Abstract

A two nation, two sector oligopoly trade model is presented in which one sector creates a negative production externality. Firms switch sectors in response to profit differentials until these are exhausted in the long run evolutionary equilibrium (EE). Under autarky, the optimal EE pollution tax is greater than standard partial equilibrium analysis since the output distortion associated with the tax is mitigated by firms migrating to the non-taxed sector. In a free trade area the pollution haven hypothesis is obtained when nations choose exogenous tax rates that differ. However, with endogenous taxation a prisoners' dilemma is obtained. The Nash equilibrium of the tax game exceeds the social planner's tax, generating a race to the top.