Environmental Standards under International Oligopoly∗
Jota Ishikawa†Toshihiro Okubo

Hitotsubashi University

Kobe University

and RIETI
December 10, 2009

Abstract
We explore the eﬀects of domestic environmental standards when a domestic
firm and a foreign rival compete in the domestic market. We focus on a situation
where the standard drives the foreign product out of the domestic market, because
it does not meet the standard. Such prohibitive standards may induce the foreign
firm to produce an environmentally friendly good through R&D or licensing fromthe domestic firm, but do not guarantee an improvement in environment. In thecase of licensing, governments may try to shift the rent from the domestic firm. The
shifted rent could exceed the foreign firm’s payment.
Key words: environmental standards, international oligopoly, R&D, licensing,rent-shifting
JEL classification numbers: F13, F18∗

We thank Naoto Jinji, Monika Mrázová, seminar participants at Australian National University,

Hitotsubashi University, Okayama University, Tohoku University, University of New South Wales andattendees at the Otago Workshop 2009, the IEFS China 2009 Annual Conference, the APTS 2009 Annual Meeting, the 2009 Far East and South Asia Meeting of the Econometric Society and the ETSG
2009 Annual Conference for helpful comments. Any remaining errors are our own responsibility. We
acknowledge financial support from the Ministry of Education, Culture, Sports, Science and Technologyof Japan under the Global Center of Excellence Project.
†
Corresponding author : Faculty of Economics, Hitotsubashi University, Kunitachi, Tokyo 186-8601,
Japan; Fax: +81-42-580-8882; E-mail: jota@econ.hit-u.ac.jp1

1

Introduction

Concern for environmental destruction has been growing in the world. To protect environment, various environmental policies are adopted all over the world. However,
attitudes towards environmental destruction are diﬀerent across countries. Thus, somecountries adopt more stringent policies than others. Examples include environmental
standards. For instance, exhaust emission and fuel consumption regulations are more
stringent in developed countries than in developing countries and hence automobiles indeveloped countries are environmentally more friendly.
It is often observed that governments prohibit firms from selling those products that
do not meet certain environmental standards. Such stringent standards (i.e., prohibitive
standards) may work as trade barriers and protect domestic producers. For example,
the United States banned imports of yellowfin tuna and their related processed products
from Mexico based on the Marine Mammal Protection Act.1 The EU prohibited the useof chrysotile asbestos products and banned their imports from Canada in 1998.2 In 2002,
China introduced the China Compulsory Certification, under which foreign firms cannot
export to China without implementing certain standards including environmental ones.
When domestic standards are prohibitive for foreign firms, however, they may have an
incentive to circumvent them. For example, foreign producers may develop new products
which meet the domestic standards. It is also widely observed that foreign firms obtainlicenses to produce environmentally friendly products or key intermediate inputs to clear
standards from their domestic rivals.3
The purpose of this paper is to explore the eﬀects of environmental standards inthe framework of international oligopoly. We ask whether prohibitive standards actually
protect environment and whether prohibitive standards actually benefit domestic firms.
In particular, we analyze a situation under which prohibitive standards lead foreign firms
1

The United States also restricted imports of shrimp and shrimp products from India, Malaysia,

Pakistan, Thailand and the Philippines under Section 609 of Public Law 101-162 of 1989.
2
Moreover, in the EU, electronic and electrical equipment that does not comply with the RoHS
(Restriction of Hazardous Substances) directive restricting the use of six hazardous materials in the
manufacture cannot be imported. The EU also introduced a regulation called Registration, Evaluation,
Authorization and restriction of Chemicals (REACH) in 2006 to protect human health and environment.
Supply of chemical substances to the EU which have not been pre-registered or registered is illegal.
3
For example, Mitsubishi Motors Corporation (MMC) and PSA Peugeot Citroën have announced
that MMC will provide PSA an MMC-made electric vehicle for Europe. The vehicle will be sold underPeugeot brand, in parallel to Mitsubishi’s own vehicle. Nissan Motor Co. is developing lithium-ion
batteries for hybrid and electric vehicles. They are planning to provide it to other auto makers.

2

to engage in R&D or get licenses from domestic rivals to produce goods that meet thestandards. In this situation, we compare with and without standards from the viewpointof environmental quality and domestic profits. We also compare between R&D andlicensing. Furthermore, the presence of R&D and licensing leads to strategic interactions
between domestic and foreign firms and generates rent. We specifically examine theopportunities of rent-shifting across countries in the presence of R&D and licensing.
To this end, we build a simple model in which a domestic firm and a foreign rival
produce slightly diﬀerentiated products and compete in the domestic market. Both domestic and foreign products generate negative externalities during either production or
consumption. However, the foreign product damages environment more than the domestic product. For example, foreign cars (say, gasoline cars) emit more carbon dioxide thandomestic cars (say, hybrid cars). The domestic government introduces a standard which
the domestic product satisfies but the foreign product does not. To serve the domestic
market, therefore, the foreign firm has to produce a product meeting the domestic standard through either R&D or licensing. In this circumstance, we obtain counter-intuitive
results that prohibitive standards may deteriorate environment and/or hurt the domestic
firm. Although the foreign firm may be led to produce an environmentally friendly good,prohibitive standards do not guarantee an improvement in environment.
In our model, the domestic firm strategically licenses their technologies or supplies
a key intermediate input to the foreign rival when the foreign firm is willing to engage
in R&D to produce a good meeting the standard. That is, the domestic firm intends todeter the foreign firm from engaging in R&D. Such a strategy mitigates the loss of thedomestic firm caused by the reentry of the foreign firm to the domestic market. When thedomestic firm sets the license fee or the input price, it tries to extract rent from the foreign
firm as much as possible. However, the foreign government may intervene to manipulate
rent-shifting through taxes and subsidies.4 We point out that the foreign government
can shift the rent from the domestic firm to the foreign government either directly or
indirectly. However, such a rent-shifting opportunity may be deterred by the domestic
government through taxes. Interestingly, the shifted rent could exceed the payment fromthe foreign firm to the domestic firm. Moreover, the presence of rent-shifting could makethe license fee negative.
There exist many studies that investigate environmental policies in the presence of4

We examine simple intervention through taxes and subsidies. For strategic environmental policy,

see Barret (1994), Kennedy (1994), Conrad (1996,2001), Ulph (1996), Tanguay (2001), and Kiyono andIshikawa (2004), among others.

3international trade.5 However, relatively little attention has been paid to environmental
standards in open economies.6 In an international duopoly model, Fischer and Serra(2000) consider optimal minimum standards and examine whether they are protectionist.
Haupt (2000) examines the relationship between environmental product standards andenvironmental R&D in a monopolistically competitive sector in a two-country model.
On the basis of a model with environmentally diﬀerentiated products and heterogeneous
consumers, Toshimitsu (2008) shows that a strict emission standard on an imported
product may or may not increase social surplus. Ishikawa and Okubo (2009) also showthat stringent environmental standards may actually worsen environment. However, they
focus on firm relocation caused by product standards in the framework of new economic
geography.
Although strategic use of licensing has been studied in the literature of industrialorganization, those studies basically deal with a closed economy.7 Thus, one cannot consider rent-shifting across countries. Only few studies analyze strategic use of licensing
or input supply in the open economy framework. Chen et al. (2004) show that underinternational duopoly, trade liberalization leads to strategic outsourcing to the rival firm,
which has a collusive eﬀect. Horiuchi and Ishikawa (2009) explore the strategic relationship between tariﬀs and North—South technology transfer in an oligopoly model whentechnology is embodied in a key component that only North firms can produce.
The rest of the paper is organized as follows. In section 2, we present an international Cournot duopoly model with negative externalities. We consider a situation underwhich consumption generates emissions that deteriorate environment.8 Then we examine
emission standards in section 3. Specifically, we consider the foreign production of thedomestic good through either R&D or licensing. In section 4, we explore the rent-shiftingby the foreign government in the presence of R&D and licensing. Section 5 concludes.
5
6

See Rauscher (2005) for the literature survey.
We deal with only compulsory standards in our analysis. Eco-laballing scheme is voluntary standards

in the sense that products can be sold in the market even if they do not meet certain standards. For
the analysis of eco-labelling scheme under international oligopoly, see Abe et al. (2001) and Tian (2003),
among others.
7
In the industrial organization literature, licensing is strategically used to (partially) deter entry. See
Gallini (1984) and Yi (1999), for example.
8
Regarding the case of production externalities, see section 5.

4

2

Base Model

We consider two goods X and Y , which are imperfect substitutes. Good X is produced
by a foreign firm (firm f ), that exports the good to the domestic country. In the domestic
country, a domestic firm (firm d) produces good Y . The two firms engage in Cournot
competition in the domestic market. We assume that emissions are generated throughconsumption of the products. By an appropriate choice of units, one unit of consumptionof good X generates one unit of emissions and that of good Y results in 0 < k < 1 unitsof emissions. The emissions cause negative externalities.
Demands are characterized by a representative consumer that consumes goods X
and Y as well as a numéraire good. The numéraire good is competitively produced andfreely traded between countries, and generates no externalities. We assume the following
utility function:
U = αxf + βyd −(xf )2 + (y d )2
− φxf y d + m − V,2

where x, y and m are, respectively, the consumption of goods X and Y and the numéraire
good, V (> 0) is externalities, α and β are parameters, and 0 < φ < 1 is a parameter
indicating the degree of substitutability between goods X and Y . Following Fischer andSerra (2000) and Lai (2004), we assume that the representative consumer ignores thenegative externalities when making the consumption decisions.9
Then the inverse demands for the imperfectly substitutable goods X and Y are,respectively, given bypx = α − xf − φyd ,(1a)py = β − y d − φxf ,(1b)where px and py are the consumer prices of goods X and Y . Consumer surplus (CS) is
given by
CS = αxf + βy d −(xf )2 + (yd )2(xf )2 + (y d )2
− φxf y d − (px xf + py y d ) =+ φxf yd22

The profits of firms f and d can be written respectively asπf= (px − cfx )xf ,π d = (py − cdy )yd ,9

There is another modelling in which consumers care about environmental damage when making theconsumption decisions. For example, in Moraga-Gonzalez and Padron-Fumero (2002), consumers diﬀer
in their willingness-to-pay for goods due to diﬀerent environmental awareness.

5where cji (i = x, y; j = f, d) is the constant marginal cost (MC) of firm j to produce goodi. Then the first order conditions (FOCs) for profit maximization are:
dπ f
dxf
dπ d
dy d

= −xf + px − cfx = 0,
= −y d + py − cdy = 0.

In the laissez-faire equilibrium denoted by subscript 0, we havexf0 =2A − φB d 2B − φA
, y0 =,
4 − φ24 − φ2where A ≡ α − cfx and B ≡ β − cdy . As the market size, α(β), becomes larger and the MC,

cfx (cdy ), becomes smaller, A (B) becomes larger. We call A (B) the eﬀective market sizefor good X (Y ). We assume that both firms serve the domestic markets in equilibrium,that is,2B − φA > 0, 2A − φB > 0.

(2)

By using the FOCs, the profits of firms f and d are
π f0 = (xf0 )2 , π d0 = (y0d )2 .

(3)

Thus, the following lemma is immediate:
Lemma 1 The profits increase if and only if the output rises.

3

Eﬀects of Standards

In this section, we consider the eﬀects of emission standards. The domestic government
introduces an emission standard, λ, which sets a maximum amount of emissions per unitof product consumption. If a product does not satisfy the standard, its sale is prohibitedin the domestic country. In our analysis, we specifically consider an emission standard
which good X does not satisfy but good Y does (i.e., k ≤ λ < 1). Thus, in the presenceof such a standard, firm f has to give up exporting to the domestic country.10

3.1

Monopoly

The standard leads firm d to be a monopolist in the market. In the equilibrium denotedby subscript M , the output and price are, respectively, given by
d
yM
=
10

B
B
, pM =+ cd .
2
2

In this section, since only good Y is produced and consumed, subscript y is suppressed.

6(4)d > y d and y d < xf + y d . As expected,
In view of (2), we can easily verify that yM000M

therefore, the standard benefits the domestic firm and reduces emissions. The change in
CS is∆CSM ≡ CSM − CS0 =¡¢8A + 4Bφ − 6Aφ2 + Bφ3 (Bφ − 2A)
8 (φ + 2)2 (φ − 2)2< 0.

Since 2A − φB > 0, CS falls. Thus, the welfare eﬀect is generally ambiguous.

3.2

R&D

In the presence of emission standards, firm f cannot serve the domestic market. Hencefirm f may try to produce good Y to serve the domestic market. In the rest of thesection, we examine such a situation. We specifically consider two possibilities. In thefirst case, firm f incurs fixed costs (FCs) of R&D, F , to develop good Y by itself. In thesecond, firm d licenses firm f a technology to produce good Y . Firm d may provide firm
f with a key intermediate input such as a hybrid engine to produce good Y instead of atechnology to produce the key input.
As long as firm f can make a positive profit from R&D, it has an incentive to invest
in R&D. With R&D investment, both firms f and d supply good Y to the domestic
market. Since there is only good Y in the market, the inverse demand is:p = β − (y f + y d ),where yf is the output of firm f . The profits of firms f and d are:πf

= (p − cf )yf − F,

π d = (p − cd )yd ,where ci (i = f, d) is the constant MC of firm i to produce good Y . In the R&D
equilibrium denoted by subscript R, we obtain:fyR=

B − 2δ dB+δ
, yR =,
3
3

where δ ≡ cf − cd . We assume both B > max{2δ, −δ} and 0 < π fR (= (B − 2δ)2 /9 − F ) <π d0 .11

We compare the R&D equilibrium with the initial laissez-faire equilibrium. We firstconsider whether firm d gains from the standard. Noting that Lemma 1 is still valid for11

If πfR > π d0 , firm f has no incentive to produce good X even without standards.

7

firm d, we check whether the output rises:
B + δ 2B − φA−
3
4 − φ2d− y0d =∆yR ≡ yR=

3Aφ − 2B − Bφ2 + δ(4 − φ2 ).
3(4 − φ2 )Thus, the R&D under the standard benefits firm d if and only if Ω ≡ 3Aφ − 2B − Bφ2 +δ(4 − φ2 ) > 0. This condition is likely to be satisfied when A is large relative to B, andδ and φ are large. A relatively large A implies relatively large demand for good X, andhence the prohibitive standard causes a relatively large demand shift to good Y . A large

δ implies that firm d is much more eﬃcient in production of good Y than firm f . Thus,
the entry of firm f into the good-Y market does not decrease the output of firm d much.
A large φ implies that goods X and Y are close substitutes. Thus, the entry of firm f
into the good-Y market caused by the elimination of good X does not aﬀect the output
of firm d much.
The change in CS is given byfd )2(y + yR(xf )2 + (y0d )2∆CSR ≡ CSR − CS0 = R− 0− φxf0 y0d22!
Ã
28B 2 − 36A2 − 18ABφ3 + 27A2 φ2 − 5B 2 φ2 + 4B 2 φ4

+δ (φ − 2)2 (φ + 2)2 (δ − 4B)=

18 (φ + 2)2 (φ − 2)2.

In general, the sign of ∆CSR is ambiguous. ∆CSR > 0 is likely to hold when when A issmall relative to B. With ∆CSR > 0, a negative eﬀect due to the decrease in variety isdominated by a positive eﬀect due to the increase in good Y .
The change in emissions is given byfd∆eR ≡ k(yR+ yR
) − (z0 + ky0 ) = (k2A − φB
2B − δ
2B − φA
)−(
).
2 +k
3
4−φ
4 − φ2

If k is suﬃciently small, then ∆eR < 0, that is, the emission standard decreases the total
emissions. However, if k is close to 1, the total emissions may increase. Evaluating ∆eRat k = 1, we have
2A − φB 2B − φA
2B − δ
)−(+)
34 − φ24 − φ2B − 3A + 2Bφ − δ(φ + 2).
3 (φ + 2)∆eR |k=1 = (=From the continuity argument, the total emissions increase if Ψ ≡ B − 3A + 2Bφ −δ(φ + 2) > 0 and k is suﬃciently close to 1. This condition is likely to be satisfied when8

A is small relative to B, δ is small and φ is large. A prohibitive standard eliminates
the consumption of good X, but increases that of good Y through the foreign R&D.
Although the emission per unit of consumption of good Y is lower than that of good X,
this could be dominated by the increase in the total consumption of good Y and hence
the total emissions could rise. A small A, a small δ and a large φ tend to increase theoutput of good Y relative to the laissez-faire equilibrium when a prohibitive standard
induces firm f to enter the good Y -market.
Again, the welfare eﬀect is generally ambiguous. If A = B and δ = 0, for example,
then ∆yR < 0, ∆CSR < 0 and ∆eR < 0 holds, that is, the profits of firm d andCS decrease but the environmental damage is mitigated. Thus, if the mitigation ofenvironmental damage is large (small), domestic welfare could improve (deteriorate).
The above analysis establishes the following proposition:
Proposition 1 Suppose that an emission standard leads firm f to incur fixed R&D costs
to develop good Y . By comparing this R&D equilibrium with the equilibrium without
the standard, there exists a range of parameterization under which the total emissions
increase. Firm d gains from the standard if and only if Ω > 0. Domestic welfare may or
may not improve.

3.3

Licensing

We now examine firm d’s technology licensing to firm f and compare this licensing
equilibrium with the R&D equilibrium. We assume that before firm f decides whether
or not to engage in R&D, firm d decides whether or not to oﬀer a take-it-or-leave-it
licensing oﬀer to firm f .12 When firm f will not develop good Y , firm d has no incentive
for licensing. This is because firm d can enjoy the monopoly situation without licensing.
Therefore, we consider the case where in the absence of licensing, firm f is willing todevelop good Y through R&D, which harms firm d. In this situation, firm d has anincentive to grant firm f permission to use its technology to produce good Y in returnfor license fees, because licensing generates revenue for firm d and mitigates its loss.
Thus, firm d designs a licensing contract so that firm f is willing to accept it. It should
be noted that firm d cannot extract all the rent from firm f by license fees because of
firm f ’s outside option, i.e., R&D.
12

The qualitative nature of our results would remain unchanged even if licensing fees are determinedby bargaining between the two firms.

9

In the presence of licensing, profits of the two firms are given byπf= (p − cf )yf − (R + ryf ) = (p − cf − r)y f − R

π d = (p − cd )yd + (R + ry f ),where we consider two-part tariﬀ and hence R and r are, respectively, a fixed fee and a
per-unit royalty.13 For simplicity, we assume that firm f ’s MC under licensing and that
under R&D are the same. We can regard (cf + r) as the eﬀective MC of firm f .
Since the outside option for firm f is R&D, firm d faces the following maximization
problem:
π dL ≡ max π d ; s.t. π f ≥ π fR ,
r,R

(5)

where π fR is firm f ’s profits with R&D. In the equilibrium, firm f is indiﬀerent between
R&D and licensing. The appendix proves the following lemma.
q2Lemma 2 Firm d sets r = r(≡ (B − 2δ − 3 ( B−2δ3 ) − F Á2) and R = 0.
This lemma implies that even if two-part tariﬀs are available, firm d charges only
per-unit royalty as license fees.14 In the licensing equilibrium, we have:yLf =B − 2δ − 2r d
B+δ+r
, yL =.
3
3

Comparing with the R&D case, the profits of firm d are larger, because licensing generates
a license fee and makes firm f less competitive due to the higher eﬀective MC. CS andthe total emissions are smaller, because the total consumption of good Y is smaller. The
diﬀerence in the total emissions is given by
eL − eR = −

kr
< 0.
3

Thus, we establish the following proposition.
Proposition 2 Licensing increases the profits of firm d relative to R&D. CS and thetotal emissions under licensing are less than those under R&D.
13

In the case where firm d supplies a key input to firm f instead of licensing, the constant MC toproduce the input is normalized to be zero and R = 0.
14This result depends on the assumption that firms f and d produces a homogenous good. If the good
firm f produces under prohibitive standards is diﬀerentiated from good Y , then R > 0 could arise.

10

4

Rent-shifting in the Presence of R&D and Licensing

In the presence of licensing, firm d sets license fees to extract rent from firm f as muchas possible. However, there are opportunities for the foreign government to shift the rent
back from firm d through simple taxes and subsidies. By facing such opportunities, thedomestic government may try to shift the rent from firm d to the domestic government
before the foreign government moves. In this section, we explore the rent-shifting by theforeign government as well as the domestic government.

4.1

Rent-shifting by the Foreign Government

In this subsection, we consider three measures to shift the rent from firm d to the foreign
government. One is direct measures and the other two are indirect ones. First, we explore
direct measures when firm d supplies a key intermediate input to firm f . Suppose thatthe foreign government imposes a tariﬀ on the input. This usually causes tariﬀ shifting.
That is, the tariﬀ increases the input price which firm f faces. In our model, however,firm d cannot directly shift the tariﬀ to firm f , because the tariﬀ shifting leads firm
f to engage in R&D. In fact, the foreign government could generate more than full
rent-shifting through tariﬀs, that is, the shifted rent could exceed the payment from theforeign firm to the domestic firm.
Suppose that the foreign government imposes a specific tariﬀ, t, on the import of the
key input. Even if a tariﬀ is imposed, firm d cannot raise the price beyond r. When t = r,therefore, the payment by firm f are fully shifted from firm d to the foreign government.
However, we should note that the profits of firm d are still larger under licensing thanunder R&D even with t = r, because firm f ’s eﬀective MC under licensing, cf + r, ishigher than that under R&D, cf . This implies that the foreign government can increase
the tariﬀ rate beyond r without aﬀecting the price firm f faces. We should mention thata foreign tariﬀ on the input does not aﬀect the output of each firm and hence the total
emissions.
Formally, in the presence of tariﬀs on the key intermediate input, (5) is modified asfollows:
π dLt ≡ max π d − tyLf ; s.t. π f ≥ π fR .
r,RThen, the foreign government faces the following maximization problem:
max tyLf ; s.t. π dLt ≥ π dR ,
t

11

(6)

where π dR is the profits of firm d with R&D. In the equilibrium, π dLt = π dR holds, that is,
firm d is indiﬀerent between R&D and licensing.
Next we investigate indirect measures to shift the rent. Firm d can charge license fees,
because firm f ’s profits become larger under licensing without any fees than under R&D.
That is, the licensing results in room for arbitrage for firm d. The foreign government
can indirectly shift the rent by reducing the room. Suppose that a production tax iscollected from firm f under only licensing.15 If a production tax, τ , is introduced before
firm d makes a licensing oﬀer, we have r + τ = r. This is because firm f will engage
in R&D if the eﬀective MC (which equals cf + r + τ ) exceeds cf + r. By increasing τ ,therefore, the license fee, r, falls. That is, a production tax reduces room for arbitrage.
In particular, by setting τ = r, firm f gets technologies without any payment to firm d.
As in the case of tariﬀs on a key input, the foreign government can raise the tax ratefurther, because firm f ’s eﬀective MC (which equals cf + r in the case of production
taxes) is higher under licensing than under R&D. Therefore, we have r < 0 with τ > r in
the equilibrium. Moreover, a production tax does not aﬀect the total emissions, because
both firm f ’s eﬀective MC, cf + r + τ = cf + r, and firm d’s MC are constant.
Formally, in the presence of production taxes, (5) becomes
π dLτ ≡ max π d ; s.t. π f − τ yLf ≥ π fR .
r,RBy aﬀecting the constraint, production taxes make indirect rent-shifting possible. The
maximization problem for the foreign government ismax τ yLf ; s.t. π dLτ ≥ π dR .
τThe foreign government can also indirectly shift the rent from firm d through alump-sum R&D subsidy, S, to firm f , which is committed before firm d moves. We firstf
f 2> 0 but π fR = (yR) − F < 0 hold and hence firm f does notconsider a case in which yR

engage in R&D. In this case, by setting the subsidy S ≥ −π fR , the foreign government can

induce R&D. Since firm d prefers licensing to R&D, however, firm d oﬀers a licensing

contract whenever the subsidy leads firm f to engage in R&D. This implies that theforeign government does not pay the subsidy in equilibrium. Even if firm f engages in
R&D without the subsidy, the foreign government could use R&D subsidies as a device
to shift the rent from firm d. With R&D subsidies, (5) is modified as
π dLs ≡ max π d ; s.t. π f ≥ π fR + S.
r,R

15

It is assumed that no production tax is imposed when firm f engages in R&D.

12

Thus, the license fees become lower as the subsidy rises. To maximize the shifted rent,
the foreign government sets S = F so that π dLs = π dR holds. With S = F , firm f obtains
the license without any payment. Moreover, with S = F , the total emissions are thesame with those under R&D if π fR > 0.
Thus, we obtain:
Proposition 3 The foreign government can shift the rent associated with licensing fromfirm d to the foreign country directly by levying a tariﬀ on the key intermediate input
and indirectly by imposing a production tax on firm f under licensing or by committing
itself to an R&D subsidy. The shifted rent could exceed the payment by firm f with the
tariﬀ on the key input. The license fees could be negative with the production tax on firm
f . The rent-shifting does not aﬀect CS and the total emissions.
In the licensing equilibrium where the foreign government completely shifts the rent
from firm d, the profits of firms f and d are the same with those in the R&D equilibrium.
When the rent-shifting is caused by taxes, CS and the total emissions are less under R&D,
because the rent-shifting does not aﬀect the total consumption and emissions. In thiscase, therefore, domestic welfare is higher in the licensing equilibrium with complete
rent-shifting than in the R&D equilibrium if and only if the mitigation of environmental
damage dominates the reduction of CS.

4.2

Rent-shifting by the Domestic Government

In this subsection, we point out that the domestic government can prevent the foreign
government from shifting rent from firm d by using simple taxes if the domestic government can move before the foreign government. We explore both direct and indirect
measures.
First, we consider direct measures: a tax on the licensing fees or an export tax on
the key input. When a specific tax on the licensing fees or a specific export tax on the
input, ρ, is imposed, (5) becomes
π dLρ ≡ max π d − ρyLf ; s.t. π f ≥ π fR .
r,RThen, the maximization problem for the domestic government ismax ρyLf ; s.t. π dLρ ≥ π dR .
ρEven if the tax is imposed, firm d cannot shift the tax to firm f . This is because thetax shifting leads firm f to engage in R&D instead of licensing. Thus, the license fees
13

faced by firm f remain to be r. Under the optimal tax, the tax rate is greater than r.
The above case is similar to the case in which the foreign government sets a tariﬀ on the
input to shift the rent from firm d.16
Next we consider tariﬀs on the final good as indirect measures. A tariﬀ on the final
good usually decreases the profits of firm f . When r = r, a tariﬀ induces firm f to switchfrom licensing to R&D. Thus, firm d lowers the license fee to prevent such a switch. In
the presence of a specific tariﬀ, T , on the final good, (5) is modified as follows:
π dLT ≡ max π d ; s.t. π f − T yLf ≥ π fR .
r,RThen, the domestic government faces the following maximization problem:
max T yLf ; s.t. π dLT ≥ π dR .
TThis is similar to the case in which the foreign government shifts the rent from firm dthrough a production tax. By imposing a tariﬀ on the final good, the domestic government can indirectly shift the rent from firm d to the domestic government. In particular,
the domestic government can eliminate the room for the rent-shifting by the foreign
government.
Thus, the following proposition is established:
Proposition 4 If the domestic government can move before the foreign government,
then the domestic government can prevent the foreign government from shifting rent
from firm d by imposing either a tax on the licensing fees (an export tax on the key
input) or a tariﬀ on the final good.

5

Concluding Remarks

Using an international duopoly model, we have analyzed the eﬀects of environmental
standards in the presence of consumption externalities. We have focused on a plausible
situation under which both domestic and foreign products generate emissions duringconsumption, but the foreign product results in more damage to environment than thedomestic product and an emission standard drives the foreign product out of the domestic
market.
16

If an export tax on the input and an import tariﬀ on the input are imposed simultaneously, then any

fcombination (t, ρ) satisfying t + ρ = ρ∗ (where ρ∗ ≡ arg maxρ ρyL; s.t. π dLρ ≥ πdR ) is a Nash equilibrium.

14

Such prohibitive standards may induce the foreign firm to produce a good meetingthe standard through R&D or licensing, but do not guarantee an improvement in environment. This is because the eﬀect of an increase in the consumption of the environmentallyfriendly good dominates the eﬀect of the elimination of the environmentally unfriendly
good. By comparing between R&D and licensing, the environmental damage is less under licensing, because the eﬀective MC of the foreign firm is higher under licensing thanunder R&D and hence the consumption is smaller under licensing. Moreover, prohibitive
standards may not benefit the domestic firm when the foreign firm starts serving thedomestic market with R&D or licensing.
We have also pointed out possible strategic interactions between the domestic firm
and the foreign government in the presence of R&D and licensing. The foreign government can shift rent from the domestic firm by levying a tariﬀ on a key intermediate
input, by imposing a production tax on the foreign firm under licensing, or by committing itself to R&D subsidies. In particular, the shifted rent could exceed the payment by
the foreign firm with the tariﬀ and the license fees could be negative with the production
tax on the foreign firm. The presence of an outside option (i.e. R&D) plays a crucialrole to derive the results. However, the domestic government may intervene to preventthe foreign government from shifting the rent from the domestic firm by imposing a tax
on the licensing fees or an export tax on the key input or by levying a tariﬀ on the final
good.
The final three remarks are in order. First, we have not fully explored the welfare
eﬀects. This is because to examine domestic welfare in details, we need to specify thedamage function, V . The welfare analysis depends on the specification of the damage
function. In particular, when only good Y is produced, the environmental damage is
mitigated if and only if CS falls. Thus, the welfare eﬀects are in general ambiguous.
If the environment is evaluated highly enough, then domestic welfare could improve
whenever the total emissions fall.
Second, the analysis can directly be applied to the case with production externalities
as long as the emissions are completely trans-boundary. Examples include emissions ofgreenhouse gases during production. However, the GATT/WTO have regarded trade
restrictions based on processes and production methods as illegal. For example, the
GATT judged that the US ban on imports of yellowfin tuna and their related processed
products from Mexico was against the GATT agreement. Thus, even if foreign production
generates negative externalities, the domestic government may not be allowed to ban the15

imports of foreign goods.
Last, the analysis of R&D and licensing is valid even if standards are not prohibitive.
For example, suppose that the domestic country introduces an eco-labelling scheme underwhich a label can be aﬃxed only on the domestic product. Although the foreign productcan still be sold in the domestic market, the sales may decrease. If the decrease is large
enough, then the foreign firm may have an incentive to produce a product on which thelabel can be put.
In this paper, we have focused on a plausible situation in which a domestic prohibitive
standard induces the foreign firm to produce the domestic product meeting the standard
through R&D or licensing. However, one can think of many other situations. The
analyses under these situations are left for future research.

Appendix
Proof of Lemma 2. Given r, the equilibrium outputs areyf =B − 2(δ + r) d B + (δ + r)
,y =
.
3
3

Thus, we have
πd = (

B + (δ + r) 2
B − 2(δ + r)
) +R+r.
3
3NotingB − 2(δ + r) 2
) − π fR3
B − 2(δ + r) 2
B − 2δ 2) −() + F,
= (
3
3

R = (

We obtain
B + (δ + r) 2
B − 2(δ + r) 2
B − 2δ 2
B − 2(δ + r)
) +(
) −(
) +F +r
3
3
3
3
2
2
2
2Bδ + B + δ − r + r (B + 4δ)+ F,
9

πd = (=

which takes the maximum value at r = (B + 4δ)/2 ≡ r∗ . If firm d sets r = r∗ , then the

output of firm f becomes zero. Thus, the maximum royalty firm d can charge, r, satisfies(

B − 2δ 2
B − 2(δ + r) 2
) =() − F.
3
3

Thus,
3
1
r = B−δ−
2
2

r

16

(

B − 2δ 2) − F.
3

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