Discussion Papers In Economics
And BusinessExport Processing Zones and Environmental Policy

Yasuyuki Sugiyama
Discussion Paper 06-22

Graduate School of Economics andOsaka School of International Public Policy (OSIPP)
Osaka University, Toyonaka, Osaka 560-0043, JAPANExport Processing Zones and Environmental Policy

Yasuyuki Sugiyama
Discussion Paper 06-22

August 2006
この研究は「大学院経済学研究科・経済学部記念事業」
基金より援助を受けた、記して感謝する。
Graduate School of Economics andOsaka School of International Public Policy (OSIPP)
Osaka University, Toyonaka, Osaka 560-0043, JAPANExport Processing Zones and Environmental Policy *Yasuyuki Sugiyama †Abstract
This paper investigates the relation between an export processing zone and a pollution quota in a small
country. The model suppose that the pollution target is implemented with a marketable permit system,and the government sets the quota to maximize domestic welfare. Then we show that, if an increase inreal income reduces marginal external damage, the pollution quota is relieved by the formation of anexport processing zone. However, if the marginal damage is augmented with an increase in the income,the optimal quota might be strengthened by the formation of the zone.

JEL Classification: F18, O24
Keywords: export processing zone, international trade, environmental policy, pollution* Acknowledgement: I am indebted to Kenzo Abe for encouragement and advice. I would like to thank Makoto
Tawada and Takumi Naito for their constructive and thoughtful comments.
† Corresponding author:
Yasuyuki Sugiyama, Graduate School of Economics, Osaka University, 1-7
Machikaneyama, Toyonaka, Osaka 560-0043, Japan. E-mail: sugiyamayasuyuki@srv.econ.osaka-u.ac.jp

1. Introduction
In most trade negotiations, the difference in economic environments between developed anddeveloping countries has been a source of conflict. Since the interests of developing countries are
economic extension and growth, progress in the management of environmental problems is noteasy 1 . In order to attain industrialization, developing countries frequently utilize the export
processing zone (hereafter, EPZ) as a trade policy measure. By forming an EPZ, these countries
partially enjoy the gains from free trade and experience more foreign capital inflow, which canlead to the creation of employment and the acquisition of foreign earnings 2 . Considering that
EPZs have been opened in many developing countries, we should direct our attention to theenvironmental impact of the formation of EPZs, because, if the opening of EPZs attracts foreign
firms with clean technology, countries with EPZs might implement looser environment policies.
Hence, the purpose of this paper is to examine the welfare effect of the formation of an EPZ
in a model involving a negative externality by pollution discharge and to clarify the correlation
between the formation of an EPZ and environmental policy.
Since the pioneering work of Hamada (1974), various researchers have published analyses of
EPZs 3 . Miyagiwa (1986) analyzes the effects of a subsidy to the EPZ. Young (1987) examines
the effects of reducing the tariff on imported intermediate goods into the EPZ. The extension
to the nontraded intermediate good is given by Din (1994), and the case where the production
technology exhibits variable returns to scale is considered by Yabuuchi (2000). In recent years, theanalysis of the EPZ has been generalized by using expenditure and GDP functions. Devereux andChen (1995) assume a two goods and many factors model, and then point out the importance ofthe effect of capital inflow on factor prices. Whereas Devereux and Chen (1995) suppose that the
final good of the domestic zone (hereafter, DZ) is protected by an import quota, Schweinberger(2003) analyzes the welfare effect of quotas on imported intermediate goods.
Despite these various analyses, as far as we are aware, environmental problems have never beentheoretically analyzed under the framework of the EPZ 4 . Hence, we rearrange Young (1987) sothat an external diseconomy is involved, and then derive the suggestive proposition. That is, weshow that, if the government of the country sets the quota to maximize domestic welfare and theratio of imported intermediate inputs to pollution levels in the production process of the EPZ ishigher than in that of the DZ, the optimal pollution quota is relieved by forming an EPZ.
This paper is organized as follows. Section 2 presents the model. In section 3, we give
preliminary comparative static results for the pollution quota and the formation of an EPZ,
and we then examine the welfare effects of these policies in section 4. The relation between theformation of an EPZ and the optimal pollution quota is analyzed in section 5. The final section
gives concluding remarks.
2. The model
We consider a small open country that establishes an EPZ. Two final goods are produced (X i , i =1 There are many studies of trade and the environment, e.g., see Copeland and Taylor (1995, 2003).
2 See Madani (1999) for a practical discussion of the EPZ.
3 Although we use the term ’export processing zone’ in this paper, there is no single term for such zones; forexample, others refer to them as duty free zones, free trade zones, export zones, or special economic zones.
4 See Copeland (1994) and Beladi et al. (1999) for a discussion of trade and the environment, including the
inflow of foreign capital.

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1, 2), and the production technology in both sectors exhibits constant returns to scale 5 . We
suppose that sectors 1 and 2 correspond to the DZ and the EPZ, respectively. Domesticallyowned capital is used only in the DZ, and foreign capital inflow is accepted only in the EPZ.
Sector specific capital (K i ) and imported intermediate goods (M i ) are used for the productionof these goods. Pollution (Z i ) is generated as by-products in their production process. We treat
pollution as a factor of production that can move between these sectors. The government of thecountry regulates the total amount of pollution by a quota (Z̄), and pollution permits are tradedin the domestic market. In addition, the government imposes an ad valorem tariff (ti ) on theimported intermediate inputs in each sector. Initially, these tariffs are at the same level in both
sectors. The formation of an EPZ means that t2 is reduced to the level below t1 .
In the following analysis, we designate the good of sector 1 as the numeraire, and we denote
the relative price of the EPZ’s good by p∗ 6 . Since we assume that all the markets are perfectlycompetitive and the technology of both sectors is constant returns to scale, the zero profit
conditions are expressed as
1 = ρz 1 (ρ, r) + ra1k (ρ, r) + q 1 a1m ,

(1)

∗

(2)

p = ρz2∗(ρ, r ) + r∗ a2k (ρ, r∗ ) + q 2 a2m ,where q i = (1+ti )q ∗ denotes the domestic price of the imported intermediate good in each sector,
r indicates the rental rate of the domestic capital, and ρ represents the price of the pollution
permit. On the other hand, z i , aik , and aim denote the unit factor requirements of pollution,
capital, and imported intermediate goods in each sector, respectively.
Noting that the government regulates the total amount of pollution in the country, and thenissues pollution permits, the factor market equilibrium conditions for pollution, domestic capital,
foreign capital, and imported intermediate inputs areZ̄ = z 1 (ρ, r)X 1 + z 2 (ρ, r∗ )X 2 ,(3)K̄ = a1k (ρ, r)X 1 ,

(4)

∗

(5)

K

= a2k (ρ, r∗ )X 2 ,M ∗ = a1m X 1 + a2m X 2 ,(6)where K̄ denotes the domestic endowment of capital, which is supplied inelastically, and M ∗indicates the level of intermediate imports.
There are six endogenous variables: ρ, r, X 1 , X 2 , K ∗ , and M ∗ from eq. (1) to eq. (6).
3. Preliminary
In this section, we present comparative static results for the pollution quota and the formationof an EPZ by using the above six equations.
3.1. The case of a pollution quota

5 Throughout this paper, we treat ai as the constant variable in order to simplify our analysis. Moreover, ourmanalysis is simplified by supposing a Leontief production function in each sector.
6 We attach an asterisk to variables corresponding to the world.

2

Firstly, we consider the effects of a pollution quota. From eqs (1) and (2), we can confirm thata change in the quota does not affect the permit price and the rental rate of domestic capital.
Moreover, from eq. (4), the production of the DZ is also not influenced by the quota. That is,dρ/dZ̄ = dr/dZ̄ = dX 1 /dZ̄ = 0. Considering these results, we obtain dX 2 /dZ̄ = 1/z 2 > 0 fromeq. (3). An intensification of the pollution quota decreases the EPZ’s production only. Hence,noting that aim is fixed from our assumption and M i = aim X i , the effect on intermediate imports
into the EPZ is written as
dM 2
a2
dX 2
= a2m
= m
> 0.
z2
dZ̄
dZ̄

(7)

Eq. (7) shows that the amount of intermediate inputs imported to the EPZ is reduced by areinforcement of the pollution quota.
3.2. The case of the formation of an EPZ
Unlike the pollution quota, a reduction in the tariff on the imported intermediate inputs into an
EPZ affects the permit price and the rental rate of domestic capital. Totally differentiating eqs(1) and (2), we obtain the following comparative static results:
2
dρ
∗ am
=
−q
< 0,
dt2
z2
2
1
dr
a z
= q∗ m> 0.
2
dt
a1k z 2(8)
(9)

On the other hand, considering eqs (8) and (9), the effects on the production of each good are
obtained from the total differentiation of eqs (3) and (4). That is:
µ
¶
dX 1
1
k dρ
k dr
= − 1 δρ 2 − δr 2 > 0,
(10)
dt2
ak
dt
dt
½µ 1
¶
µ 1
¶
¾
dX 2
1
z k
dρ
z k
dr
z
z
=
δ
+
δ
−
δ
+
δ
< 0,
(11)
ρ
r
dt2
z2
a1k ρ
dt2
a1k r
dt2
where δρk ≡ X 1 (∂a1k /∂ρ), δrk ≡ −X 1 (∂a1k /∂r), δρz ≡ −X 1 (∂z 1 /∂ρ) − X 2 (∂z 2 /∂ρ),δrz ≡ X 1 (∂z 1 /∂r). All the δ are defined by the positive value. By using these comparative static
results, we can derive the effect on the level of intermediate imports. Total differentiation of eq.
(6) is given by
µ 1
¶
µ 1
¶
dM ∗
z
a2m z drz
a2m z dρkk=θδ − 2 δr−θδ − 2 δρ
< 0,
(12)
dt2
a1k r
z
dt2
a1k ρ
z
dt2
where θ ≡ a1m /z 1 − a2m /z 2 denotes the relative ratio of the unit factor requirements for thepollution and the imported intermediate inputs in each sector.
Eqs (10) and (11) tell us that the effects of the formation of an EPZ on each product havereverse signs. However, if θ < 0, the EPZ’s good is pollution intensive relative to the DZ’sgood. In this case, when the government reduces the tariff on the EPZ’s intermediate inputs,
the increasing effect on the products of the EPZ is larger than the decreasing effect on those of
the DZ. Therefore, the opening of an EPZ increases the total amount of intermediate imports(dM ∗ /dt2 < 0).

3

4. The welfare effects of a pollution quota and the formation of an EPZ
In this section, the welfare effects of a pollution quota and the formation of an EPZ are examined.
We take a representative consumer in a country and assume that pollution is a pure public badfor the consumer. The expenditure function that represents the minimum expenditure on final
goods is described as E(p∗ , u + φ(Z̄)), where u denotes the consumer’s utility level 7 .
Suppose that the government’s revenue from the tariff is redistributed to the domestic households in a lump-sum fashion; the budget constraint of the country is written byE(p∗ , u + φ(Z̄)) = X 1 + p∗ X 2 − q 1 M 1 − q 2 M 2 − r∗ K ∗+t1 q ∗ M 1 + t2 q ∗ M 2 .

(13)Hence, total differentiation of eq. (13) yields the effects on the utility level as
Eu du = (ρ − Eu φ0 )dZ̄ + t1 q ∗ dM 1 + t2 q ∗ dM 2 ,(14)

where Eu ≡ ∂E/∂u. Under our assumption for the utility function, Eu φ0 indicates the marginal
willingness to pay for pollution reduction, and thus represents the marginal damage caused bypollution. Eq. (14) shows that there are two sorts of distortion in the economy. Since pollution
gives the disutility to domestic consumers, the government has to correct not only the tariff
distortion but also the external diseconomy.
4.1 The case of the pollution quotaFirstly, the effect of the pollution quota on welfare is derived from Eq. (14) as
dudM 2= (ρ − Eu φ0 ) + t2 q ∗
.
(15)
dZ̄
dZ̄
We have already shown in eq. (7) that the amount of intermediate goods imported into the EPZ
is reduced by a reinforcement of the pollution quota, and thus the tariff revenue is decreased.
Therefore, if the government sets the pollution quota at the optimal level, the permit price islower than the marginal damage in order to weaken this effect.
Eu

4.2 The case of the formation of an EPZ
Secondly, we investigate the welfare effect of the formation of an EPZ. Although we suppose there
is an external diseconomy by pollution discharge, the welfare effect of the tariff reduction follows
Young (1987), because the total amount of pollution is unchanged as the policy instrument.
Hence, we briefly explain these comparative static results.
Noting that tariffs on both sectors are initially at the same level (t1 = t2 ), the welfare effectof the formation of an EPZ is obtained from eq. (14) as
¯
du ¯
dM ∗
(16)
Eu 2 ¯¯= t2 q ∗ 2 < 0.
dt t1 =t2
dt
Eq. (16) denotes that an improvement in welfare depends on whether the total amount ofintermediate imports increases. However, we have already confirmed in eq. (12) that if, θ < 0, a
reduction in the tariff on the EPZ’s intermediate inputs increases the total amount of intermediate
imports. Hence, the welfare of the country is improved by the growth of the tariff revenue.
7 We assume that the utility function is additive separable in the consumption bundle and pollution, and thatthe damage function (φ(Z̄)) has the following properties: φ0 (Z̄) > 0, φ00 (Z̄) > 0.

4

5. The formation of an EPZ and the optimal pollution quota
In this section, we examine the effect that the formation of an EPZ has on the pollution quota.
In order to make the analysis, we suppose that the tariff of both sectors is initially at the samelevel and that the government of the country executes the optimal pollution quota.
Given Z̄, t1 , and t2 , we obtain the utility level of the country from eq. (13). Note that a change
in the quota does not affect the permit price and the rental rate of capital. Then, substituting eq.
(7) into eq. (15), the optimal quota that implements welfare maximization satisfies the following
condition:
Az (Z̄, t1 , t2 ) ≡ B(t1 , t2 ) − Eu [u(Z̄, t1 , t2 ) + φ(Z̄)]φ0 (Z̄) = 0,(17)where B(t1 , t2 ) is defined asa2m
B(t1 , t2 ) ≡ ρ(t1 , t2 ) + t2 q ∗ 2.
z [ρ(t1 , t2 ), r∗ ](18)

The first term of B(t1 , t2 ) is the permit price, which is equal to the value of the marginal productof emission in a competitive market. The second term represents the effect of the pollution quota
on tariff revenue. Hence, eq. (17) means that the domestic pollution quota is chosen so that themarginal damage equals the sum of the permit price and the change in the tariff revenue. In
other words, since a decrease in the pollution quota reduces the amount of intermediate inputs
imported into the EPZ, the permit price is lower than the marginal damage.
From eq. (17), the effect of the formation of an EPZ on the optimal quota is given bydZ̄
A 2= − zt ,
dt2
Azz

(19)

where subscripts z and t2 , which are attached to Az , denote the partial derivatives by Z̄ and t2 ,respectively 8 . Since the quota does not influence the permit price, the denominator Azz in eq.
(19) is written as
Azz = −{Euu (φ0 )2 + Eu φ00 }.

(20)

The sign of Euu closely depends on the shape of the utility function. Although we do not assume
the sign, Azz < 0, from the second-order condition of welfare maximization.
On the other hand, noting that ρt2 = −q ∗ a2m /z 2 in eq. (8), Azt2 is derived from eq. (17) as
Azt2 = −Euu φ0 ut2 + Bt2 ,(21)

where Bt2 denotes the partial derivative by t2 , and is expressed by
Bt2 (t1 , t2 ) = −t2 q ∗ a2m zρ2 ρt2< 0.
(z 2 )2(22)

Eq. (21) shows that the influence of the formation of an EPZ on the optimal pollution quota
is classified into two effects. The first term of the right hand side indicates the effect on themarginal damage that is caused through a change in the income. Although the opening of an
8 We use the same subscripts in B, u, ρ, and r.

5

EPZ improves welfare by the growth of the tariff revenue, the improvement is tied to the change
in marginal damage. This effect is closely related to the sign of Euu . The second term denotes
the effect on intermediate inputs into the EPZ. An intensification of the pollution quota decreases
the EPZ’s intermediate imports. However, since the tariff reduction raises the permit price andthus decreases the unit factor requirement for EPZ’s pollution, the marginal revenue of the tariff
is augmented by the opening of an EPZ (Bt2 < 0).
Hence, if Euu is nonpositive (Euu ≤ 0), we can derive the definite relation between the optimal
quota and the opening of an EPZ from eq. (21).
Proposition 1: Suppose that the tariff on both sectors is initially at the same level and thegovernment of the country executes the optimal pollution quota. In this case, if θ < 0 andEuu ≤ 0, the formation of an EPZ relieves the optimal pollution quota.
(Proof): ρt2 < 0 from eq. (17). If θ < 0 and initially t1 = t2 , ut2 < 0 from eqs (12) and (16).
Hence, if Euu ≤ 0, we can obtain Azt2 < 0 in eq. (23), and then dZ̄/dt2 < 0. (Q.E.D.)
Fig. 1 denotes the determination of the pollution quota. The marginal damage is equal to thesum of the permit price and the change in tariff revenue. As shown in eq. (18), B = ρ+t2 q ∗ a2m /z 2
does not depend on the level of pollution quota; thus, the formation of an EPZ increases themarginal tariff revenue (Bt2 < 0). Hence, the horizontal line B 0 shifts up to B 1 with the opening.
On the other hand, Eu φ0 in eq. (17) denotes the marginal damage caused by pollution. Since
the damage is augmented by a relaxation of the pollution quota, the line M D slopes upward.
Moreover, if Euu < 0, the damage is decreased with an increase in income. Hence, when thegovernment of the country opens an EPZ, the line M D0 moves to M D1 in Fig. 1. As a result, theformation of an EPZ definitely loosens the optimal pollution quota from Z̄ 0 to Z̄ 1 . If Euu = 0,
the line M D0 does not shift. However, since the increasing effect of the marginal tariff revenue
0
remains, the optimal pollution quota is moved to Z̄ 0 .
Finally, we note that, if Euu > 0, there is a possibility that the optimal quota is strengthenedby the formation of an EPZ, because the marginal damage is swollen with an increase in theincome. In this case, although two effects of the opening of an EPZ have reverse signs in eq.
(21), we can derive the sufficient condition for the optimal pollution quota to be reinforced.
Substituting eqs (12), (16) and (20) into (21), Azt2 is written asµ¶t2 q ∗ a2m zρ2 ρt2 Euu 0 2
Azt2 = Ω +
φ
Z
−
1
,
(23)
(z 2 )2
Eu
where Z 2 = z 2 X 2 , and Ω is defined by
Ω≡−

½µ 1
¶
Euu 2 ∗ 0
z
a2m z
k
t q φ
δ
r t2
θδ
−
Eu
a1k r
z2 r
¶ ¾
µ 1
a2m 1 1zkθδ + 2 X zρ ρt2 > 0.
−
a1k ρ
z

(24)

Ω is positive from ρt2 < 0, rt2 > 0, Euu > 0, and θ < 0. Hence, in eq. (23), if Euu φ0 Z 2 /Eu ≥ 1,
we obtain Azt2 > 0. In order to clarify the meaning of the sufficient condition, we rearrange thecondition as
Euu 0 2φ Z − 1 = ²u ²z βu βz − 1 ≥ 0.
Eu
6

(25)

Eu is the inverse of the marginal utility of income, and then we define the elasticity of Eu as²u ≡ (u + φ)Euu /Eu , where ²u > 0 under the assumption Euu > 0. ²z ≡ Z̄φ0 /φ denotes theelasticity of φ. Since we assume that φ0 > 0 and φ00 > 0, as long as the pollution discharge is
not zero, ²z > 1. Moreover, βu ≡ φ/(u + φ) < 1 indicates the share of the external damage tothe utility level and βz ≡ Z 2 /Z̄ < 1 denotes the share of the pollution discharged from sector 2
to the aggregate pollution. Hence, if ²u ²z > 1/(βu βz ) in eq. (25), we can get Azt2 > 0 from eq.
(23).
Under the assumption Euu > 0, when the formation of an EPZ increases the income of acountry, the marginal damage is also increased. Thus, the larger the value of ²u , the greater theeffect of income on marginal damage. Similarly, when the value of ²z is above one, the effect of
the quota on marginal damage is emphasized further. Therefore, if the value of these elasticities
is sufficiently large, the optimal pollution quota might be reinforced. The line M D2 in Fig. 1
corresponds to this case. If ²u ²z βu βz ≥ 1, the government definitely strengthens the optimal
pollution quota to Z̄ 2 .
6. Concluding Remarks
We have rearranged the model of the EPZ so that an external diseconomy is included, and thenshown the relation between the formation of an EPZ and the optimal pollution quota. Further
research is required in the following areas. Firstly, as mentioned in the introduction, there arevarious models for analyzing the EPZ. Therefore, we need to investigate whether our conclusion
is also obtained with other frameworks. Secondly, to sharpen the focus, we supposed that theunit factor requirements for the intermediate good are fixed in each sector. However, in orderto generalize our analysis, we must consider the case where these coefficients are allowed to bevariable. Thirdly, we assume that all the markets including the pollution permit are perfectlycompetitive. Hence, it would be interesting to see how our result is modified under imperfectcompetition.

7

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ρ, Eu φ0

M D2

B1

E0

M D1

E1

E0

B0

0

0

E2

M D0

Z̄ 2

Z̄ 0

0

Z̄ 1
Z̄
Z̄ 0
Fig. 1. The determination of the optimal pollution quota

9