsourcing firms in the North (e.g., United States [US] and Europe) cause environmental damage to the vendor country in the South, as exemplified by the People's Republic of China (PRC). But, as its primary goal, the South pursuing economic development is willing to bear the costs of environmental degradation. Moving into Stage II, the environmental deterioration becomes so severe in the South that the vendor country begins to tackle the environmental problem by enacting government regulations. As a result, the costs and, hence, the prices of outsourced goods and services tend to increase for the firms in the North. However, the environmental protection measures undertaken generally fall short of the levels needed to restore the environmental quality acceptable by WHO standards. We present a framework for analyzing the effects of international outsourcing on environment and, ultimately, social welfare in terms of gains and losses under three alternative scenarios regarding no, partial or full accountability for outsourcing induced environmental damages. The policy implication is clear: to fully resolve the environmental problem in Stage III, the implementation of strong regulations or the fostering international cooperation is desirable; that is, until the environmental costs of outsourcing are fully accounted for by the outsourcing firms in the North. Such firms, however, may react by resorting to insourcing, diversified outsourcing and other strategies.