Environmental Regulations, Innovation, International Trade and Strategic
Behavior
1Savas Alpay
TOBB Economy and Technology University, Ankara, Turkey

Abstract
Will international trade lead to relaxation of environmental policies? Will the incentives ofgovernments for acting strategically in setting their environmental policies be higher if
producers competing in international markets behave strategically? What will be the Nashequilibrium of the strategic game between governments and producers in the presence ofinnovation, international trade and environmental regulations? How does the equilibriumchange when we move from a simultaneous-move game to a sequential-move game?

Our paper attempts to provide answers to these questions. In a standard model used inearlier studies in this literature (see Ulph 1996), we analyze the behaviors of governments
and producers related to environmental policy making and R&D investment, respectively.
Governments may act strategically by recognizing that the output of the foreign producer
depends on the emission level it sets, and thus, it may distort its environmental policy inorder to generate competitive advantage to its producer. Producers may act strategically byadjusting the level of investment in R&D by considering the associated impact on theoutput of the rival producer. Our main objective is to determine the Nash equilibrium of
this game including governments and producers in the presence of environmental
regulations, international trade and innovation. Surprisingly, this has not been reported
before.

We show that there is a unique Nash equilibrium in the simultaneous-move game, and bothproducers and governments behave strategically. Producers overinvest in R&D, andgovernments lower their emission standards. Both countries end up with a lower welfare,and higher emission level than the case in which none behaves strategically. This is like aprisoner’s-dilemma-type outcome. In the sequential-move game, two equilibria exist, but
one dominates the other in terms of both the welfare and emission levels. In the equilibrium,
first-moving (leader) government acts strategically, the follower government will not act
strategically, and none of the producers will behave strategically. The first-moving country
gets higher welfare than the follower country. Similarly, producer in the first-moving
country gets higher profits than the producer of the follower country; both producers will
choose their R&D investment efficiently. Furthermore, as expected, emission level ishigher in the first-moving country because of the strategic behavior.

1Assoc. Prof.
E-mail: salpay@tapdk.gov.tr, Phone: +90-505-212 9390,
Fax:+90-312-455 0428. Correspondence address: 96. Sok., Yazikiri Sitesi, B2-25, Umitkoy,
Ankara, Turkey.

Our explicit analysis of the welfare levels and profits not only reveals the equilibrium
behaviors but also puts doubt on some of the earlier findings in this literature. For example,Ulph (1996) states that allowing governments to act strategically increases the incentive for
producers’ to act strategically (overinvestment in R&D). As seen in the pay-off tables wehave presented, producers will prefer to behave non-strategically (i.e. efficiently) when
governments act strategically. Producers will prefer to act strategically only if the otherproducer is acting strategically. Finally, the highest welfare levels correspond to the cases
in which only one government acts strategically and the other one efficiently, but this set ofbehaviors can not be sustained.

In this paper, only the identical-country case is analyzed. This analysis will be extended tonon-symmetric cases in future works, and initial expectations for the impact of such anextension will also be presented.

Keywords : Environmental Policies, Trade, R&D Investment, Strategic Behavior,Welfare Analysis.