Location choice under trade and environmental policies

In this paper, we use a game theoretic model to analyze the trade-off between the attractiveness of FDI and the environmental damage caused by production under asymmetric information. In the first stage, the domestic developing country reveals the level of import tariff and pollution tax under information uncertainty about the environmental damage that the foreign firm can cause. The foreign firm from a developed country decides where to locate afterwards with complete information about its own damage. Results show that the developing country can be better off encouraging FDI if and only if the marginal damage of pollution is sufficiently low. The optimal level of pollution taxes attracting FDI is higher than the marginal damage of pollution. However, the optimal pollution tax without FDI can be lower than the marginal damage of pollution with sufficiently high demand in the developing country.

Research highlights► We analyze the effects of trade and environmental policies on the FDI decision. ► There is uncertainty in the level of pollution damage of the foreign firm. ► Developing country prefers encouraging FDI under low pollution damage levels. ► Pollution taxes attracting FDI are higher than the marginal damage of pollution. ► Without FDI, taxes are lower than the marginal pollution damage under high demand.