Endogenous environmental policy for small open economies with transboundary pollution

We analyze how governments set their environmental policies if pollution is transboundary and countries are too small to affect world market prices. Assuming that governments are self-interested (rather than maximizing social welfare) we use a common agency framework to portray the calculus of political support-maximizing governments that find themselves in a situation of strategic interaction created by transboundary pollution. Our model shows how distortions created by the strategic interaction of national governments interact with distortions that arise due to the political processes in both countries. For instance, strong environmental lobbies may improve welfare as they counteract the distortion caused by the international externality, yet only up to a point. Instead of assuming interior solutions as most of the literature does, we show that corner solutions are a realistic possibility and derive conditions under which they occur. Moreover strong political distortions may create instability and thus lead to corner solutions.