Abstract

This paper uses a three-stage game to analyze how environmental tariffs affect the strategic behavior of a foreign country in designing its environmental policy. The theoretical framework is based on an international duopoly model with detrimental externality in production and asymmetric environmental policies between the two countries. It is shown that the welfare effect of the foreign country's strategic environmental policy on the home country is ambiguous. In the case that the home country would be worse off because of the lenient environmental policy of the foreign country, there exists an optimal environmental tariff. If the home country imposes the optimal tariff on the pollutionintensive imports of the foreign country, any deviation from the first best environmental policy by the foreign country would make the home country better off. In addition, the implementation of the environmental tariff would mitigate the motivation of the foreign country to pursue strategic environmental policy, and drive the lenient environmental standard toward the efficient level. The theoretical results imply that in an open economy with non-harmonized environmental standards imposing a well defined environmental tariff on imports from the lax regulation countries would correct the adverse welfare effect, and more importantly induce the upward harmonization of environmental policy across countries.