FDI Decisions in Imperfectly Competitive Markets, Green R&D with Spillovers and Host-Country Welfare

One of the main features of globalisation is the increasing foreign direct investment (FDI) that it has brought with it. While it is true that such investment flows can have positive consequences for consumers and in terms of social welfare, the environmental implications can potentially be negative. Firms may be attracted to countries where environmental regulations are laxer than in their home countries, allowing them to produce (and pollute) more, turning these host countries into “Pollution Havens”. This shift in firms' internationalisation strategy is known in the literature as the “Pollution Haven Hypothesis”, which argues that firms relocate (part of) their production to countries whose environmental policies are less stringent than in their home countries. On the other hand, empirical evidence suggests that many of these FDI flows tend to be from developed countries to developing countries, so such firms can be expected to possess cleaner technology than firms in host countries. This suggests that the presence of firms technologically more advanced and with cleaner production processes may be positive for firms in host countries, if there are technological externalities from which they can benefit to reduce their own emissions. This effect is known in the literature as the “Pollution Halo Hypothesis”, which suggests that technologically more advanced firms contribute indirectly through technological spillovers to the reduction of host country firms' emissions. The purpose of this thesis is, through the use of theoretical models, to shed light on the effects of environmental policy on firms' internationalisation decisions, and how the resulting market structure affects consumers and social welfare in the host country. The first chapter presents an introduction to this issue using data collected by the OECD and a review of the literature on environmental policy and FDI. The second chapter presents a model that analyses the conflict of private (firms) and public (governments) interests in the presence of pollution, and how an environmental tax can correct it. Furthermore, it is suggested that a Prisoner's Dilemma situation exists even in the absence of such external effects, which can also be corrected by the environmental policy. Specifically, the model shows that an environmental tax equal to the environmental marginal damages eliminates the conflict of public and private interests and, in turn, reduces the interval in which the Prisoner's Dilemma situation arises. On the other hand, the model also suggests that an environmental tax higher than the environmental marginal damages can also eliminate this Prisoner's Dilemma situation. The third chapter studies how governments can, unilaterally, strategically influence firms' internationalisation decisions through the use of environmental policies. It shows that the government imposing the environmental tax, maximising its own social welfare, tries to incentivise the host firm to undertake FDI and the foreign firm to export, which is consistent with the Pollution Haven Hypothesis. However, the model suggests that the government may not always be able to alter firms' internationalisation decisions. To be precise, the model proposes that trade costs being relatively high and the cost of setting up a production plant in the foreign country being relatively low, the government implementing the environmental tax cannot alter the internationalisation strategy of the foreign firm. On the other hand, when the cost of setting up a production plant in the foreign country is extremely high, the government cannot change the internationalisation strategy of the host firm. Finally, the fourth chapter analyses how FDI flows from developed countries to developing countries affect the latter, taking into account that firms may invest in clean technologies and that there may be technological spillovers from foreign firms to host firms. The model suggests that, relative to production, exporting firms invest the most in clean technologies, followed by host firms, with firms that invest in FDI investing the least in green R&D. The model also shows that an increase in the oligopoly size increases the amount of green R&D investment for all three types of firms. The numerical examples suggest that there may be benefits in receiving FDI from developed countries in terms of investment in clean technologies, emissions, consumer surplus and social welfare, these results being consistent with the Pollution Halo Hypothesis.