Bilateral trade and the environment: A general equilibrium model based on new trade theory

This study develops a trade–environment model based on new trade theory and emphasizes the role of international productivity differences in quantifying environmental consequences of trade. I introduce environmental policy and factor endowment differentials into a multi-country general equilibrium model of bilateral trade with random productivities and trade barriers. I calibrate the model for the OECD countries by estimating trade barriers and productivity parameters so as to match bilateral manufacturing trade shares. The calibrated model is used to analyze impacts of free trade and two types of environmental harmonization policies. I find that full trade liberalizations help to lower OECD pollution emissions by 32%, and about half of the decline in pollution is due to international productivity differences. I also show that harmonization of environmental taxes across the OECD countries is predicted to be more effective than the harmonization of pollution quotas in reducing aggregate pollution while under both policies trade impacts are relatively small. •Full trade liberalization is predicted to lower OECD air pollution emissions by 32%.•About half of the decline is due to international productivity differences.•Harmonization of pollution taxes is predicted to be more effective than quotas.