Competitive dominance of emission trading over Pigouvian taxation in a globalized economy

This paper examines the welfare implication of adopting a Pigouvian taxation scheme or emission trading scheme. In a globalized economy with international trade and cross-border pollution, we show that adopting the latter is the strict dominant strategy of each country, and global welfare is maximized when all countries adopt the latter, because emission trading incentivizes the other country to tighten its environmental regulation without concern for excessive shrinkage of domestic production and aggravation of cross-border pollution.