Resource and Energy Economics 25 (2003) 141154

Strategic environmental policy when the

governments are threatened by relocation
Mads Greaker
Statistics Norway, P.O. Box 8131 Dep., 0033 Olso, Norway
Received 5 December 2001; received in revised form 13 February 2002; accepted 5 June 2002

Abstract
This paper analyzes how the threat of relocation influences environmental policy. The stringency
of environmental policy is determined in a game between two governments. There is one firm
in each jurisdiction, and both firms threaten to relocate their production to the other jurisdiction.
Because there is asymmetric information about the cost of relocation, the governments do not know
the credibility of the threat.
We compare the outcome of this game with the outcome of a game in which relocation is not
possible. We find that the threat of relocation can increase both the level of environmental regulation
and welfare. The profit tax level proves to be the most decisive for the result; that is, the higher the
profit tax level, the lower the level of environmental regulation.
2002 Elsevier Science B.V. All rights reserved.
JEL classification: H7; Q2; R3
Keywords: Environmental policy; Strategic trade theory; Industrial flight

1. Introduction
Policy makers are often faced with the difficult dilemma of weighing export revenue
against improved environmental quality. In one of their latest reports The WTO Committee
on Trade and the Environment (1999) reports that industries seem to have some success
in delaying new environmental policy initiatives; . . . industries often appeal to competitiveness concerns when lobbying against environmental regulations, and on occasion with
some success.
Frequently, industry officials not only refer to competitiveness, but also threaten to relocate production facilities. Since such threats often seem to work, and industries do not
Tel.: +47-21-09-00-00; fax: +47-21-09-49-63.
E-mail address: mgr@ssb.no (M. Greaker).

0928-7655/02/$ see front matter 2002 Elsevier Science B.V. All rights reserved.
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M. Greaker / Resource and Energy Economics 25 (2003) 141154

relocate, it is hard for governments to assess the credibility of the threats. One may, therefore, question whether a general liberalization in the movement of capital will tighten the
pressure on environmental policy even further, as industries become increasingly footloose.
Further, governments are probably likely to be interested in attracting new investment.
Having a more stringent environmental policy than other countries could seriously hamper
such prospects. Many fear that this will cause what is popularly called a race to the bottom,
that is, a situation in which firms are able to play their governments against each other so
that the result is no, or very weak, environmental regulation.
Our point of departure is a duopoly industry structure with two firms located in their
respective home countries, exporting to a third market as in the BranderSpencer model
(1985). The governments in the two countries simultaneously introduce new environmental
regulation which increases the firms costs. Each firm has the possibility of relocating to
the other country, but may have to write off sunk costs.1 The governments do not know
the actual relocation cost, but maximize welfare based on their subjective beliefs about the
relocation cost.
The situation is very similar to the game described by Barrett (1994).2 Barrett also uses
the BranderSpencer model, and as this paper, he looks at environmental standards instead
of looking at export subsidies.3 The major finding in Barrett (1994) is that environmental
standards will be set too weak if competition is Cournot, and too strong if competition
is Bertrand. However, in Barrett (1994) as in the BranderSpencer model, firms do not
have the option of relocating, and consequently, they cannot threaten to relocate in order to
influence their governments.
Surprisingly, we find that the threat of relocation may yield both stronger levels of environmental regulation and higher welfare than in the case in which relocation is not possible.
The reason is that given the profit tax rate and the amount of environmental damage, governments may benefit from trying to force their firms to move. In equilibrium, none of the
firms move, but levels of environmental regulation are set stronger.
Our result to some extent matches the finding in Janeba (1998) that subsidies are eliminated in the BranderSpencer model with firm mobility. Janeba introduces relocation to the
BranderSpencer model, and considers a production subsidy-cum-tax. Further, there are no
relocation costs, and the firms will move for any arbitrarily small difference in policy. Since
it is better for a government to let the other government subsidize its firm, governments
under-bid each other hoping that their firm will move to the other country. The same thing
happens in this paper if the cost of environmental damage exceeds the profit tax income. It
is then better to let the firm relocate and enjoy lax environmental standards abroad.
Markusen et al. (1995) and Hoel (1997) also analyze a location game between two
countries in which the strategic variable is the level of environmental policy. However, in
their models the monopoly in question has no historical location and, hence, no sunk costs in
either of the countries. Consequently, their results are not directly comparable to the results
1

For example: factory buildings, non-transportable machinery, training of personnel who do not want to move.
For other examples on strategic environmental policy see Rauscher (1993), Conrad (1994) and Ulph and Ulph
(1995).
3 Since the GATT rules prohibit the use of export subsidies, factor input subsidies, etc., but do not hinder
weak environmental regulation, the restriction that governments only have environmental standards as their policy
instrument may not be particulary unrealistic.
2

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143

of this paper. It is further assumed that governments are able to commit to an environmental
policy before the monopoly has made its location decision. The government which gets the
investment is, therefore, precluded from increasing its level of environmental regulation
after the location decision is made.
De Santis and Stlher (2001) look at the opposite case. In their model, governments
cannot commit to an environmental policy before the choice of location is made and, thus,
cannot use their environmental policies to attract foreign investment. Instead, De Santis and
Stlher (2001) compare the outcome of two games: one in which foreign direct investment
is not possible, and one in which such investment is possible. Although the game in De
Santis and Stlher (2001) is different from the game in this paper, they also find that the
possibility of making foreign investment may strengthen the environmental policy.
The degree of commitment power by governments is further explored in Ulph and
Valentini (2001). Capital mobility is perfect at the beginning of the game, and the firms
in question have no historical links to any country. However, when firms have chosen their
location, they are no longer mobile; that is, relocation costs have become infinitely high.
The governments are either able to commit to an environmental policy before the location
decision, as in Markusen et al. (1995) and Hoel (1997), or they must wait until after the
choice of location is made, as in De Santis and Stlher (2001).
As long as the firms choose to locate in different countries, the latter situation is equal to
the game described by Barrett (1994). This paper differs from Ulph and Valentini (2001)
and De Santis and Stlher (2001), in that we analyze a situation in which capital mobility
never completely disappears; that is, firms can always chose to relocate after the level of
environmental policy is set. This suggests that firms always keep some bargaining power
vis-a-vis the governments.
In particular, we assume that the governments can commit to an environmental policy
before the location decision is made. This implies that they can use their environmental
policy to attract foreign investments. However, the assumption is not crucial, as it is in Ulph
and Valentini (2001), because the firms keep their mobility; that is, the governments do
not find it tempting to tighten the environmental policy after the location decision is made
because then the firms may relocate again.
Sections 2 and 3 set out the model. In Section 4 the solution to the model is presented,
and the policy equilibrium is described. Then in Section 5 we look at comparative static,
and in Section 6 we give an example with Cournot competition. Finally, in Section 7 we
conclude.

2. The model
The model is a three-stage game with the following stages: (1) a policy decision whereby
the two governments maximize expected welfare with respect to the level of environmental
regulation, (2) a location decision whereby firms decide where to locate their production,
and (3) a market game whereby firms compete and pay taxes.
We label the two countries and their two firms domestic and foreign. Capital letters refer
to the foreign firm (country). Further, we do not model Stage 3 explicitly. Profits are instead
expressed by the reduced-form profit functions and the relocation costs. Denote the level of

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M. Greaker / Resource and Energy Economics 25 (2003) 141154

environmental regulation in the domestic country by e and in the foreign country by E. Let
define the feasible set of E-values.4
[0, e]
define the feasible set of e-values, and let [0, E]
Denote the relocation costs by m and M.
There are three possible outcomes of the location decision:5
Configuration
Domestic profit before tax
NR (no firm relocates)
(e, E)
DR (domestic firm relocates) (E, E) m
FR (foreign firm relocates)
(e, e)

Foreign profit before tax

(E, e)
(E, E)
(e, e) M
(1)

where and are the reduced-form profit function. The first argument in each function is
the level of environmental regulation which applies to the firm, while the second argument
in each function is the level of environmental regulation which applies to the other firm.
We assume 1 , 1 < 0 and 2 , 2 > 0, and that |1 | > 2 and |1 | > 2 where 1
denotes the derivative of the profit function with respect to the first argument, etc.6 Since
both firms export to the same market, and the issue of setting up a new plant somewhere in
the third market is not considered, we do not include trade costs explicitly.
Welfare is expressed by tax income and profits, less environmental costs. There is no
consumer surplus because all production is for export. Denote the environmental costs
by an environmental damage function d(e), de < 0, dee 0, implying that a stronger
environmental policy makes environmental damage decrease. For simplicity, we assume
that the environmental damage function is linear in the number of firms.
We have chosen to model a pure profit tax. This implies that the tax rate does not influence
the price/output decisions of firms, which makes the analysis easier to follow. We also
assume a source tax, which implies that firms are only taxed in the country in which they
operate. Lastly, we assume that any relocation costs are tax deductible.7
Let t denote the domestic profit tax rate and T the foreign profit tax rate. Welfare conditioned on the realized configuration is then given as:
Configuration
NR
DR
FR

Ex post welfare domestic country

w nr = (e, E) d(e)
w dr = [1 T ][(E, E) m]
w fr = (e, e) + t[ (e, e) M] 2d(e)

(2)

The first line in (2) refers to the case in which the government has succeeded in keeping
its own firm. Since the profit tax is a pure transfer in this case, we do not have to include
4 Here, e = e
could, for example, mean that environmental damage costs were zero, or that any e > e would
imply negative profits.
5 It is argued later that the configuration in which both firms relocate is not possible.
6 For our purpose, the nature of competition in the market does not matter, as long as profits decrease with
the stringency of environmental regulation. This can be shown to hold for a wide range of Bertrand and Cournot
models. See also the example presented in Section 6.
7 As an alternative to a source tax, we could have assumed that each home country has made it possible for
their residents to credit taxes payed in a foreign country against domestic tax liability. However, as long as the tax
rates and tax bases are identical, a system with tax credits and a source tax are identical. See Janeba (1996) for an
excellent discussion of different tax systems.

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145

it explicitly. The second line in (2) refers to the case in which the domestic government
has seen its own firm relocating. In this case, there is no environmental damage, and the
non-taxed part of the profit is transferred back to the country through the owners who are
still located there.8
The last line in (2) refers to the case in which the government has managed to attract the
foreign firm. The profits of both the domestic and the foreign firm are then included in the
expression for ex post welfare.9
Given the different configurations, foreign welfare is a mirror image of domestic welfare:
Configuration

Ex post welfare foreign country

NR

W nr = (e, E) D(E)

DR

W dr = (E, E) + T [(E, E) m] 2D(E)

FR

W fr = [1 t][ (e, e) M]

(3)

In the following, we will focus on the symmetric game, i.e. m = M, t = T , (e, e) =

(e, e) and d(e) = D(e), e. For simplicity, we will just write m for the relocation cost
and t for the profit tax rate.
Unlike Janeba (1998) we treat the profit tax rate as exogenous. While in Janeba (1998) the
firms can be interpreted as representative, this is not the case in our model. The polluting
firms are likely to be only one of many firms in each country subject to profit taxation.
Hence, it would be very difficult for the governments to lower the profit tax rate for only
their polluting firm without doing the same for all the others.

3. The relocation decision

Since the owners of the two firms are taxed at the same rate, independently of location, the
choice of location depends solely on the relocation cost m for a given set of environmental
regulation (e, E). We define a domestic critical level of the relocation cost mh given that
the foreign firm do not relocate:
mh = (E, E) (e, E)

(4)

If m < mh , the domestic firm will relocate. Clearly, mh can only be larger than zero
as long as we have e > E. Further, we have dmh /de = 1 (e, E) > 0 and dmh /dE =
1 (E, E) + 2 (E, E) 2 (e, E) < 0.
Next, we define a foreign critical level of the relocation cost ml given that the domestic
firm do not relocate:
ml = (e, e) (E, e)

(5)

8 Both Barrett (1994) and Janeba (1998) assume that owners of the firms are located in the firms home countries.
Thus, a relocation will lead to a loss of rents to the extent that the profit is taxed in the foreign country. Clearly, a lot
of other factors can add to this loss: positive externalities between the firm and other firms; structural adjustment
costs due to temporary unemployment; social costs due to early retirement of workers, etc.
9 Like Janeba (1998), we assume that discrimination among firms is not possible. Hence, a firm that relocates to
the other country, will be subject to the same environmental regulation and profit tax rate as the firm historically
located in that country.

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M. Greaker / Resource and Energy Economics 25 (2003) 141154

If m < ml , the foreign firm will relocate. Clearly, ml can only be larger than zero as
long as we have e < E. We also have dml /de = 1 (e, e) + 2 (e, e) 2 (E, e) < 0 and
dml /dE = 1 (E, e) > 0.
The governments will have to base their decisions on their subjective beliefs about the relocation costs. We assume that these beliefs can be described by a probability function F (m)
with density function f (m), where m can take any value between 0 and + (or an upper
limit; m).
In order to ensure concavity of the pay-off functions, we also assume f
0; that
is, we restrict the set of possible density functions to the set of weakly downward sloping density functions. Note, however, that f
0 is not a necessary condition for global concavity.
Zero appears to us as the only reasonable lower bound on the support of m. Any positive
lower bound has to be arbitrary, given the nature of the problem; that is, why should a
government believe that the relocation cost is at least mlow , and not mlow , where  is a
very small number.
On the other hand, governments have good reason to believe that relocation costs are
non-negative. Since we are studying a symmetric game, it seems reasonable to assume
that countries have the same level of environmental regulation when the game starts. Thus,
both firms would already have moved if relocation costs were negative. Finally, given that
relocation costs are non-negative, it follows that we cannot have that both firms relocate.
Each possible configuration can then be assigned a subjective probability, which is dependent on e and E. Define then:


F (mh ), if e E
= pr{DR} =
0,
if e < E


F (ml ), if e E
= pr{FR} =
0,
if e > E
where ml and mh , are functions of e and E. We see that if > 0, then = 0 and vice-versa.
Hence, we have; pr{NR} = 1 , e.
Further, we make the following observations:
d
> 0,
de

d
< 0,
dE

for e E and 0 otherwise

(6)

d
< 0,
de

d
> 0,
dE

for e E and 0 otherwise

(7)

When setting out a policy, the government must base its decision on the expected relocation cost conditioned on the realized configuration, and not on the ex post realized relocation
cost. We define the conditional expected value of m in case of domestic relocation (DR)
and in case of foreign relocation (FR) by:
 mh
sf(s)
h
m
= E[m|DR] =
ds
F
(mh )
0
 ml
sf(s)
m
l = E[m|FR] =
ds
F
(ml )
0

M. Greaker / Resource and Energy Economics 25 (2003) 141154

We make the following observations:

 i
 i
dm

dm
= sign
, for i = h, l
sign
dj
dj

and

j = e, E

147

(8)

The change in the conditional expected relocation cost can be explained as follows: the
higher the level of domestic environmental regulation/domestic profit tax rate at which
domestic relocation occurs, the higher the expected relocation cost. Conversely, the higher
the level of domestic environmental regulation/domestic profit tax rate at which foreign
relocation occurs, the lower the expected relocation cost.

4. The environmental policy game

The governments maximize expected welfare based on their subjective belief about relocation costs. Thus, in the policy game the domestic government solves:
max E[w] = [1 ][(e, E) d(e)] + [1 t][(E, E) m
h]
e

+{(e, e) + t[ (e, e) m
l ] 2d(e)}

(9)

and simultaneously the foreign government solves:

l]
max E[W ] = +[1 ][ (E, e) D(E)] + [1 t][ (e, e) m
E

+{ (E, E) + t[(E, E) m
h ] 2D(E)}

(10)

(e , E )

which constitutes a Nash

The solution will be a set of environmental policies;
equilibrium in the policy game. It is shown in the working paper version of this paper,
Greaker (2000), that the pay-off functions are continuous. Further, we assume that the
second-order derivatives of the pay-off functions are negative, and that | 2 E[w]/e2 | >
| 2 E[w]/Ee| which ensures uniqueness of the Nash equilibrium.10
For comparison purposes, let, for a moment, the relocation costs m be commonly known
We then have that the
to be infinitely high, i.e. = = 0, e [0, e]
and E [0, E].
solution to the policy game can be described by the following equations:
w nr
=0
e
W nr
=0
E
Definition 1. Let (e , E ) be equilibrium policies in the game in which = = 0,
e, E.
We now want to find out how the solution to the game in which relocation is possible,
(e , E ), differs from the solution to the game in which it is not possible, (e , E ).
10 See for example Tirole (1997). Both assumptions are discussed further in the working paper version of this
paper.

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M. Greaker / Resource and Energy Economics 25 (2003) 141154

By taking first order derivatives of the pay-off functions and setting them equal to zero,
we get a system of two equations in two unknowns. Since the countries and their firms are
symmetric, we look for a symmetric equilibrium. Then, because e = E in a symmetric
equilibrium, , , m
h and m
l must be zero in the symmetric equilibrium. After some
11
rearranging, we finally get:

E[w]
wnr
+
[t(E, E) d(e)] = 0
=
e |e=E
e
e

(11)

W nr
E[W ]

[t (e, e) d(E)] = 0
=
E |e=E
E
E

(12)

Regarding the terms inside the brackets, we have that t(E, E) is the expected loss of
loosing the local firm when e = E, while d(e) is the corresponding gain in environmental
damage. As long as the sum of these two terms is negative, the government prefers having
no firm to having one. Further, it prefers having one firm to having two firms, because the
net gain of attracting the foreign firm must be negative. If the sum, [t(E, E) d(e)], is
positive, preferences are reversed.
Observe that both /e and /E from (11) and (12) are strictly negative. Thus,
levels of environmental regulation in the game in which relocation is possible can be either
less stringent, equally stringent or more stringent than in the game in which it is not possible:
Proposition 2.
If [t(e , e ) d(e )] > 0, the equilibrium (e , E ) in the game in which relocation
is possible involves less stringent environmental regulation, compared to the game in
which relocation is not possible i.e. e = E < e = E .
If [t(e , e ) d(e )] 0 the equilibrium (e , E ) in the game in which relocation
is possible involves more or equally stringent environmental regulation, compared to the
game in which relocation is not possible i.e. e = E e = E .
Proof. If [t(e , e ) d(e )] > 0, E[w]/e|e=E < 0 for e = E = e since
wnr /e = 0. Hence, by the assumptions; 2 E[w]/e2 < 0 and | 2 E[w]/e2 | > | 2 E[w]/
Ee| we have: e = E < e = E .
If [t(e , e ) d(e )] 0, E[w]/e|e=E 0 for e = E = e since w nr /e = 0.
Hence, by the assumptions; 2 E[w]/e2 < 0 and | 2 E[w]/e2 | > | 2 E[w]/Ee| we
have: e = E e = E .


The intuition behind the equilibrium strategies e = E < e = E is that each
government balances the desire to attract the other firm against the desire to increase the
level of environmental regulation of its local firm. In equilibrium, no relocation happens,
but none of the governments has an incentive to lower its level of environmental regulation
further because then the expected value of attracting the other firm is too low to compensate
for the loss in welfare from giving the existing firm even weaker environmental regulation.
11

See the working paper version of this paper for a full derrivation of the expressions.

M. Greaker / Resource and Energy Economics 25 (2003) 141154

149

The intuition behind the equilibrium strategies e = E e = E is that each

government balances the desire to force the local firm to leave against the loss from reduced competitiveness and potentially high relocation costs. Again, no relocation happens
in equilibrium, but none of the governments has an incentive to tighten its level of environmental regulation even further because: (i) there is still a probability of no-relocation and
the welfare in the no-relocation configuration is decreasing in e(E) ((for e > e )), and (ii)
the expected value of allowing the firm to relocate is decreasing because the conditional
expected relocation cost increases in e (E).
Note that if the tax rate, t, is zero, the governments will always choose equilibrium strategies such that e = E e = E . In the case of t = 0 and e = E , the governments
have nothing to lose on a relocation. Hence, they always set the levels of environmental regulation more stringently than in the case in which relocation is not possible. Clearly, the size
of t is crucial for what kind of equilibrium we get. This is further explored in the next section.
5. Comparative statics
There are especially three exogenous factors in the model which could potentially influence the kind of equilibrium to be expected. These three factors are:
The common profit tax rate; t.
The level of environmental damage for a given regulation.
The effect of a small change in regulation on the probability of relocation; /e.
We start by looking at the profit tax rate. Since we are looking at two symmetric equilibria,
we must have de/dt = dE/dt. From differentiating the first order condition (11) with
respect to t(dt = dT ) we then get:
de
(/e)(e , E )
<0
= 2
dt
( E[w]/e2 ) + ( 2 E[w]/Ee)
where the denominator is negative by the uniqueness criterion.
When the profit tax rate is higher, the loss of relocation is higher. Thus, both countries
become less interested in losing their own firm and more interested in getting the foreign
firm. Consequently, they lower their levels of environmental regulation, and, hence, we have:
Proposition 3. The level of environmental regulation depends negatively on the profit tax
rate.
Further, since the profit tax rate does not influence e the levels of environmental
regulation in the case in which relocation is not possiblewe can conclude that the higher
the profit tax rate, the more likely we have an equilibrium in which e = E < e = E .
In order to look at the level of environmental damage, we include a shift parameter d in

the environmental damage function; that is, the environmental damage is equal to d(e, d),

dd > 0. This shift parameter will influence both e and e . Firstly, we have:
2 w nr
>0

de

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M. Greaker / Resource and Energy Economics 25 (2003) 141154

and hence de /dd is positive; that is, in the case in which relocation is not possible,
governments will increase their levels of environmental regulation in response to a higher
level of environmental damage.
we get:
Then by differentiating (11) again, but with respect to d,

(/e)dd ( 2 w nr / de)
de
>0
= 2
2
2
( E[w]/e ) + ( E[w]/Ee)
dd
Proposition 4. In the case in which relocation is possible, governments will increase their
levels of environmental regulation in response to a higher level of environmental damage.
It is, however, difficult to say in what direction the seriousness of the environmental
damage influences the kind of equilibrium to be expected; that is, whether we have e =
E e = E or e = E < e = E . More serious environmental damage makes
domestic relocation more desirable for a given e, but since e also becomes more stringent,
domestic relocation may be no more desirable in the end.
Lastly, we take a closer look at the sensitivity of the relocation probability. For simplicity, let each government possess a uniform probability distribution on the relocation cost;
f (m) [0, m]
with m
> maxe,E [ml , mh ]. The probability is then equal to ml /m,
and
l /e. Hence, the higher the m,
its derivative /e is equal to (1/m)m

the less sensitive is

the relocation probability. Consider then an increase in m:

(ml /e)[t(e , E ) d(e )]

de
=
dm

2
[( 2 E[w]/e2 ) + ( 2 E[w]/Ee)](m)
which implies


de
= sign[t(e , E ) d(e )]
sign
dm

Thus, we have the following proposition.

Proposition 5. If we have an equilibrium in which e = E e = E , an increase in
m
will weaken the level of environmental regulation. Further, if we have an equilibrium in
which e = E < e = E , an increase in m
will strengthen the level of environmental
regulation.
The reason is that a high m
in general decreases the difference between the strategic
environmental policy solution e and the solution e . On the other hand, the size of m
does
not influence the kind of equilibrium to be expected.

6. A Cournot example
In order to show that the threat of relocation may yield both more stringent environmental regulation and higher welfare, we include an example. In the example the assump-

M. Greaker / Resource and Energy Economics 25 (2003) 141154

151

tions made with respect to the expected welfare functions can be demonstrated to hold i.e.
2 E[w]/e2 < 0 and | 2 E[w]/e2 | > | 2 E[w]/Ee|.
Let demand be described by the linear demand function P = 1 Q, where P is the
market clearing price and Q is industry output. Assume a technology which is such that
domestic marginal cost is equal to e where e is the level of environmental regulation.12 The
reduced-form profit functions of the two firms is then given:
(e, E) =

(1 2e + E)2
9

(E, e) =

(1 2E + e)2
9

Let further environmental damage be represented by:



1
2

d(e) = d[1 4e] , e e,

4
where d is a parameter indicating the seriousness of the environmental damage, and where
e is some lower bound on the level of regulation. It is then easy to calculate the policy
equilibrium in the case in which relocation is not possible:
e = E =

18d 1
,
72d 1

1
for d
18

Further, let each government possess a uniform probability distribution on the relocation
i.e. d = 1/8, we
cost defined on the interval [0, m]
as above. By choosing a value on d,
can calculate the policy equilibrium e for different values of m
and t and compare it to
e (1/8) 0.156. The figure also includes a welfare calculation (Fig. 1).
The dashed horizontal line is the equilibrium level of regulation for the case in which
relocation is not possible; e . Note that e is independent of the tax rate. As indicated by
the labeling of the graphs, the two other curves are drawn for different m.
We observe that
the higher the m,
the closer is e to e . Further, note that in the specific example we have
e = E e = E for profit tax rates below 22%.
Since no relocation takes place, ex post equilibrium welfare is simply given from the
expression for welfare in the no-relocation case, i.e. w nr (=W nr ). As seen from the figure,
domestic welfare (measured on the x-axis) is dropping in hole interval of e. The reason is
that the policy equilibrium is a kind of Prisoners Dilemma (see for example Barrett (1994)).
Thus, in the example the threat of relocation actually turns out to be a benefit for the two
countries as long as t <22%.
We have also worked out an example with Bertrand competition. Although the Cournot
and Bertrand examples are not directly comparable, simulations with different parameter
values indicates that the range of t in which the Bertrand example yields e = E e =
E , is likely to be much smaller than for the Cournot case. One intuitive reason is that,
in the case in which relocation is not possible, the governments generally set a stronger
12

See the working paper version of this paper for a richer treatment of the Cournot model.

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Fig. 1. Environmental policy and welfare under the threat of relocation.

policy with Bertrand competition than with Cournot competition (see for example Barrett
(1994)). Hence, the benefit of getting the firm to relocate when e = e is, in general,
smaller. On the other hand, the rent loss when the firm relocates is, in principle, no different
than for Cournot competition. Thus, ceteris paribus, the governments are more inclined to
set e = E < e = E for Bertrand competition.13

7. Discussion
We have assumed throughout the paper that there is asymmetric information about relocation costs. One may ask why the governments do not learn relocation costs over time. As
we have seen though, relocation never happens in the model, and, hence, the governments
never have the opportunity to learn the relocation cost.
If we had included asymmetries in profit taxes and asymmetries in environmental damages, we would probably have found asymmetric equilibria with a positive probability of
relocation. Of course, in such equilibria the government would learn the relocation cost, to
the extent that relocation happened. However, one could also argue that relocation costs are
firm and time specific, and that observing one relocation does not reveal much information
about another potential relocation.
Alternatively, the governments could have used some form of revelation mechanism, as
in Brainard and Martimort (1997), to learn the relocation cost. Brainard and Martimort
(1997) analyze a strategic trade policy setting in which the governments do not know the
13

The Betrand example can be obtained from the author upon request.

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153

marginal costs of firms. Firms are then offered contracts for which they receive a production
subsidy in exchange for information about their marginal costs and a lump-sum tax to the
governments.
A possible extension of the present analysis could be to introduce a similar type of
contract; that is, the firms are offered pollution abatement cost subsidies in exchange for
information about the relocation cost. Some care must be taken though, since it can be
shown that no Nash equilibrium in pure strategies exists when the relocation cost is known
with certainty and is positive.
With respect to the type of policy instrument, in principle emission quotas, technology
standards, emission/output ratios, etc. are all compatible with the model as long as they are
used cost effectively. Emission taxes are also compatible with the model, provided that the
emission tax revenue is recycled back to the firms. If emission tax revenues are not recycled
back to the firms, the choice of instrument would influence the probability of relocation.
Further, we would have to rewrite the expression for welfare in case of foreign relocation,
taking account of the emission tax revenue from the foreign firm, which comes in addition
to the profit tax.
There are a number of potentially interesting extensions with respect to the welfare
function. As the model is formulated, the loss of losing a firm is equal to the gain of
attracting a firm in equilibrium and vice versa; and the gain of losing a firm is equal to the
loss of attracting a firm in equilibrium. This is a special feature of the model. The loss of
losing the home firm would be higher than the gain of attracting the foreign firm if we had
included asymmetric social costs; that is, a loss from layoffs, but not a gain from new jobs.
Further, the loss of losing the home firm would also be higher than the gain of attracting
the foreign firm if for example environmental costs were convex in the number of firms.
Although the pay-off function would still be continuous for this version of the game, the
best response function would be discontinuous. Hence, we may have two symmetric Nash
equilibria of which one is pay-off dominated.
Another possibility is to have agglomeration effects when both firms locate in the same
country. Given equal levels of environmental regulation, this would imply that the profit of
a firm would be higher if the other firm also located in the same country. As above, this
yields a discontinuous best-response function. Further, we may obtain more equilibria, in
particular, two asymmetric Nash equilibria. One should not be surprised though. If there
are agglomeration effects, there is an extra gain from gathering the firms in one country,
and hence, it may be worthwhile to have a positive probability of relocation in equilibrium.
It is also interesting to look at other assumptions about the residence of the shareholders.
If both firms have shareholders located in a third country, the solution to the game in which
relocation was not possible would have to be redefined, that is, we would no longer have
the game described by Barrett (1994). Further, we would have to say something about the
tax system in the third country. However, apart from that, the results would not change;
that is, the threat of relocation could both increase or decrease the levels of environmental
regulation and welfare compared to the situation in which relocation is not possible.14
Regarding policy implications, it seems that those who believe that globalization and
free movement of capital imply an unambiguous downward pressure on environmental
14

Analysis of all these cases can be obtained from the author upon request.

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M. Greaker / Resource and Energy Economics 25 (2003) 141154

standards, somewhat overstate one possible effect. In this paper, we have shown that the
level of environmental regulation might as well move in the opposite direction. A potential
danger is that politicians systematically understate the actual relocation costs and overstate
the loss of relocation. At least the WTO committee (1999) seems to be of this opinion
when they write: . . . environmental initiatives are nevertheless defeated from time to time
because of competitiveness concerns. This finding suggests that at least perceived regulatory
autonomy has diminished alongside the removal of trade and investment barriers . . .

Acknowledgements
I am very grateful for the advice and comments I have recieved from my former supervisor Nils Henrik von der Fehr. Further, I thank two anonymous reviewers for very helpful
comments on an earlier draft. Lastly, I would also like to thank the Norwegian Research
Council for financial support.
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