The Welfare Effects of Opening to Foreign Direct Investment in Polluting Sectors

This article investigates how attracting foreign direct investment (FDI) in a polluting sector affects home-country welfare relative to a closed polluting sector scenario. A welfare-maximizing government sets environmental regulations while accounting for public infrastructure levels, environmental quality, and FDI in a polluting sector. We show that in a closed polluting sector, environmental regulations are increasing over infrastructure. With FDI, a similar relationship holds but the optimal environmental regulation is higher to account for the decrease in domestic producer surplus and increase in pollution damages. A critical infrastructure level exists where welfare under a closed polluting sector and welfare with polluting FDI are equal. Countries with underdeveloped infrastructure below the critical infrastructure level are better off deterring FDI entrance into the polluting sector. As infrastructure quality increases beyond the critical infrastructure level, welfare is higher with FDI than under a closed polluting sector because of an increase in consumer surplus from lower prices.