Induced institutional change in the trade and environment debate

Because of the assumption of constant emission factors, economy-environment models often show that free trade has negative environmental consequences. However, this pessimistic view ignores the possibility of trade strengthening the demand for regulatory institutions. An 'institutional optimism hypothesis', stating that the net environmental result of trade liberalization is benign, is thus formulated in this paper. The hypothesis is examined with a CGE model that treats institutional change as an endogenous process dependent on income. Application to NAFTA, using a broad range of scenarios, provides some support for the institutional optimism hypothesis. The net pollution effect of trade liberalization is in many cases beneficial or low, even for the country specializing in polluting industries. The implication is that in many cases environmental interests are served better by a focus on institution building in trading partners, than on the process of trade liberalization itself.