The first term in (2.21) is the scale effect, as before. The second term measures the effect on pollution of an increase in the capital/labor ratio. This is a composition effect. Since the polluting industry is capital intensive, a more capital abundant country generates more pollution, all else equal. The remaining terms all reflect the effects of changes in pollution policy; we will refer to them as technique effects.8 An increase in the level of per capita income increases the demand for environmental quality, and leads to stricter pollution policy (Sf I > 0); an increase in the number of people exposed (N > 0) leads to stricter pollution policy via the Samuelson rule; and an increase in the marginal disutility of pollution (5 > 0, which may arise from increased knowledge about pollution) will also increase the demand for environmental quality and increase the pollution tax. Finally it is worthwhile to note the strength of these last three technique effects depends on ST t*, which indexes the government responsiveness to the preferences of the representative agent.
Equation (2.21) neatly summarizes our predictions about how pollution varies across countries and over time in response to observable variables (holding prices and the abatement technology fixed). Pollution rises with the scale of the economy and capital abundance. Increases in income, the marginal disutility of pollution, and the number of people exposed to pollution lead to a tightening of policy and a reduction in pollution. Equation (2.21) is not a suitable basis for estimation however because we have held both world and domestic prices fixed in its derivation.
To examine the consequences of increased openness on pollution levels, suppose transport costs or other frictions act as a barrier to trade. Given a common world price pw, the domestic price in any country can be written, p = bpw where b measures the importance of trade frictions. Note b > 1 if a country imports X and b < 1 if a country exports X. We refer to a movement of b towards 1 as an increase in openness, or freer trade. Referring again to (2.18), recall that any change in the economy (including an increase in openness) generates scale, technique and composition effects. In deriving (2.21) we held domestic prices fixed. If we now allow for both trade frictions and world prices to change we have
where g6 = g7 = jyS% ~ + Z Sa9S9,t(1 – STx*Sf,p) > 0.10 T he remaining gi are as defined previously. As before, pollution varies with scale, capital abundance, income levels, etc. but as well, pollution now also varies with world prices and trade frictions. Equation (2.22) is very important to our subsequent analysis because it establishes one key result and naturally leads to a discussion of how we identify the impact of trade in our empirical work. The key result contained in (2.22) is simply that a reduction in trade frictions will affect different countries in different ways. We should not expect to find openness per se related in any systematic way to pollution. This follows because b rises with freer trade for an exporter of the polluting good and b falls for an importer. While the AA coefficient of b is positive, an increase in openness yields b > 0 for a country with a comparative advantage in dirty goods, and b < 0 for a country with a comparative advantage in clean goods. We summarize these results in Proposition 1.