ECOLOGICAL ECONOMICS 66 (2008) 638– 652

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ANALYSIS

Trade and the governance of ecosystem services

Richard B. Norgaard⁎, Ling Jin

Energy and Resources Group, University of California, Berkeley, United States

ARTICLE INFO ABSTRACT

Article history: We work with a basic general equilibrium model of an economy with an industrial good and Received 17 January 2007 a rural good. Industrial good production results in pollution that affects the provision of Received in revised form ecosystem services and thereby the production of the rural good. The assignment of 19 October 2007 ecosystem rights to the industrial polluters or to the rural pollutees results in differential Accepted 29 October 2007 transaction costs that affect production possibilities between the two goods. Ecosystem Available online 9 January 2008 rights are assigned to maximize social welfare. Over time, technological change and differences in income superiority affect the choice of the assignment of rights. Opening to trade affects the choice of the assignment of ecosystem rights depending on the nature of technological change, but the relative income superiority of goods no longer affects the assignment of ecosystem rights in a small economy. Thus, among other findings, we demonstrate that the phenomena known as the environmental Kuznets curve does not hold for the protection of ecosystem services in production, or production externalities generally, because trade separates consumption from production. © 2007 Elsevier B.V. All rights reserved.

The environmental economic literature on trade and the material production. Early in the environment and trade debate, environment emphasizes how trade might affect the govern- ecological economists stressed how globalization might affect ance of consumption externalities in the urban environments in the protection of ecosystem services (Folke et al., 1994). Our which most people live. Because health and environmental formal analysis of how trade affects the governance of amenities are sufficiently superior goods, these environmental ecosystem services indicate that the relationship between qualities will eventually be protected as income increases trade and ecosystem service governance is complicated, and through trade and development. This emphasis on a particular the argument that the gains from trade will lead to greater type of consumption externalities provides the primary support protection does not necessarily hold for production external- for what has become a near universal belief in the environ- ities. The arguments for an environmental Kuznets curve have mental Kuznets curve. Ecological economists, on the other been overstated through their focus on sufficiently income hand, have long stressed how nature's services support superior, consumption externalities. agriculture, forestry, and fisheries in largely rural areas (Jansson Primary production sectors depend on the services of et al., 1994). Interest has increased dramatically in the services, nature. Since this has long been understood, numerous for example, of soil microbes that sustain soil fertility, natural institutions were established to encourage soil conservation, predators that control agricultural and forest pests, and of protect fresh and coastal waters, and otherwise manage marshlands that process waste. The Millennium Ecosystem nature to assure the economic productivity of rural areas. Assessment (2005) focuses primarily on problems associated Some institutions, like priorities to water, trace back to rights with the decline of ecosystem services that contribute to long given rural producers; others, like soil protection, trace to

⁎ Corresponding author. 310 Barrows Hall, University of California, Berkeley, California 94720-3050, United States. Tel.: +1 510 845 5359. E-mail address: [email protected] (R.B. Norgaard).

0921-8009/$ – see front matter © 2007 Elsevier B.V. All rights reserved. doi:10.1016/j.ecolecon.2007.10.026 ECOLOGICAL ECONOMICS 66 (2008) 638– 652 639 the rise of nature conservation movements that arose with tion costs associated with monitoring and interpreting the rapid industrialization and urbanization during the 19th condition of the ecosystem delivering services, determining century. The term “ecosystem services,” however, arose who is affecting it how, and enforcing rights (Norgaard and during the last quarter of the 20th century as ecologists and Liu, 2007). Some ingenious environmental markets have been economists joined their understandings of ecological and created, all characterized by a few points at which monitoring economic systems to re-portray our relationship to nature in is relatively easy, but they still require public monitoring and the now dominant language of economics. We use the term enforcement because interests beyond the parties to the “ecosystem service governance” to refer to how the combina- market transaction are at stake. For example, transaction tion of pollution and land use controls, both urban and rural, costs continue to thwart the implementation of water markets affect the protection, or not, of ecosystem services (Brookes in California (Haddad, 2000; Carey et al., 2002). Complexity, et al., 2002). We explore how technology, relative income indivisibility, and thereby higher transaction costs are the superiority, and trade affect the choice of governance of essence of environmental problems. Yet, with few exceptions ecosystem services. We provide a positive analysis of how (for example, Stavins, 1995; Cason and Gangadharan, 2003), countries are likely to behave if they myopically optimize in there is a tradition of not including transaction costs in response to changing, short-run conditions. environmental economic models that has been carried over We start in Section 1 with a very brief review of the lite- into the trade and environment literature. rature on trade, transaction costs, and environmental govern- Third, our model complements the existing literature by ance. In Section 2 we present our simple general equilibrium looking at how governance changes under first-best condi- model and the findings established earlier (Norgaard and Hall, tions. Most of the trade and environment literature falls into 1974) for a country not engaged in trade. These are our base the category of second-best arguments wherein “surprising” scenarios illustrating how technological change and social outcomes arise from a first-best perspective. However, sec- preferences favor, or not, the protection of ecosystem services ond-best arguments beg first-best solutions (Krugman, 1997). before trade. In Section 3 we look at how opening up to trade The models, however, typically imply first-best solutions that affects the choice of ecosystem governance for a small do not actually exist because transaction costs have not been country. In Section 4, we extend the analysis, though under included. Brander and Taylor (1998:198-9) provide a clear more restrictive conditions, for a country whose trade affects example: world prices. Our conclusions are summarized and interpreted in the light of the findings of others in Section 5. Rather obviously, the “first-best” policy would be to solve the open access market failure by establishing some system of appropriate property rights or by using an 1. Relation of our analysis to the literature appropriate harvest tax. By hypothesis, however, this is either impossible or very costly, leading to a search for alternative Where there are distortions in the choice between market and policy instruments. (our underlining) environmental goods, a society may be better off constraining trade (reviewed in Copeland and Taylor, 2004). Our own model Had the very costly transactions of the “first-best” policy complements the existing literature in three ways. been included in their model, the policy would have been First, while the vast majority of the literature stresses how interior to the possibility frontier and obviously not “first-best” ecosystem services affect our enjoyment of health and ame- at all. While some solutions are implicitly excluded by tran- nities, i.e. consumption externalities, our contribution stresses saction costs, the solutions explored in most of the literature the role of ecosystem services in production, or production are presumed not to have transaction costs. externalities. When health and amenities are sufficiently Not explicitly addressing transaction costs yet implicitly superior goods, society will have an incentive to protect them including them in analytical models leads to other contra- as income increases through trade. However, for ecosystem dictions. For example, Chichilnisky (1994) constructed a two- services that contribute to the production of a tradable good, country general equilibrium model of trade to investigate trade provides the opportunity to purchase or sell them from the role of property rights on primary resource exploitation. abroad, and this affects the gains from protecting ecosystem Her model posits a North country with private property services domestically. The contribution of the income super- rights where externalities are fully internalized (i.e. implying iority of environmental amenities to stronger environmental no transaction costs) and a South country with open access governance is over emphasized in the current literature because to natural resources (implying transaction costs prevent the role of ecosystem services in the production of tradable common management) such that private harvesters do not goods has been little explored. Bulte and Van Soest (2001) make bear the full costs of extraction. The implicit asymmetry in a similar point without formally exploring the implications for the treatment of transaction costs leads to overproduction in governance. the South and overconsumption in the North relative to the Second, our analysis incorporates transaction costs. While situation where the South also has private property rights some types of access to ecosystem services can be divided and and externalities are internalized. Our model differs from assigned as private property, it is inherently more difficult to that of Chichilnisky in that we have an externality in each divide and assign rights to clean water, migrating fish, and country, treat transaction costs the same across countries, biological controls of agricultural pests than to divide and and allow each country to internalize its externality to the assign labor and capital. The more indivisible and complexly point where the marginal gains of internalization equal the embedded in ecological processes, the larger are the transac- marginal transaction costs of internalization. The interaction of 640 ECOLOGICAL ECONOMICS 66 (2008) 638– 652 transaction costs and the assignment of pollution rights on production, consumption, and welfare is a unique contribution of our model.

2. A general equilibrium model with transaction costs of ecosystem governance

Ronald Coase (1937) identified the importance of transaction costs to economic organization while also providing the article (1960) that has confused environmental economists to this day. Alan Randall (1972) provided a clear explanation of the misinterpretation of Ronald Coase's famous article on social cost (1960). Coase himself denied the “Coase Theorem” in his Nobel Address (1991). Yet to this day, environmental – economists ignore transaction costs and the assignment of Fig. 1 Production possibility frontiers. property rights, not infrequently citing Coase. Ezra Mishan (1971) asked why there was an onslaught of legislation protecting the environment during the 1960s. This shift in PP 1 environmentalrightstowardconsumersandfuturegenera- lity curve labeled T=0 in Fig. 1. Since transaction costs are tions was clear evidence of an environmental Kuznets curve. zero (and distributive effects are presumed to be offset by Norgaard and Hall (1974) proffered an economic explanation the use of a social indifference curve), this is the production for the shift to stronger protection of environmental ame- possibility curve regardless of whether producers of indus- nities, showing that this rapid change, perhaps discontinuity, trial goods initially hold rights to affect the level of eco- in governance could have been driven by technological system services used by rural producers or whether the change favoring manufactured goods over environmental rural producers have rights to ecosystem services at their “ ” 2 amenities. Yet Bulte and Van Soest (2001) note: “While there is natural level. some ad hoc reasoning regarding the mechanisms driving the When there are transaction costs, two distinct production EKC, should it exist, formal modeling in this field is scarce.” possibility curves emerge: one where industrial producers NorgaardandHallhadprovidedaformalmodelthatcould have rights to affect the level of ecosystem services used by explain the environmental Kuznets curve, but economists rural producers and one where rural producers have rights to simply continued to ignore it, as they have to this day. The ecosystem services undiminished by industrial producers. For model is not easy to use, but like any formal model, it also the first case, rural producers must purchase rights in order to helps identify the conditions when an EKC would not arise, a reduce the externalities to rural production. Following Mishan discussion notably missing in the mainstream literature on (1971), Randall (1972), and Norgaard and Hall (1974), we refer to environment and development. this as L law. In the second case, rural producers hold all of the We have adopted the Norgaard and Hall model to fit rights and industrial producers must purchase rights from the conditions of tradable goods. Consider an economy rural producers in order to engage in production. We refer to ¯¯ that produces two goods. Let's call them industrial goods this as L law. We noted in the introduction the complex and rural goods, X and Y respectively. Industrial goods historical development of environmental law and the way the should be interpreted broadly for they could include urban law typically evolves on the basis of precedents. This means “ ” industry as well as rural industry, “industrial” agricultural that what we are simply referring to as the rights to affect or practices, as well as other activities like transportation. The to have access to ecosystem services are by no means explicit important thing is that industrial goods are relatively less rights but rather implied or potentially inferable in a myriad of ¯¯ dependent on ecosystem services than rural goods. The institutions. This ambiguity means that the term L really production of industrial goods entails externalities that affect the availability of ecosystem services for the production of rural goods while the production processes of rural goods do not have 1 analogous non-market impacts on the production of industrial As in most economic analyses, we are assuming away the possible complications of non-convexity in our possibility frontier goods. Efficient production requires the internalization of the (Baumol and Bradford, 1972; Dasgupta and Mäler, 2003). externalities. Thus the production possibility frontier in our 2 The distributive effects between the industries can be model, unlike the vast majority in the literature, includes important over time. Dynamic models of pollution externality the costs of internalizing externalities, i.e. the costs of monitor- resolution show that the returns to capital and other factors of ing, bargaining, and enforcement inherent in environmental production in the polluting industry are higher if the polluting governance. industry holds the right as compared to when it does not. This Now, imagine a world in which there are no transaction leads to the entry of firms and a higher level of production of the polluting good over time, partly through entry of polluting and costs to resolving externalities. Then the production possi- exit of non-polluting firms (elaborated in Hanley, Shogren, and bility curve for efficient combinations of industrial and White, 1997, pages 73–75). For simplicity in our analysis, we are rural goods, including the costs of controlling the loss of assuming these distributive effects are resolved in the process of ecosystem services, are defined by the production possibi- reaching consensus on a social indifference curve. ECOLOGICAL ECONOMICS 66 (2008) 638– 652 641

Fig. 2 – a. Social indifference curves determine choice of governance. b. A society indifferent between L and L¯¯ law might consume different mixes of goods.

PP refers to environmental governance being strongly directed to verges from T=0 as fewer manufactured goods and more the protection of ecosystem services. rural goods are produced.3 For the same reasons, under L¯¯ law The labor and capital expended in the transactions of when the rural producers hold the right to ecosystem services monitoring, bargaining, and enforcement could have been and manufacturers must purchase rights from rural producers used to produce goods. Thus the production possibility to degrade ecosystem services, the production possibility curves for goods with transaction costs will be interior to curves with and without transaction costs are at the same the production possibility curve without transaction costs. point when only rural goods are produced and moves inward Now consider the situation where only industrial goods are as more industrial goods are produced. We can now dispense PP produced. Under L law where industrial producers hold the with the transaction costless frontier T =0. right, rural producers do not have to purchase rights from We then invoke social indifference curves to determine industrial producers since rural production is zero. Clearly, at whether society is better off under L or L¯¯ law.4 In Fig. 2a, we this point, there are no transaction costs. In short, under L law, the production possibility curve with transaction costs is at the same point as the production possibility curve without 3 Some readers have been troubled that we attribute transaction transaction costs when only manufactured goods are pro- costs at the end point of the curve where only rural goods are duced. As more rural goods and fewer manufactured goods are produced and the production of industrial goods is no longer causing externalities. How can there be transaction costs if there produced, however, it is efficient for rural producers to pur- are no longer externalities? The answer is that there are no longer chase more and more of the rights. We argue that the costs of externalities because of the transactions entailed in the purchase transacting increase, in terms of goods that could have been of all of the rights and enforcement to assure that no producers of produced, as more rights are purchased because of increasing X actually produce. 4 difficulties of reaching, monitoring, and enforcing exchange Neither the presumption of social indifference curves nor imagining a representative agent avoids the myriad distributional agreements as more and more rights are exchanged. Thus in issues of real economies or the geopolitical debate we are trying PP T Fig. 1 the production possibility curve T,L (where desig- to address. The senior author has a modest preference for social nates the existence of transaction costs and L that the indifference curves because they remind us that we are addres- industrial manufacturers hold the rights), increasingly di- sing social choice. 642 ECOLOGICAL ECONOMICS 66 (2008) 638– 652 illustrate how the choice of ecosystem service governance can be affected by whether a society has a stronger preference for manufactured or rural goods. In Fig. 2b, society is indifferent between the two general states of ecosystem law, illustrating how when a choice between them exists, the state of the law itself can have a significant effect on the mix of goods produced as well as the level of ecosystem service protection. If society chooses the “polluter-pays” principle, i.e. giving rights to ecosystem service protection to rural producers, for example, fewer industrial goods, less ecosystem services reduction, and more rural goods are produced than under “pollutee-pays” ecosystem governance. Not only are transaction costs clearly visible in terms of reductions in production, but the production differences clearly affect one industry more than the other. Thus L law favors industry and vice versa. This provides a simple illustration of how the assign- ment of rights affects the efficient market solution when transaction costs are included in the analysis. For this reason, we refer to the two types of ecosystem governance with respect to how each “favors” different industries. Similarly, we also refer to L¯¯ law as stronger ecosystem governance because it favors the rural sector that is hurt by the externalities of industrial production by providing stronger control of the externalities. In our two-period analysis (period 1: T=0 and period 2: T=1), both the shape of production possibility frontiers and expansion path of indifference curves can be changed by exogenous forces. Fig. 3a shows the case where technological change happening between periods 0 and 1 favors good X, Fig. 3 – a. Technological change favors good X. b. Relative resulting in a relatively larger increase of X goods being income superiority of Good Yt. produced (Definition 7 in Appendix A). Fig. 3b shows how the preference change with the rising income may direct the income expansion path to favor Y goods between the periods 1 and 2 (Definition 9 in Appendix A). Hereafter we refer to a the environmental amenity manifests itself as a relatively preference change such as that illustrated in Fig. 3b as the Y superior good) and economic growth is driven by a neutral good being the “relatively superior” good.5 expansion of inputs or technological change for manufac- Comparing environmental amenities and manufactured tured goods and amenities, then society will eventually prefer goods, Norgaard and Hall (1974) demonstrated plausible L¯¯ law and transfer the pollution rights to the pollutees. phenomena for a closed economy leading to what we now Central to Norgaard and Hall, however, was the more difficult call the environmental Kuznets curve. If society starts argument with respect to how differences in technological with manufacturers having the right to pollute (L law), change between the industries affect environmental govern- ance in a closed economy. The assumptions, underlying equations of the model, and key theorems are provided in Appendix A. 5 In our model, a relatively superior good is one where relatively There is an intuitive interpretation for these results in more of the good is purchased at the same price as income Norgaard and Hall. From Fig. 1 it can be seen that the increases. Norgaard and Hall referred to this as “sufficiently transaction costs are effectively borne by the industry that ” superior. By convention, indifference curves exist through time does not hold the rights. When the goods are substitutes, it as income changes, as if people at one level of income could makes sense to switch consumption toward the good that is express what their tastes would be at a substantially higher level. becoming disproportionately cheaper through technological Because CES indifference curves are symmetric around rays through the origin, relative income superiority cannot be shown change, letting the other industry for which consumption is in a consistent set of CES indifference curves. Thus to show one decreasing bear the transaction costs. When the goods are good having greater income superiority than the other, we shift to complements and hence best consumed together, it makes new indifference curves, sometimes referring to this as “pre- sense for the transaction costs to be borne by the industry that ” ference change. While our approach flouts convention, it is is being favored by technological change since its costs, and certainly just as realistic to think of new indifference curves hence the relative burden of the transaction costs as well, are arising with new income, circumstances, and knowledge. The becoming lower. role of relative income superiority on governance is intuitive but somewhat tedious to prove with CES functions. We do not include The updated results for a closed economy from Norgaard the proof but can supply it for those who wish to see it. and Hall (1974) presented in Table 1 are our base cases for ECOLOGICAL ECONOMICS 66 (2008) 638– 652 643

Table 1 – Summary of the effects of technological change and relative income superiority in a closed economy Elasticity of Change in production Change in consumption substitution Technological Society eventually Relative income Society eventually change favors prefers superiority prefers

Substitutes (0blb 1) Rural goods ¯¯L Rural goods ¯¯L Industrial goods L Industrial goods L Complements (lb0) Rural goods L Rural goods ¯¯L Industrial goods ¯¯L Industrial goods L Elasticity is 1.0 (l=1) Rural goods Maintain prior governance Rural goods ¯¯L Industrial goods Maintain prior governance Industrial goods L

considering how trade affects the governance of ecosystem production of the industrial goods lead this country to switch services. to L law because it favors the production of industrial goods? The answer is almost trivial (though a proof is available at Theorem 3.1 in Appendix B). Trade separates consumption 3. Trade and ecosystem governance for a from production. In our model, the governance of ecosystem small country services is determined by levels of production and, for a small country open to trade, these are entirely determined by world Imagine a small country with factor endowments, tastes, or prices. Thus neither growth in income through trade nor production conditions that differ from the rest of the world relative income superiority affects ecosystem governance. (ROW) such that there are possibilities for gains from trade. Thus if the world price for industrial goods is sufficiently How does opening up to trade of goods affect the governance higher than the domestic prices before trade, it will lead to of ecosystem services? weaker protection of ecosystem services, i.e. L law being pre- Our conclusions in the previous section were driven by ferred over L¯¯ law. continuous technological change or factor augmentation and Now let's consider the effects of technological change. were stated in terms of “eventually,” or not, a change would Corollary 3.1 tells us that, for a small country engaged in trade, occur. We begin this section by looking at a one time change the governance of ecosystem services will eventually favor the from a closed to an open economy and our conclusions sector experiencing greater technological change. Now we depend on whether the price change due to trade is simply compare our findings from Section 2 with respect to sufficiently large or not to drive a change in governance. To how technological change affects governance without trade start, imagine a country that when closed finds it optimal to and for a small country engaged in trade (see Table 2). give rural producers strong protection of ecosystem services, Changes in the international regime over the past few i.e. L¯¯ law. After opening to trade, this country becomes an decades have favored capital mobility. While our model does exporter of industrial goods (Fig. 4). Will the increased not explicitly include factors of production, differences in factor intensities between the industries and capital mobility would lead to relative shifts in production possibility curves comparable to those illustrated in Fig. 3a. Thus, for example, if industrial manufacturing is capital intensive relative to the rural economy and our small country is relatively capital poor, then increasing capital mobility would be analogous to having technological change favoring industrial manufacturing. The effect of this on the choice of environmental governance,

Table 2 – Summary of the effects of technological change and trade on a small economy Elasticity of Technological change Society eventually substitution (or capital mobility) prefers favors Without With trade trade

Substitutes Rural goods ¯¯L ¯¯L (0b lb 1) Industrial goods LL Complements Rural goods LL¯¯ (lb 0) Industrial goods ¯¯L L Elasticity is 1.0 Rural goods Maintain prior ¯¯L (l=0) governance Industrial goods Maintain Prior L Fig. 4 – Trade Effects for a small country and the critical Governance price line. 644 ECOLOGICAL ECONOMICS 66 (2008) 638– 652 without and with trade in goods, should be comparable to can set the governance of ecosystem services as the mix of those shown in Corollary 3.1 for technological change. goods being produced changes such that the two sectors In contrast to a closed economy, Corollary 3.2 says, relative themselves never need to negotiate the level of governance income superiority no longer affects the choice of environ- and hence no transaction costs occur. This assumption mental governance when a small economy is opening up to allows us to work off simply the one production possibility trade, because domestic demand is too small to affect the curve, C|T =0, while also being able to say something about the world price. change in governance of ecosystem services. Governance is still driven by transaction costs, though now they are hypothetical transaction costs that are perfectly avoided by 4. Trade and ecosystem governance for a a central planner. Considering transaction costs experienced large country by the central planner would make the change from one governance regime to the next “lumpy,” as they are in reality, It proved considerably more difficult to use our model to but not affect the direction of change, the focus of our explore how trade affects the governance of ecosystem analysis. services for countries of comparable size, or a very large Now consider the case of trade between countries of country trading with the rest of the world (ROW). To make any comparable size or a country big enough to affect world headway, we had to further simplify our formal model. In prices. We assume initially that the country imports rural some ways, though more difficult to conceive, the simplifica- goods and exports industrial goods. Following the previous tion is more realistic. Regardless, the simplification helps us discussion, we assume that production and governance of see new phenomena. ecosystem services are linked in a single constant elasticity of There is a tradition in the literature of environmental transformation function where each location along the economics to juxtapose the extreme cases of whether the possibility curve reflects the best possible combination of polluter or pollutee should pay, yet pollution rights are rarely governance of ecosystem services that would have been so simply defined or distributed. Polluters are typically reached had negotiations over ecosystem service protection allowed to pollute up to some limit after which they are between the industries actually occurred. While we do not penalized. This is comparable to giving polluters some have actual institutional outcomes, we know that the protec- pollution rights, though they cannot trade them, but not all tion of ecosystem services increases as more rural goods and of the pollution rights. As economic and technological fewer industrial goods are produced and vice versa.For conditions change, or new environmental information arises, example, in the left graph in Fig. 5, the protection of ecosystem societies regularly adjust their environmental laws without services is stronger at A than at B. Thus a shift in production going to the extreme cases represented by L and L¯¯ in the from A to B would be a “move toward L Law” (for more details, previous sections. With respect to climate change policy, for please refer to assumptions in Appendix C). example, we see a healthy debate over how carbon rights Now, assuming the preferences and production conditions might best be distributed between rich and poor countries as shown in Fig. 6, we can say that, after engaging in trade, the well as between polluting industries and the public (see, for domestic economy moves toward L with trade while the rest example, Baer et al., 2000). of the world (ROW) moves toward L¯¯ as shown in Fig. 7.It Flexibility in the level of governance of ecosystem services should be fairly intuitive that, for our model, moves in the in practice simplifies treatment of them in theory. Recall that governance of ecosystem services before and after trade are when only one good is being produced and governance favors always in opposite directions between the countries (see that sector, no adjustments in governance are needed, there Appendix C, Theorem 4.1 and its Corollary for the proof). This are no transaction costs, and the economy is effectively on the is a simple way to show that basic trade theory augmented transaction costless production possibility curve C|T =0.Aswe with a simple model of ecosystem governance supports move from either of these extreme positions, governance is neither a race to the bottom nor to the top. Governance adjusted optimally depending on the mix of goods being moves in opposing directions to complement comparative produced. Now, imagine an all-knowing central planner who advantage.

Fig. 5 – Comparison of ecosystem service governance. ECOLOGICAL ECONOMICS 66 (2008) 638– 652 645

Fig. 6 – Effect of trade domestically.

Theorems 4.2–4.5 in the Appendix suggest the individual domestic economy back to stronger ecosystem protection of effects of technological change and relative income super- ecosystem services than the pre-trade level. However, if iority. We would expect the domestic economy to further expenditures on rural goods increase faster with income weaken its protection of ecosystem services, if 1) technological than expenditures on industrial goods, the domestic economy change favors the industrial production domestically; or 2) may adopt stronger governance to protect ecosystem services. preference changes toward industrial goods, or 3) technologi- We have shown that the overall effects of growth in either of cal change favors the production of rural goods in the rest of the industries and capital mobility are to lead the domestic the world, or 4) industrial good production domestically economy to weaken protection of ecosystem services. So even attracts more foreign investments. On the other hand, the if relative income superiority eventually leads the country to domestic economy would strengthen its protection of ecosys- strengthen its governance of ecosystem services, the outcome tem services, if 1) the rural industry experiences more rapid with respect to the strength of governance is still ambiguous growth domestically, or 2) expenditures on rural goods at any compared with the pre-trade level. given price increase faster with income than industrial goods The major difference from the small country case is that now (relative income superiority), or 3) technological change favors the preferences of the domestic economy can affect the choice of industrial production in the ROW, or 4) domestic rural ecosystem service protection because it affects the relative production attracts more foreign investments. Furthermore, demand in the world market and thus the relative price. So a as shown in Theorem 4.3, the ecosystem protection domes- change in preference with increasing income toward rural goods tically may become strengthened when rural production may help to restore stronger governance of ecosystem services. domestically experiences more rapid growth, but it will still Clearly, if both countries choose relatively more rural goods with be weaker than the governance the country chose before it a rise in income, this will lead to stronger ecosystem governance, opened up to trade. This means that technological change and vice versa, the same as in the single country case. As in the alone cannot restore the level of ecosystem service protection small country case, strengthening of ecosystem service protec- back to the level that would have been chosen before trade. tion in one country always accompanies a weakening of And since capital movement has the analogous effects as governance in the other country, other things being equal. technological change, our model indicates that neither growth All the results for trade in the large country case assume the in either industries nor in capital movement could lead the elasticity of substitution for the two goods is 1 (the Cobb–Douglas

Fig. 7 – Effect of trade on the rest of the world. 646 ECOLOGICAL ECONOMICS 66 (2008) 638– 652 form within the general CES function). When they are suffi- comparative static analyses that are conventionally ignored as ciently complementary or substitutable, the effects of trade on well. Obviously, this is neither the case for predominantly the protection of ecosystem services will be more complicated. physical systems like the global climate nor predominantly Nevertheless, some conclusions can be inferred from the Cobb– biological systems and our concern with biological diversity. Douglas case. When the two goods are sufficiently complemen- Governance of ecosystem services not only needs to address tary, technological change favoring one industry in one country long term dynamics, but the two foregoing examples also may lead this country to move toward governance favoring the remind us that many of the ecosystem costs of national other industry. The direction of change is similar to the closed economic activity and the benefits of ecosystem governance economy (Theorem 2.2), but the change is less. When the two are global rather than national. goods are substitutes, the direction of change in governance is The use of explicit functional forms means we can carry similar to the Cobb–Douglas case, except that the change of our analysis further than simply using general functional governance is greater compared to the case where same properties, but it also means that our analyses are limited to technological change happens in a closed economy. these forms. The consumption possibility frontiers we have used are continuous and concave to the origin. It is mathematically convenient and probably encompasses the 5. Summary and discussion of findings relevant range of the general policy issues. As mentioned in Norgaard and Hall (1974), discontinuities are possible at the Our model documents that the governance of ecosystem axes if externalities have fixed costs, and the frontiers can be services entering into production is sensitive to trade under convex when externalities become sufficiently extreme. If first-best conditions. The relationship between trade and the convex region is relevant for analysis, then preference of governance is intuitive at one level, yet becomes quite the laws should be further investigated. In the two-country complicated through the interactions of technology and case, only the Cobb–Douglas form is sufficiently simple to taste over time. First, the effect of opening to trade alone is to allow us to explore how trade affects ecosystem governance. shift ecosystem governance in the direction that favors the However, this already shows huge differences in the effects sectors in which each country has its comparative advan- of technological change, preference change, and capital tage. Second, since trade separates production from con- movement compared to the closed economy and small sumption, it also separates the governance of ecosystem country case. services from consumption. This means the role of relative In spite of these limitations, our model helps document a key income superiority under increasing income is severed or issue for the literature on environmental Kuznets curves. When much reduced, breaking the links driving the environmental a small economy opens to trade, consumption and income Kuznets curve. Third, basic trade theory supports neither a superiority no longer affect the assignment of rights to race toward stronger or weaker ecosystem service govern- ecosystem services supporting the production process because ance. While these basic findings are fairly intuitive from trade separates consumption from production. While this basic trade theory, they are neither in the existing literature finding is obvious from the nature of trade and our model, the nor a part of policy debates on trade and the environment. distinction between ecosystem services entering into produc- Our basic findings are novel but, given their intuitiveness, tion and those affecting utility directly is neither made by not surprising. What is surprising is that our findings are economists who have provided empirical documentation for neither a part of economic understanding nor a part of the apparent existence of environmental Kuznets curves (Cole, political discourse after nearly two decades of academic and 2003; Dinda, 2004) nor by economists drawing on the apparent political debate. existence of environmental Kuznets curves in treatises on trade, Some of our results are less intuitive and more surprising. growth, and the environment (reviewed in Copeland and Taylor, Taste change that favors the imported good will also favor 2004).6 This is all the more surprising since the empirical shifting ecosystem service rights toward the sector produ- documentation of the EKC arose and was invoked early in the cing the imported good, but the shift is not as great for the trade and environment debate (Grossman and Krueger, 1993).7 same taste change had it occurred before trade. Thus a Our findings, though in many ways obvious from trade theory, country importing rural goods will protect its ecosystem services more forcefully if taste change favors rural goods, but it would have protected them even more were it not engaged in trade. We also show that, for example, if industrial goods manifest themselves as relatively superior, 6 Copeland and Taylor (2004) acknowledge in their conclusions taking a larger portion of rising income, domestically or in (page 66) that the environmental Kuznets curve literature places the rest of the world, then the protection of ecosystem too much emphasis on income as the driver (while our analysis governance will weaken domestically and in the rest of the brings in technological change as well). world with rising income. 7 To further complicate matters, the early empirical work was A few important caveats are also in order. Comparative based on cross-country analyses of per capita income levels and static analysis has significant limitations when stock effects environmental conditions at a time before trade was being heavily promoted as an engine of growth. Presumably one would are important. Our model assumes ecosystem services can be want to control for the extent that a country's per capita income instantaneously increased without investment and have no was due to trade to explain environmental outcomes with respect thresholds below which they collapse. There are analogous to the influence of trade, but trade as a factor influencing problems with capital stocks and labor skills embedded in environmental governance is missing in the underlying models. ECOLOGICAL ECONOMICS 66 (2008) 638– 652 647 further confirm that efforts to establish relationships between Next, we introduce social indifference curves with constant factors associated with economic growth and environmental elasticity of substitution. governance need to be more specific with respect to the extent 1=l that ecosystem services affect the production of goods or of U ¼ c dyl þ gxl where : l V 1; d z 0; g z 0; and c N 0 utility directly, the extent to which trade drives development, and the extent to which production, consumption, or other For different periods, we have: factors actually frame environmental governance. 1=l0 ¼ d l0 þ l0 ðA:5Þ While our model draws on a social indifference curve to U0 c 0y g0x (A.5) neatly determine optimal ecosystem governance, actual politics 1=l1 ¼ d l1 þ l1 ðA:6Þ entail multiple constituents with competing interests. While U1 c 1y g1x (A.6) our model is driven by the transaction costs of a particular assignment of ecosystem service rights, it ignores the transac- We define the following conditions: tion costs of changing the distribution of rights, and this is the 1. typical focus of environmental politics. Our model assumes the Weak regularity conditions: Technological change is weakly b externality only affects production costs, not the quality of the regular if k0 k1; 2. environment realized by citizens, and that production condi- Strong regularity conditions: Transaction costs are strongly ⁎ ⁎ tions determine environmental governance. In short, our model regular if k0 =k0 =k0 and k1 =k1 =k1; 1 and 2 are called the suggests that even under relatively simple conditions, trade and regularity conditions; 3. environment will likely be complicated and politically conten- Transaction costs are weakly neutral to the legal structure α α β β α α β β tious issues. Making the conditions more general will not reduce when 0/ 1 = 0/ 1 in period 0 and 2/ 3 = 2/ 3 in period 1; 4. the complexity of the possible outcomes, the main point of our Transaction costs are strongly neutral to the legal structure analyses. Our model helps document the complexity of inter- when they are weakly neutral and strong regularity twined factors affecting trade and ecosystem governance as the conditions hold; 5. global economy evolves. Transaction costs are weakly neutral to technological α α α α change under L law when 3/ 2 = 1/ 0 and under L¯¯ law β β β β when 3/ 2 = 1/ 0; 6. Acknowledgments Transaction costs are strongly neutral to technological change if they are weakly neutral, k0 =k1, and the strong Xuemei Liu assisted Ling Jin with the mathematics at the regularity conditions hold; 7. X α α β bβ Y beginning of this project. We have benefited from diverse Technological change favors when 2 = 0, 2 0; favors β β α bα insightful comments following presentations of earlier drafts when 2 = 0, 2 0; and 8. X Y of this paper at the public policy workshop of the Department and are both neutral to technological change when α α β β of Economics, University of Chicago; at the Department of 2 = 0 and 2 = 0. g0 g1 9. Y is a relatively superior good, iff (if and only if) d N d (i.e. the Agricultural and Resource Economics, University of California, 0 1 X Berkeley; and at a Rockefeller Center Seminar, Dartmouth income expansion path is curved toward the Y axis); and g0 g1 is a relatively superior good, iff d b d (i.e. the income College. Richard Howarth provided specific comments on the 0 1 X model and text. Several anonymous reviewers have helped us expansion path is curved toward axis). clarify our argument and put it in context. Theorem 2.1. If strong regularity conditions hold and Y(X)is a relatively superior good, then¯¯ L (L) law will eventually be preferred.

Corollary 2.1. Appendix A If transaction costs are strongly neutral to technolo- gical change, the elasticity of indifference curve is 1 (l=0), and Y is a ¯¯ Since the model developed by Norgaard and Hall (1974) has not relatively superior good, then L Law is eventually preferred, no matter ¯¯ been used since its initial publication, we re-present their model, the initial legal structure is L Law or L Law. underlying definitions, and key theorems and corollaries. Proofs Theorem 2.2. If technological change favors Y, the elasticity of can be found in the appendix of Norgaard and Hall (1974). substitution is greater than 1, kN1 the strong regularity conditions We assume constant elasticity of transformation in the hold, and transaction costs are weakly neutral to technological production of the two goods x and y. The transformation change under L Law, then¯¯ L Law is eventually preferred. frontiers before and after technological change are: Corollary 2.2. If technological change favors X,0blb1, kN1, tran- 4 4 4 PP j ; a k0 þ b k0 ¼ ðA:1Þ 0 T L 1y 0x b0k0 (A.1) saction costs are weakly neutral to technological change under¯¯ L Law,

P and strong regularity conditions hold, then L Law is eventually preferred. PP j ; a k0 þ b k0 ¼ ðA:2Þ 0 T L 0y 1x b0k0 (A.2) Theorem 2.3. If technological change favors Y,lb0, i.e. elasticity is 4 4 4 PP j ; a k1 þ b k1 ¼ ðA:3Þ 1 T L 3y 2x b1k1 (A.3) less than 1; kN1, transaction costs weakly neutral to technological P change under L Law, and strong regularity conditions hold, then L PP jT; L a yk1 þ b xk1 ¼ b k (A.4)ðA:4Þ 1 2 3 1 1 Law is eventually preferred.

b a V a b a a b a N ; : 0 2 0 1; 2 3; k 1 for all k Corollary 2.3. If technological change favors X,lb0, kN1, transac- b b V b b b b b b b b : 0 2 0 1; 2 3;0 b0 b1 tion costs are weakly neutral to technological change under¯¯ L Law, 648 ECOLOGICAL ECONOMICS 66 (2008) 638– 652 and strong regularity conditions hold, then¯¯ L Law is eventually the industry that is experiencing more technological change preferred. will eventually get the pollution rights. More conveniently, we can prove this as follows: Since Theorem 2.4. If transaction costs are strongly neutral to technolo- production is determined by the tangency of the production gical change, neither good is superior, and the elasticity of sub- possibility curve and world price line, and the elasticity of this stitution is one, then society prefers to maintain its initial legal price line is infinite, the claim follows from Corollary 2.2 found in structure no matter whether it is L Law or¯¯ L Law. Appendix A.

Corollary 3.2. With trade, if the home is a small country, the Appendix B indifference curve of the home country no longer affects the relative price that is determined in the world market. Thus the choice of Theorem 3.1. If the world price of the exported good is sufficiently environmental law is no longer affected by which good is superior. high and transaction costs are strongly regular, a country will switch its environmental law to favor the exported good. Under a general form of production possibility frontiers: Appendix C

; a k2 þ b k2 ¼ ð(B.1)B:1Þ T L 1y 0x bk2 The additional key assumptions for this section are:

; ¯ a k3 þ b k3 ¼ ðB:2Þ T L 0y 1x bk3 (B.2) 10. The CES social indifference curve is assumed to be the simplest form when l=0, i.e. the familiar Cobb–Douglas δ γ Suppose x is the exported good, starting from the situation form: U=Cy x , where δ+γ=1, and the elasticity σ=1. ⁎ where ¯¯L is initially preferred, letting k=k2 =k3, we have: 11. For simplicity, k and k are held constant over time; and the two countries have the same proportional neutral b ⁎ 1. if Pr Pc, L¯¯ Law will be preferred. Note, however, that change embodied by b and b , and thus conveniently, they N 2. if Pr Pc, L Law will continue to be preferred, and that can be considered as constants over time.

3. if Pr =Pc, society is indifferent to L¯¯ Law and L Law. 12. We only define the rule for comparing preference of laws at different locations on the same curve (or parallel curves). price of good x The relative price Pr ¼ , and critical price Now we assume transactions costs are neutral to the legal ! price of good y 1 1 k 1 ak1 ak1 1 structure, locations at different possibility curves of one ¼ 0 1 : Pc 1 1 bk1 bk1 country over time can be compared after coordinate 0 1 1/k 1/k Proof. Under ¯¯L Law, the first order condition yields: conversion: Y=yα , and X=x β , which converts different 1 k k a k1 ¼ Pr 0 : functional forms into parallel curves X +Y =some con- xL¯ b yL¯ 1 stant. Or equivalently, we can compare the slopes of rays 1 α β − 1/k ¼ B k normalized by ( / ) . For example: the following ap- Substituting back, we get: yL¯ a u , 0 L¯ proaches are equivalent for the right graph in Fig. 5 in the 1 k a k text. A (x , y ), B(x , y ), B′(x′ , y′ ) u ¼ þ 0 k1: a a b b b b where B=bk, and ¯ 1 b Pr L 1 1 a k1 ¼ Pr 1 Similarly, under L Law we have: xL b yL and 1/k 1/k 1 0 • βι αι ¼ B k Xi =xi ,Yi =yi , i=a, b; then compare Yi/Xi. yL a u = 1 L • yi xi Compare the normalized slope ðÞb =a 1=k Then i i 1 1 1 1/k 1/k u ¯ a k 1 k k • β α β α b Z L N 0 0 Z u ¯ B N u B Z ¯ þ ¯ N þ Compare r1 = ya/xa with r2 =(yb/xb)( a/ a) /( b/ b) ,and Pr Pc u a L a u ¯ a u PrxL yL PrxL yL L 1 0 L L 1 L since only slope matters, the intersection of ray r2 and which means ¯¯L Law will be preferred. curve 1, B′, is the equivalent point of B on curve 1. Similarly,

b Z þ b þ Z If not stated otherwise, these assumptions are applied to Pr Pc PrxL¯ yL¯ PrxL yL L Law will be preferred; the following theorems. ¼ Z þ ¼ Pr Pc PrxL¯ yL¯ PrxL Now for the following derivation and proofs, we assume ¯ þyLZL Law and L Law are indifferent; as claimed: the trade pattern considered in Fig. 6 in the text. Before trade,

the equilibrium occurs at T1, with trade, the equilibrium Therefore, the theorem holds after claim 2. Fig. 4 helps to moves to T2. Now we want to explore the relationships among illustrate the situation with the critical line in red. the world relative price p (the negative slope of the price line in

Corollary 3.1. For a small country engaged in trade, the assign- the figure), the level of imports Fy, and the level of exports Fx. ment of the property right will eventually go to the industry CET : ayk þ bxk ¼ bk and CES : U ¼ Cydxg experiencing greater technological change. kN1

b k1 With trade, Pr =Pw, where Pw is the relative price in the dy xp MRTj ; ¼ ¼ ¼p ðÞxp yp a k1 world market. Consider the case where the domestic economy dx yp is small such that Pw is not affected by the domestic economy, X N then when technological change favors , eventually, Pr Pc, L

Law will be preferred; when technological change favors Y, dy gyc MRSjðÞ; ¼ ¼ ¼p b xc yc d eventually, Pr Pc, ¯¯L Law will be preferred. That is, with trade, dx xc ECOLOGICAL ECONOMICS 66 (2008) 638– 652 649

Now we have a system of equations together with CET and

CES to solve for (xp, yp) and (xc, yc): b k1 ¼ a k1 ðC:1Þ xp p yp (C.1) gy ¼ pdx (C.2)ðC:2Þ c c yc yp ¼ pxp xc (C.3)ðC:3Þ From Eq. (C.1) and CET, we obtain:

= = bk 1 k bk 1 k x ¼ ; y ¼ ; where t p bðÞ1 þ t1 p aðÞ1 þ t =ðÞ ðÞ ¼ pk k 1 ðÞa=b 1 k 1 (C.4)ðC:4Þ Fig. 8 – Equivalent points on two curves. Then with Eqs. (C.2). and (C.3), we have:

ðÞ = 1 k 1 k 1=k xc ¼ g 1 þ t ðÞbk=b ; yc ¼ gðÞ1 þ t yp ðÞ = = ¼ gðÞþ k 1 kðÞ=a 1 k ðC:5Þ γα δβ −1/k 1 t bk (C.5) Known from previous derivation that r0 =( / ) ; while Eqs. (C.1), (C.4), and (C.8) where t was defined above. − 1=k Therefore, domestic economy imports Fy =yc yp can be yp 1=ðÞk1 ta 1=k Zr1 ¼ ¼ ðÞb=ap ¼ b bðÞga=db ¼ r0, i.e. the Do- expressed as a function in terms of p, α, β, γ, and δ: xp mestic economy is moving toward L. □ = F ¼ f ðÞp; a; b; g; d ¼ ðÞbk=a 1 kG (C.6)ðC:6Þ y 1 1 Corollary 4.1. When ROW engages in trade, it is moving toward L¯¯. ¼ dðÞþ ðÞk1 =kðÞþ 1=k where, G1 t 1 t 1 k k k k Lemma 4.1. For two CET curves, C1: αy +β1x =bkandC2: αy +β2x = Similarly, Domestic Export Fx =x1 − x2 can also be expressed α β γ δ bk, point M1 (x1,y1)onC1 is equivalent to the point M2 (x2,y2), i.e. they as a function in terms of p, , , , and : 8 havethesamepreferenceofthelaws, if y1=y2. (Similarly, if only α's are ¼ ðÞ; a; b; ; d ¼ ðÞ=b 1=k ðC:7Þ Fx f2 p g bk G2 (C.7) different, then M1 and M2 are equivalent if x1=x2.) = ðÞ = ¼ 1 þ 1 k 1 þ k 1 k where G2 t 1 g t 1 Proof. As stated in Assumption 12, when transactions costs

4 k 4 k 4 4 are assumed to be neutral to the legal structure, it is sufficient a þ b ¼ = CET : y x b k yi xi to show that ðÞb =a 1=k, i=1, 2, are the same (Fig. 8). 4 4 i CES : U ¼ C4yd xg i 4 6a ¼ a ¼ a; ¼ k N1 1 2 y1 y2 ub xk ¼ bk ayk ¼ bk ayk ¼ b xk 1 1 1 2 2 2 □ F⁎ F ⁎ u = ¼ ðÞb =b 1=k Let ROW import and export be x and y, respectively. By x1 x2 2 1 = = = symmetry, without repeating the same steps we can also derive y1 x1 y2 x2 x2 x1 u = ¼ ¼ 1 α⁎ β⁎ δ⁎ γ⁎ ðÞb =a 1=k ðÞb =a 1=k ðÞb =b 1=k these quantities as a function of , , , ,andworldprice.By 1 1 2 2 1 2 equating the world price, we can see that the import and export Lemma 4.2. Without trade, the country will retain its legal in the Domestic economy and ROW achieved at the trade equi- structure during technological change. librium are functions of supply and demand in both countries. To facilitate comparative static analysis in the coming theo- Proof. Without loss of generality, assume that technological rems, signs of the partial derivatives of these quantities with change happened to good x, and since we only care about the respect to parameters that determines production possibility slope of rays from the origin, parallel curves can be considered frontier and indifference curve, are presented in Table 3. as equivalent. Therefore, for simplicity, let b's be the same. Theorem 4.1. When the Domestic economy engages in trade with the Now we can use the same notation in Lemma 4.1, and let ROW with the trade pattern as assumed in Fig. 6,itismovingtowardL. the indifference curve be: Proof. Here by assuming the Domestic economy imports y,we d U ¼ Cy xg have yc Nyp, i.e. dðÞt þ 1 ypNypZdðÞt þ 1 N1

1 d g Using Lemma 4.1, it is sufficient to show that y =y (Fig. 9). ut N ¼ (C.8)ðC:8Þ 1 2 d d From the derivation from previous chapters, We have: Let the slope of line OT0 be r0, and the slope of line OT1 be ¼ ½d =a ðÞþ 1=k r1. y1 bk 1 1 g 1=k y2 ¼ ½dbk=a2ðÞ1 þ g

Table 3 – Summary of partial derivatives (“+” indicates Since when only good x experiences technological change “−” α α □ greater than 0, and indicates less than 0) and good x does not, we have 1 = 2, I get y1 =y2. ⁎ ⁎ ⁎ ⁎ Functions ∂•/∂α( ) ∂•/∂β( ) ∂•/∂δ( ) ∂•/∂γ( ) ∂•/∂p

− − − Domestic Import Fy =yc yp + + +

Domestic Export Fx =xp −xc + − + − + ⁎ − − − − ROW Import Fx=Fx =xp xc + + 8 The following phrases have the same meanings when used in ⁎ − − − − ROW Export Fy=Fy =yc yp + + proof: preference of the laws, distribution of the pollution rights. 650 ECOLOGICAL ECONOMICS 66 (2008) 638– 652

Fig. 9 – Two equivalent points. Fig. 10.

4 Af 4 4 4 1 b Z ðÞN ðÞ¼ ðÞ Lemma 4.2 shows that the conclusion we obtained in the While Ap 0 Fy2 p2 Fy2 p1 Fy2 p3

previous model setup for the l=0 case is consistent in our 4 4 uF ðÞp b F ðÞp ; : : F ðÞp F ðÞp b current modified model setup. y2 2 y2 2 i e y2 2 y2 2 0

Theorem 4.2. With Trade, assuming the trade pattern does not Then we show that new equilibrium occurs at price

change, technological change favoring the export good in one country between p2 and p3. Holding other parameters constant, we − ⁎ will lead to moving toward the law that favors the export good in that can construct a function g(p)=Fy2(p) Fy2(p) it is continuous country, while the opposite happens in the other country. and monotone increasing because

4 dF ðÞp A dF ðÞp A 4 Because of symmetry we only need to prove: With trade, when y2 ¼ f1 N y2 ¼ f1 b A 0 and A 0 technological change happened to good x in Home country, the dp p dp p legal structure will move toward L, while Foreign will move to ¯¯L. N b And we have already shown that g(p3) 0, and g(p2) 0, there- We can use the same notation in Lemma 4.1 and Lemma a ∈ fore, pe (p2,p3), such that g(pe)=0, when the new trade equi- 4.2. M1 is the tangent point of price line P1 and CET curve C1, b b librium occurs. Let the new point be Me (xe, ye), I have y3 ye y2, M2 is the equivalent point of M1 on C2, M3 is the tangent point b slope OMe slope OM2. Since M2 is the equivalent point of M1,we of P and C , where P //P , and M (x , y ). P is the price line 3 2 3 1 i i i 2 can conclude that the legal structure is moving toward L. tangent to C2 at M2 (not shown in Fig. 10). b ⁎ ⁎ Since pe p3 =p1, we can conclude that Foreign is moving Let F , F be Home export and import in period i; F , F be xi yi xi yi toward L¯¯. Foreign import and export in period i, i=1, 2. In period 1, We ⁎ ⁎ Theorem 4.3. have Fx1 =Fx1, and Fy1 =Fy1. Let the slope of the price lines at Mj With Trade, assuming the trade pattern does not − N be pj, j=1, 2, 3. We have p1 =p3 p2.(the analogy of the change, technological change favoring the import good in one country Rybczynski model 1955). As the transformation frontier is a will lead to moving toward the law that favors the import good in that smooth function, it is sufficient to prove that in period 2, the country, while the opposite happens in the other country, but both

new equilibrium price is between p1 and p1, such that the new countries cannot reach the pre-trade level of the environmental law.

tangent point is located between M2 and M3. Once this is

satisfied, we see the country is moving from M2 (the By symmetry, we only need to prove the following:

equivalent point of M1) downward. With trade, when technological change happened to good y First, we derive the sign of difference import and ROW in Home country, the legal structure will move toward ¯¯L, but can

export at world price p2 and p3. never reach the pre-trade level while Foreign will move to L,but also cannot reach the pre-trade level. (Bounded Movement) A 6 fi b ðÞ: ; : ; ; b Nb ; ¼ ; ¼ ; The proof will follow the same logic as the previous one. Ab 0 C 6 C 7 and Table 4 and 1 2 p1 p3 i 1 2 u ¼ ðÞa; b ; b ðÞa; b ; ¼ ðÞ Fx1 f2 1 p1 f2 2 p3 Fx2 p3 4 ¼ 4 a4; b4; ¼ 4 a4; b4; ¼ 4 ðÞ Fx1 f2 p1 f2 p3 Fx2 p3

u b ðÞ 4 ¼ 4 ðÞ Similarly we have Fy1 Fy2 p3 and Fy1 Fy2 p3 6 ¼ 4 ; ¼ 4 Fx1 Fx1 Fy1 Fy1 u 4 ðÞb ðÞ; : : ðÞ 4 ðÞN Fy2 p3 Fy2 p3 i e Fy2 p3 Fy2 p3 0

On the other hand, at M2, 1=k 6 ¼ ¼ bk y1 y2 and yi aðÞþ ; 1 ti ¼ k=ðÞk1 ðÞa=b 1=ðÞk1 ; ¼ ; where ti pi i i 1 2

ut1 ¼ t2 hi u ðÞ¼ðÞ¼a; b ; ðÞ=a 1=k dðÞþ ðÞk1 =kðÞþ 1=k Fy2 p2 f1 2 phi2 bk t2 1 t2 1 = ðÞ = = ¼ðÞbk=a 1 k dðÞt þ1 k 1 kðÞt þ 1 1 k ¼f ðÞ¼a; b ; p F 1 1 1 1 1 y1 Fig. 11. ECOLOGICAL ECONOMICS 66 (2008) 638– 652 651

Table 4 – The direction of the change in ecosystem service protection for comparably sized countries Domestic tech ROW tech change Expenditures on rural Expenditures on industrial change goods increase faster goods increase faster with income with income Rural industrial rural Industrial

Domestic ¯¯L LLL¯¯ ¯¯L L ROW LL¯¯ ¯¯L LL¯¯ L

In Fig. 11, M1 is the tangent point of price line P1 and CET the new equilibrium Me, therefore Home cannot reach the pre- curve C1, M2 is the equivalent point of M1 on C2, M3 is the trade level of the environmental law. 6 N ; u tangent point of P3 and C2, where P3//P1, and Mi (xi, yi). pe p3 Foreign is moving toward L, but according to ⁎ ⁎ Let Fxi, Fyi be Home export and import in period i; Fxi,Fyi be Theorem 4.1 and Lemma 4.2, its environmental law is still Foreign import and export in period i, i=1, 2. In period 1, I have above the pre-trade level. ⁎ ⁎ − Fx1 =Fx1, and Fy1 =Fy1. Let the slope of the price lines at Mj be pj, b j=1, 2, 3. I have p1 =p3 p2. Theorem 4.4. With trade, other things held constant and the trade A pattern does not change, both countries will move toward L, if x is the 6 fi N ðÞ: ; : ; ; a N a ; ¼ ; ¼ ; Aa 0 C 6 C 7 and Table 4 and 1 2 p1 p3 i 1 2 relatively superior good. (Unbounded Movement) u ¼ ðÞa; b ; N ðÞ¼a; b ; ðÞ Fx1 f2 1 p1 f2 2 p3 Fx2 p3 4 4 4 4 4 4 4 4 ¼ a ; b ; ¼ a ; b ; ¼ ðÞ A A A Fx1 f2 p1 f2 p3 Fx2 p3 Proof. − ⁎ F b ; F N ; F N : X Let F=Fx ;Fx, according to Table 4, Ag 0 Ad 0 Ap 0 If is 4 4 g1 g2 6 ¼ ; ¼ the relatively superior good, d b d (as defined in Appendix A), Fx1 Fx1 Fy1 Fy1 1 2 where the subscripts denote the periods 1 and 2. u 4 ðÞN ðÞ; : : ðÞ4 ðÞb Fx2 p3 Fx2 p3 i e Fx2 p3 Fx2 p3 0 γ δ γ bγ δ bδ We know + =1, so above inequality means 1 2, 1 2,

On the other hand, at M2, which is the equivalent point of this would reduce F. To restore F to 0, i.e. the equilibrium, I

M1 on C2, I have x2 =x1, that is the x values for the two points need to increase p. Therefore, the new equilibrium point is are equal. Same as in Theorem 4.2, Fx2(p2)=Fx1. moving down along the curve in both countries, which is 4 Af 4 4 4 2 b ; b Z ðÞb ðÞ¼ ðÞ equivalent to say that both countries are moving toward L. While Ap 0 p1 p2 Fx2 p2 Fx2 p1 Fx2 p3 g2 If one good is sufficiently relatively superior (e.g. d Yl), u ðÞN 4 ðÞ; : : ðÞ4 ðÞN 2 Fx2 p2 Fx2 p2 i e Fx2 p2 Fx2 p2 0 this change will continue without bound. □

Holding other parameters constant, we can construct a Theorem 4.5. Suppose good X is capital K intensive, then when ⁎ function g(p)=Fx2(p), it is continuous and monotone increasing capital K is moving from the Domestic economy to ROW as Domestic ðÞ A dF4 ðÞp Af 4 dFx2 p ¼ f2 N x2 ¼ 2 b : because dp Ap 0 and dp Ap 0 economy opens up to trade, comparing to the earlier state without b N And we have already shown that g(p3) 0, and g(p2) 0, exporting capital, the Domestic economy will move toward L¯¯, and a ∈ therefore, pe (p2,p3), such that g(pe)=0, when the new trade Foreign will move to L, if two countries have the same tastes, i.e. equilibrium occurs. Let the new point be Me (xe, ye), we have same indifference curve Fig. 12. b b N x3 xe x2, slope OMe slope OM2. Since M2 is the equivalent Proof. point of M1, we can conclude that the legal structure is moving When K moves from Domestic to ROW, the change of toward L¯. Let M4 be the tangency of indifference curve and C2. the production possibility frontiers is analogous to technolo-

From Theorem 4.1 and Lemma 4.2, we know that M4 is above gical change happening in x industry in ROW. And the budget

Fig. 12 – Capital movement. 652 ECOLOGICAL ECONOMICS 66 (2008) 638– 652 constraint shifts out Δ amount in the Domestic economy and Winter, Sidney G. (Eds.), The Nature of the Firm: Origins, shifts in the same Δ amount in ROW. This makes no difference Evolution, and Development. Oxford University Press, Oxford. Cole, Matthew A., 2003. Development, trade, and the environment: if we still use the dashed line above to derive the equilibrium, how robust is the environmental Kuznets curve? Environment because after the shift, the same amount will be added to the and Development Economics 8, 557–580. domestic imports and foreign exports, and deducted from Copeland, Brian R., Taylor, Scott M., 2004. Trade, growth, and the domestic exports and foreign imports, so that the equilibrium environment. Journal of Economic Literature XLII (1), 7–71. stays the same. Dasgupta, Partha, Mäler, Karl-Goran, 2003. The economics of Therefore, using Theorem 4.4 we can conclude that the non-convex: introductions. Environmental and Resource – domestic economy moves toward L¯¯, while the rest of the Economics 26499 26525. Dinda, Soumyananda, 2004. Environmental Kuznets curve world moves toward L. □ hypothesis: a survey. Ecological Economics 49, 431–455. Folke, Carl, Ekins, Paul, Costanza, Robert (Eds.), 1994. Special REFERENCES Issue,TradeandtheEnvironment.EcologicalEconomics,vol.9(1), pp. 1–97. Grossman, Gene M., Krueger, Alan B., 1993. Environmental Baer, Paul, Harte, John, Herzog, Antonia, Holdren, John, Hultman, impacts of the North American free trade agreement. In: Nate, Kammen, Daniel, Kresch, Barbara, Norgaard, Richard B., Garber, P. (Ed.), The U.S. – Mexico Free Trade Agreement. MIT Raymond, Leigh, 2000. Equity and greenhouse gas responsibility Press, Cambridge, MA, pp. 13–56. in climate change policy. Science 289, 2287 29 September. Haddad, Brent M., 2000. Rivers of Gold: Designing Markets to Baumol, W.J., Bradford, David F., 1972. Detrimental externalities Allocate Water in California. Island Press, Washington, D. C. and non-convexity of the production set. Economica 39 (154), Hanley, Nick, Shogren, Jason F., White, Ben, 1997. Environmental – 160 176. Economics in Theory and Practice. Oxford University Press, Brander, James A., Taylor, M. Scott, 1998. Open access renewable Oxford. resources: Trade and trade policy in a two-country model. Jansson, AnnMari, Hammer, Monica, Folke, Carl, Costanza, Robert – Journal of International Economics 44, 181 209. (Eds.), 1994. Investing in Natural Capital. Island Press, Brookes, Richard O., Jones, Ross, Virginia, Ross, 2002. Law and Washington, D.C. Ecology: The Rise of the Ecosystem Regime. Ashgate, Hants, Krugman, Paul, 1997. What should trade negotiators negotiate UK. about? Journal of Economic Literature XXXV, 113–120. Bulte, Erwin H., Van Soest, Daan P., 2001. Environmental Millennium Ecosystem Assessment, 2005. Ecosystems and Human degradation in developing countries: households and the Well-Being: Synthesis. Island Press, Washington, D.C. (reverse) environmental Kuznets curve. Journal of Development Mishan, Ezra J., 1971. The postwar literature on externalities: an – Economics 65, 225 235. interpretive essay. Journal of Economic Literature 9, 1–28. Carey, J., Sunding, D.L., Zilberman, D., 2002. Transaction costs and Norgaard, Richard B., Hall, Darwin C., 1974. Environmental trading behavior in an immature water market. Environment amenity rights, transactions costs, and technological change. – and Development Economics 7, 733 750. Journal of Environmental Economics and Management 1, Cason, Timothy N., Gangadharan, Lata, 2003. Transactions costs in 251–267. tradable permit markets: an experimental study of pollution Norgaard, Richard B., Liu, Xuemei, 2007. Market governance – market design. Journal of Regulatory Economics 23 (2), 145 165. failure. Ecological Economics 54 (2), 634–641. – Chichilnisky, Graciela, 1994. North south trade and the global Randall, Alan, 1972. Market solutions to externality problems. – environment. American Economic Review 84 (4), 851 874. Theory and practice. American Journal of Agricultural Coase, Ronald, 1937. The nature of the firm. Economica 4 (16), Economics 54 (3), 175–183. – 386 405. Stavins, Robert, 1995. Transactions costs and tradable permits. Coase, Ronald, 1960. The problem of social cost. Journal of Law and Journal of Environmental Economics and Management 29, – Economics 3, 1 44. 133–148. Coase, Ronald, 1991. The institutional structure of production. Nobel lecture. Reprinted in 1993. In: Williamson, Oliver E.,