Consider the model with mobile capital sketched in section 12.4.3.

(a) Set up the equation system that characterizes the international competitive equilibrium for the commodity and the capital markets.

(b) Conduct a full comparative statics analysis for a domestic tax increase.

(c) Derive a formula for the unilaterally optimal domestic emission tax rate.

Data from section 12.4.3

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We have seen that domestic strengthening of environmental policy in a large open economy shifts production from the domestic to the foreign country and thus, other things equal, increases emissions abroad. The pathway for this effect is an increase in the world market price. Matters are similar when capital is mobile. To show this briefly, we revert to our model with one consumption good, which is now produced using a polluting input e and capital k, where the latter is mobile between countries. Domestic output is produced according to the production function x-f(k,e); we assume fek(ke)=fke(ke)>0, so that capital improves the marginal product of the polluting input, and vice versa. When capital flows out to the foreign country, domestic households consume domestic production plus imports, where imports are financed using the interest earned on domestic capital that is employed in the foreign country. If the domestic country borrows from abroad, some of the domestic production must be transferred to the foreign country.