Can the terms of trade externality outweigh free-riding? The role of vertical linkages

This paper analyzes the impact of vertical linkages on the international effects of environmental policy. With vertical linkages, stricter environmental policy at home indirectly reduces pollution in the rest of the world. This spillback effect can reinforce the free-rider problem that arises under strategic interaction. When pollution is transboundary a race to the bottom ensues, despite the fact that vertical linkages make it easier for national regulators to export the costs of environmental policy via the terms of trade. We also find that while trade liberalization can be good for the environment, vertical linkages tend to increase global pollution.