Pollution, foreign direct investment, and welfare

• An oligopolistic model of production and pollution is considered.
• An endogenous number of foreign firms serve the market.
• We characterize optimal lump-sum taxes and emission standards.
• Optimal tax is positive.
• The number of domestic firms does not affect either the tax or the standards.

We characterize the optimal environmental policy in an oligopolistic model of production and production-generated pollution. A number of foreign firms are located in the host country which is assumed to be small in the market for foreign direct investment so that entry of foreign firms is endogenous. We derive closed-form solutions for the optimal entry tax and the optimal emission standards for foreign and domestic firms. Inter alia, we find that the optimal tax must be positive to control FDI, the number of domestic firms does not affect optimal policy and the emission standards depend on the relative efficiency of the domestic and foreign firms.