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The role of income differences

An alternative theory of trade patterns is the pollution haven hypothesis. According to this view, poor countries have a comparative advantage in dirty goods because they have relatively lax pollution policy, and rich countries have a comparative advantage in clean goods because of their stringent pollution policy. This result can be obtained as a special case of our model: if all countries have the same relative factor endowments, but differ in per capita incomes, then indeed richer countries will have stricter pollution policy and this will lead to a comparative advantage in clean goods. When countries differ in factor endowments as well, then we can obtain a weaker result: if a country is sufficiently rich, holding all else constant, then it will export the clean good.

As before, we begin by determining domestic prices prior to trade. Consider the effects of increasing income in a country, holding relative factor abundance constant. In this case, (2.24) reduces to
Since environmental quality is a normal good, we have Sf д > 0. Hence we conclude from (2.25) that p > 0. In autarky, the relative price of the pollution intensive good rises with per capita income if we control for relative factor abundance. Hence high income, all else equal, tends to generate a comparative disadvantage in pollution intensive goods. More concretely, we can show that if the country is sufficiently rich, it must export the labor intensive (clean) good.

Proposition 3. Suppose the world price p is fixed and there exists S such that Sf : > S > 0. Then, for a given level of the capital/labor ratio к (and holding all else constant), there exists I, such that if I > I, then Home exports Y. Moreover, for such a country, the pure composition effect of trade liberalization will be to reduce pollution.

Proof: The relative price of x facing producers is p = p(1 – 9) – t1(1 – a(9)) < p(1 – 9) -t1(1 – a(1)) where 1a(1) < 1). Because Sf : > S , the pollution tax increases without bound as income rises (and moreover 9 rises), and hence there must exist some I for which pp falls to 0, in which case the output of X is 0. The relative demand for X is, however, independent of income. Hence for sufficiently large I, Home must import X and export Y. The fall in pollution follows from Prop.1.