Which of the following theories argues that the observed pattern of trade between nations may in part be due to the ability of firms to capture first mover advantages?

The Facts

Policy intervention in international trade appears to be systematically related to economic events. Across-the-board trade restrictions are not prompted by a slowdown in employment growth. Rather, the most important determinant of major trade-reducing policies since 1960 has been a deteriorating trade balance. At the industry level, the story is quite different. A decline in an industry’s employment growth or in its stock returns relative to the average for the economy, however, results in a significant increase in industry-specific protectionist policies.

The empirical evidence suggests that trade restriction more often than not, does not achieve their stated objectives. Around the time across-the-board restrictions are imposed, equity values and employment decline, rather than improve [7]. Even policies aimed at protecting specific industries tend to fail to achieve their stated goal. Equity values fell in the leader shoe, color TV, automobile, and other industries following the implementation of protectionist policies. The employment performance around the announcement of trade restrictions also deteriorated. The steel industry experience with trade restrictions was associated with a deterioration in the industry stock price index [8].

The implications for policymakers, money managers, and financial analysts are clear: a protected economy or a protected industry will tend to underperform relative to economies and industries that are forced to meet the rigors of intentional competition. Worse yet, the protectionist policies only delay the inevitable. These protected sectors will have to retool to be a viable and compete in the market place. In the meantime, the economy’s resources are being either wasted or used inefficiently.

2.2 International Trade

In the economic growth literature, the influence of international trade has been in the spotlight especially recently, when globalization and its consequences are prominent. As Rahman and Mamun (2016, p. 807) pointed out “an absence of international trade variable (export plus import) in a growth model may underestimate or overestimate the effect of energy consumption on macroeconomic growth.” Both the trade-led growth (where the assumption is that exports and imports are conducive to the country’s economic growth) and the growth-led trade (where the assumption is the economic growth boosts the trade performance of the country) hypotheses are evaluated extensively. In the literature, four possible directions of the relationship were detected in the literature: (1) Transfer of academic and technical knowledge and technology as well as foreign direct investment (FDI) flows can motivate economic growth; (2) economic growth might create the conditions for a country to have a competitive advantage in the trade with other countries; (3) Trade and economic growth are independent; (4) There is a negative relationship between trade and economic growth, which is usually attributed to imports being higher than exports that affect economic growth negatively.

In the energy literature, the issue of international trade started gaining significance recently among other factors. As was explained in Katircioglu et al. (2016) and Sadorsky (2012), trade, economic growth, and energy usage patterns are moving together over time, and hence, possible causal relationships should firstly be examined not only to comprehend the implied dynamics better but also to assist with trade policy designing and implementation. A few channels of this tripartite relationship are presented next:

When economic growth is being promoted by export activities, then the exporting sectors require higher amounts and better quality of factors of production to increase their output, and hence, their demand for energy input increases;

When policy makers focus on the reduction of energy consumption for environmental reasons or in cases (as has occurred in many developing countries recently), with frequent power interruptions, extra constraints are put from an input-availability point of view in the production of goods and services both domestically (and hence, economic growth is pressured) and for trade purposes (and hence, exports are pressured);

The more straightforward connection among the three is the following; when real economic output increases, subsequently there is an upward push in energy capacity and consumption. Based on fundamental economic thinking, this usually results in an increase in imports in the following periods. The effect is more intense for energy importing countries;

A general increase in energy consumption has high potential to boost the country’s economic activity of the country and the household incomes which will result in higher trading opportunities both from an export and import point of view;

Energy conservation policies that aim at mitigation of greenhouse gas emissions would decrease the volume of international trade, when trading activities are greatly associated with energy consumption (Sadorsky, 2012). Such activities include, for example, transportation that is energy-intensive and particularly dependent on oil.

Trade can be proxied in the quantitative analysis by exports (total volume or percentage to GDP), or imports (total volume or percentage to GDP), or openness. Trade openness can be defined as trade shares (sum of exports and imports divided by GDP); or trade barriers (taxes on international trade or indices of tariff and nontariff barriers); or exchange rates and comparative prices, as a signal or an indication of the competitive advantages of the country.

Quantitative analysts must carefully select the proxy for energy, as the causal relationship depends on whether the energy is considered from the supply or demand point of view (Abidin et al., 2015). In addition to this, the type of energy plays also a particularly different role in the establishment of the relationship with economic growth and trade: Amri (2017) explains that specifically renewable energy “helps the integration of the developing and developed countries into international trade.”

All things considered, the role of international trade on energy should not be neglected when designing and planning energy and environmental policies. To achieve the desired sustainability through policy making, a well-coordinated effort is necessary to balance the dynamics of energy use and international trade. Trade policies should also consider the sustainability and energy consequences (Rahman and Mamun, 2016).

2.3 “New” New Trade Theory

Since the beginning of the 21st century, a new international trade system with firms at the core has emerged as the international division of labor and globalization of business activities goes further. The effects of firms’ different characteristics on international trade in different fields have become a hot research topic of international economics. “New” new trade theory3 represented by trade models with heterogeneous firms and endogenous boundary model of the firm has emerged as the latest theory of international trade. “New” new trade theory breaks with the firm homogeneity assumption in traditional trade theory and new trade theory and includes heterogeneity in the analytical framework for firms so that the variables of analysis are changed from countries and industries on the macrolevel to firms on the microlevel (Fan, 2007). The analysis of firms’ trade and investment for internationalization and outsourcing and integration for global organization of production marks a new area of international trade research.

The concept of “new” new trade theory was first proposed by Baldwin and Nicoud (2004) but the earliest studies were conducted by Melitz (2003), Antras (2003), and Bernard et al. (2003). The theory has two branches. One of them concerns the choice of internationalization, based on the study by Melitz (2003), is also known as trade models with heterogeneous firms, and it explains why in reality only some firms choose export and FDI. The other concerns the choice of global organization of production, based on the study by Antras (2003), and is also known as endogenous boundary model of the firm. It integrates the concepts of industry organization and contract into the trade model, well explains intrafirm trade, and introduces a theoretical innovation in the research into firms’ global production.4

2.1.6.2 Competitiveness and international trade

National competitiveness was associated in the past mainly with exports and international trade (McGreehan, 1968). The removal of trade barriers over the last 30 years, through consecutive agreements on international trade progressively building a new system of free international trade and the global expansion of trade promoted through many changes across the international environment, has exposed domestic firms to international competition, enhancing their vulnerability and the levels of domestic competition in most states. Many concerns have been raised on the state’s self-sufficient production, i.e., their actual capacity to produce goods and services and not to leave ample room for imports to cover their production needs. These concerns were also spurred by the increasing generation of new technologies, R&D research, their spillovers, and other technological advances that have driven growth and the restructuring of many economies and technological products, as well as by the advent of an age associated—more than any other before—with the use of information and communication technologies. Nation states are all now burdened with the need to cope with such changes and keep or enhance their capacity to produce across a range of industries, to sustain or increase their productivity and export their products, without at the same time undermining their standards of living nor worsen their terms of trade.

The relationship between competitiveness and trade varies, and various trade theories or views have been suggested that relate trade to the capacity of state to compete and sustain their competitiveness (Krugman, 1996). In the classic—Ricardian—view, states gain a comparative advantage when offering products and services that they produce using the factors of production offered in lower costs. The principal factor of production tested in the Ricardian model is labor. The lower labor costs, especially salaries, act as opportunity costs, moving production from one state to another, through trade (Krugman and Obstfeld, 2000). The states with lower labor costs in the production of particular goods and services gain a comparative advantage in this particular production. Trade leads nations to their production specialization, as labor used in domestic production moves from those industries where it is less productive to those where it is comparatively more productive (Krugman and Obstfeld, 2000). This process brings an industrial restructuring inside states. But it is not certain whether states will manage to achieve industrial specialization in a new industry. Removing industrial specialization from one industry does not necessarily bring industrial specialization in another. Several conditions should be first met, such as for example the creation of institutions supporting firms in one new, infant industry and providing information on production (as discussed in Best, 1990). In the Heckscher–Ohlin view it is the analogy of factors of production available and employed in states that drives trade. But the Leontief paradox proved that US’s exports had a lower analogy of capital to labor than its imports, emphasizing the priority of labor costs, as in the Ricardian view, apart from the role of protection (more present at the time). This seeming paradox could also relate to the economies of scale created among domestic industries, forming an aggregate advantage of economies that are turned to a comparative advantage (Krugman and Obstfeld, 2000).

In general a larger, positive balance of trade is likely to indicate roughly a state’s capacity to compete, the more it is extended on time.

However, trade is subject to exchange rates and associated with competition in price terms. Undermining the value of a currency is a temporary, technical reason for the creation of trade surpluses. Even though a large trade deficit could signal an economy’s vulnerability, it could also derive from large foreign direct investments (Candace and Singh, 2000). Similarly, the case of Mexico in the 1980s that was forced to run large trade surpluses to repay the interests for its loans is an example of the limitation of the use of trade as a competitiveness indicator (Krugman, 1994). Trade balances can reveal export performance. This however is subject to trade barriers and decisions on supporting strategic trade, which are not uniform all around the world. Hence they may not reveal well the comparative state performance in trade. For all these reasons trade balances alone may be “inappropriate” for measuring state’s competitiveness (Krugman, 1994).

Trade surpluses are not only subject to costs and prices, as Kaldor’s empirical paradox has revealed. According to this paradox, Germany and Japan improved their world trade in the 1960s and early 1970s, while their prices and costs rose rather than decreased, as opposed to the United States and the United Kingdom that deteriorated their position while their prices and costs decreased (Kaldor, 1978).

The relation of trade with competitiveness depends on whether trade is a zero-sum or a positive-sum game. In the former case that is less accepted nowadays, states increasing trade surpluses achieve it against other states and so their relative competitiveness would be higher. But if trade is a positive-sum game (as pertained in Krugman, 1994; Krugman and Obstfeld, 2000; and many others), a good trade record of a state does not necessarily reflect the weaknesses of another, especially in families of nations, such as the EU is considered.

The Balassa–Samuelson theorem, which states that productivity growth varies more by country in the traded goods sector (rather than in the nontraded goods sector), relates state-level competitiveness, measured through productivity, back again to traded goods and state’s international trade. Integrating the nontradable goods sector in international comparisons on competitiveness helps to move away from static analyses on competitiveness based on trade only and to view the broader picture of an economy.

Both the Balassa–Samuelson theorem and the emphasis placed on the role of labor by trade theory highlight the significance of labor and its productivity.

Globally integrated versus segmented capital markets

The world's economies have become more interdependent since WWII due to expanding international trade. As restrictions to foreign investment have been removed, country financial markets also have displayed similar interdependence or integration such that fluctuations in financial returns in one country's equity markets impact returns in other countries' equity markets. Between 1960 and 1990, the correlation among equity market financial returns for seven large developed countries increased, reflecting the emergence of a global capital market.4 Furthermore, the correlation between equity market returns in emerging economies compared to global financial market returns has increased following the liberalization of their stock markets.5

However, in contrast to earlier studies, there does not seem to have been an increase in the upward trend in correlation among financial returns for 23 developed countries between 1980 and 2003 (Table 17.2).6 The major exception is the correlation among equity market returns in European countries. However, the correlation appears to be highly sensitive to the time period examined. For example, the correlation between the performance of U.S. and European stocks increased from less than 30% in the 1970s to 90% for the five-year period ending in 2006.7

Table 17.2. Long-Term Movements in Country Financial Return Correlations between 1980 and 2003

Source: Bekaert, Hodrick, and Zhang (2009).

Globally integrated capital markets provide foreigners with unfettered access to local capital markets and local residents with access to foreign capital markets. Factors contributing to the integration of global capital markets include the reduction in trade barriers, removal of capital controls, the harmonization of tax laws, floating exchange rates, and the free convertibility of currencies. Improving accounting standards and corporate governance also encourage cross-border capital flows. Transaction costs associated with foreign investment portfolios have also fallen because of advances in information technology and competition. Consequently, multinational corporations can more easily raise funds in both domestic and foreign capital markets. This increase in competition among lenders and investors has resulted in a reduction in the cost of capital for such firms.

Unlike globally integrated capital markets, segmented capital markets exhibit different bond and equity prices in different geographic areas for identical assets in terms of risk and maturity. Arbitrage should drive the prices in different markets to be the same, since investors sell those assets that are overvalued to buy those that are undervalued. Segmentation arises when investors are unable to move capital from one market to another due to capital controls or simply because they prefer to invest in their local markets. Segmentation or local bias may arise because of investors having better information about local rather than more remote firms.8

Investors in segmented markets bear a higher level of risk by holding a disproportionately large share of their investments in their local market as opposed to the level of risk if they invested in a globally diversified portfolio. Reflecting this higher level of risk, investors and lenders in such markets require a higher rate of return to local market investments than if investing in a globally diversified portfolio of stocks. Therefore, the cost of capital for firms in segmented markets without easy access to global markets often is higher than the global cost of capital.

There is evidence that capital markets in some countries may be segmented to the extent that local factors are more important in determining cash flows, access to capital, and share prices of small firms than of large firms.9 Consequently, the share price of a major French retailer like Carrefour may trade very much like the giant U.S. retailer Wal-Mart. However, the stock of a small French retail discount chain, affected more by factors in its local market segment, may trade differently from either Carrefour or Wal-Mart and exhibit a much higher cost of capital.

Marketable Securities Held by Banks

1.

Bankers Acceptances: These instruments arise mostly in connection with international trade. A banker’s acceptance is a bank-guaranteed indebtedness of the bank’s customer to a third party. This instrument usually arises as a time draft written by a firm in order to pay for some goods either in local currency or in foreign exchange. The draft is then “accepted” by the bank, that is, the bank guarantees its face value at maturity. The acceptance is then either held by the bank or sold in the secondary market and may be held by another bank. The originating bank typically charges a fee for the guarantee (acceptance) that is independent of the interest paid on the borrowing. Maturity is usually less than 6 months.

A banker’s acceptance facilitates trade between parties that operate in different legal systems with wide geographical and cultural separation. If the exporter does not know the importer well enough, it will not ship goods, even on a COD basis. However, it is likely that the importer’s bank is better known and hence its willingness to guarantee payment – which serves the purpose of substituting its own credit risk for that of the importer – facilitates trade. The bank issuing the guarantee also can be expected to know more about the importer, usually a customer of the bank. Its informational advantage vis-á-vis the exporter allows the bank to earn a fee on the acceptance. Thus, bankers’ acceptances are closely tied to the bank’s role in providing a more efficient resolution of informational problems. For more on this, see Chapter 10.

Commercial Paper: This is unsecured debt issued on the strength of the issuer’s name. It is sold on a discounted basis like Treasury bills,6 with maturities ranging from 3 to 270 days and interest rates typically lower than prime and comparable to those on CDs and bankers acceptances. Only the best-known firms issue commercial paper because it is sold directly to investors, without an intermediary to resolve informational problems.

U.S. Government Securities: These are important instruments for commercial banks because of their default-free nature and the highly liquid markets in which they are traded. As we saw in Chapter 3, private information content undermines liquidity, so U.S. government securities – which embody virtually no private information – provide banks with liquidity.

Income from all U.S. government securities is subject to federal income taxes as well as capital gains tax, but is exempt from state and local income taxes. Marketable U.S. government securities are of three types: bills, notes, and bonds. Treasury bills (T-bills) are short-term U.S. government securities (with original maturities of 91 days, 182 days, and 1 year) that, like commercial paper, are sold on a discounted basis. Treasury notes are similar to T-bills except that they have maturities not less than 1 year and not more than 7 years. Treasury bonds are issued with original maturities that often exceed 10 years, and can be as long as 30 years.

U.S. Government Agency Securities: These are certificates of indebtedness issued by agencies of the U.S. government, such as the Federal Intermediate Credit Bank, the Federal National Mortgage Association (FNMA or Fannie Mae), the Federal Home Loan Bank (FHLB), and the Government National Mortgage Association (GNMA or Ginnie Mae). They are not direct obligations of the U.S. government, and they typically trade at a small premium over Treasury debt. Income on these securities, like direct U.S. government obligations, is exempt from state and local taxes, but not from federal taxes.

State and Local Securities and Municipal Bonds: These debt instruments usually have a higher after-tax yield than Treasury and agency securities of comparable duration because of higher default risk and weaker liquidity. Their interest payments are exempt from federal income taxes as well as from home-state and local taxes. State and local government bonds can be divided into three broad categories: housing authority bonds, general obligation bonds, and revenue bonds. Housing authority bonds are issued by local housing agencies to build and administer housing. They are guaranteed by the federal government and are therefore virtually riskless. A bond is called a general obligation bond if the full faith and credit of the issuer stands behind the debt. In contrast, the interest and principal of a revenue bond is supported solely by the cash flow of a designated public project or undertaking. The revenues supporting these bonds may come from: (i) specifically dedicated taxes such as those on cigarettes, gasoline, and beer, (ii) tolls for roads, bridges, and airports, (iii) rent payments on buildings, office spaces, and the like. Typically, the bond payments are linked to the revenues produced by the project the bonds were used to finance.

Other Assets: These include vault cash and deposits at the Federal Reserve, equity in subsidiaries, physical capital like buildings, computers, and loans originated by other banks that may have been acquired by the bank as part of a loan sale or through securitization. For short periods of time, the bank may also possess a variety of other assets acquired as collateral from delinquent borrowers.

5.7.3 International trade, foreign direct investment, and automation

As a final extension, we discuss the possible effects of automation on international trade and foreign direct investment (FDI). In this context, globalization has led to a trend of offshoring production to low-wage countries in recent decades.17 Decreasing transport costs made shifting production (or some parts thereof) to poorer countries and exporting goods back to consumers in richer countries more profitable for firms. This has allowed firms to benefit from lower wages and, thus, lower production costs in poor countries.

Most recently, however, a trend toward reshoring emerged, where some firms started to shift production back to rich countries (see, e.g., Carbonero, Ernst, & Weber, 2018; Chu, Cozzi, & Furukawa, 2013; Krenz, Prettner, & Strulik, 2018; Tate, 2014; The Economist, 2013). One reason for this shift might be rising wages in low-income and middle-income countries, particularly in China, to the extent that the cost advantage of offshoring started to disappear. However, automation also seems to have made it possible to produce a range of goods—which previously required many workers—with a much lower need for labor input at home (Krenz et al., 2018).

To capture this effect, Abeliansky, Martinez-Zarzoso, and Prettner (2020) introduce 3D printing technology into the trade and FDI model proposed by Helpman, Melitz, and Yeaple (2004)—which is itself an extension of Melitz (2003)—to take FDI into account. The blueprints for the production by means of a 3D printer can be sent across the world instantaneously. Physical capital in the form of the 3D printer could then print the corresponding object wherever it is desired (of course, also in the home country). This form of production is particularly useful for infrequently needed customized products that have required a substantial amount of specialized labor input in the past. The 3D printing technology implies that firms using it are less and less reliant on labor supply in the locations where they produce, potentially threatening the strategy of export-led growth in poorer countries that relied on FDI from richer countries. While Abeliansky et al. (2020) concede that it is still too early and the technology is not yet sophisticated enough to envision these implications on a large scale, they provide the first tentative evidence in favor of this view for industries in which many 3D printers are employed.

More generally, the emergence of automation technologies could have exerted downward pressure on wages in rich countries that reduced the incentives for offshoring in the first place. Krenz et al. (2018) propose a model of production with low-skilled and high-skilled labor in which robots are not very productive initially when the technology is still young. Thus, some firms that face low trade costs benefit from offshoring production to low-wage countries at that stage. With an increasing productivity of robots, however, the incentives to offshore decrease and reshoring becomes more attractive. As firms start to return to high-wage countries, it is, however, predominantly the production factor of skilled labor that benefits, whereas robots replace low-skilled workers. Increasing tariffs can speed up the process of reshoring in this model, but it cannot help the low-skilled workers who are only replaced faster by robots in the case of increasing tariffs.

Krenz et al. (2018) provide evidence that, indeed, in the sectors that are using robots more intensively, reshoring is more pronounced. In addition, they provide evidence for a positive effect of reshoring on the wages of high-skilled workers but not on the wages of low-skilled workers. Altogether, the findings in this paper also suggest that the export-led growth strategy could become less and less viable for low-wage countries.

Although the wage rates for low-skilled workers decline in the face of automation in both high-income and low-income economies, reshoring would have more severe effects on the wages of low-skilled workers in low-income countries. The reason is that the firms that relocate production back to high-income countries tend to have a large workforce employed in low-income countries. Setting off such large numbers of workers in low-wage countries when the firms are reshoring production to high-income countries would put a downward pressure on wages in low-income countries. This, in turn, could lead to a situation in which the incentives to migrate from low-income countries to rich countries rises as Zhou, Bloom, and Tyers (2019) show.

Globally Integrated Markets Versus Segmented Capital Markets

The world’s economies have become more interdependent since WWII due to expanding international trade. Financial markets have displayed similar interdependence or global integration such that fluctuations in financial returns in one country’s equity markets impact returns in other countries’ equity markets. Factors contributing to the long-term integration of global capital markets include the reduction in trade barriers, the removal of capital controls, the harmonization of tax laws, floating exchange rates, and the free convertibility of currencies. Improving accounting standards as well as stronger creditor protections and corporate governance also encourage cross-border capital flows. Transaction costs associated with foreign investment portfolios have also fallen because of advances in information technology and competition. Multinational companies can now more easily raise funds in both domestic and foreign capital markets. Increasingly, firms are listing on domestic as well as foreign stock markets to more easily tap global capital markets. Such cross-listing often makes such firms more likely to be targets of potential acquirers.4

These developments represent a mixed blessing for the world’s economies. Globally integrated capital markets provide foreigners with unfettered access to local capital markets and provide local residents access to foreign capital markets and ultimately a lower cost of capital. However, they also transmit disruptions rapidly in capital markets in major economies throughout the world, as evidenced by the global meltdown in the equity and bond markets in 2008 and 2009.

Unlike globally integrated capital markets, segmented capital markets exhibit different bond and equity prices in different geographic areas for identical assets in terms of risk and maturity. Arbitrage should drive the prices in different markets to be the same, since investors sell those assets that are overvalued to buy those that are undervalued. Segmentation arises when investors are unable to move capital from one market to another due to capital controls, prefer to invest in their local markets, or have better information about local rather than more remote firms.5 Investors in segmented markets bear a higher level of risk by holding a disproportionately large share of their investments in their local market as opposed to the level of risk if they invested in a globally diversified portfolio. Reflecting this higher level of risk, investors and lenders in such markets require a higher rate of return on local market investments than if investing in a globally diversified portfolio of stocks. As such, the cost of capital for firms in segmented markets, having limited access to global capital markets, often is higher than the global cost of capital.

3.2 The theory of interest groups and environmental outcomes

The second generation of work on the positive theory of environmental regulation has taken up this challenging issue. The basic approach involves setting out a public-choice or political setting in which competing interest groups, taking the form of lobby groups, provide support in one form or another (often monetary support for their preferred candidate), and then, making use of game-theoretic analytical techniques, characterizing outcomes under differing conditions. Such models can, for example, provide an explicit rationale for the choice of command-and-control instruments over more efficient incentive-based measures under certain specified circumstances.

This body of work draws heavily on recent research into the positive theory of international trade – research that seeks to explain the introduction of tariffs and other impediments to free trade through the political interplay of various interest groups [Hillman (1989), Grossman and Helpman (1994)].9 It is useful, following Grossman and Helpman (1994), to distinguish between two strands in this literature. The first envisions the political setting as one of political competition between opposing candidates (or parties). The competing candidates announce the policy measures that they will introduce if elected, and then organized interest groups make their decisions concerning which candidate to support [e.g., Hillman and Upsprung (1992)].

The second approach to the study of endogenous policy determination involves a setting in which an incumbent government seeks to maximize its political support through the choice of policy measures. Under this “political support” type of model, the various interest or lobby groups offer contributions, and the government determines policy so as to maximize the likelihood of being re-elected. This typically involves the maximization of an objective function that includes as arguments both the general welfare of the electorate and the contributions from the various interest groups [e.g., Aidt (1998)]. Under this latter approach involving the so-called “common agency model of politics”, one of the intriguing findings (mentioned earlier) is that if all agents have their interests represented accurately by an interest group, then the political equilibrium is socially efficient. All external effects become effectively internalized through the political process with the result that the policy-maker chooses both the efficient policy instrument and the efficient level of regulation; in the case of environmental policy, this is a Pigouvian tax.

To get a better sense of these quite striking results, it may prove helpful to treat all this a bit more formally. We shall follow Aidt (1998) here; his formulation builds on Grossman and Helpman (1994). In Aidt’s model, the government’s objective function encompasses both social welfare goals and political contributions:

(1)Gpqte=ΘWp,q,te+∑Cipqte,

where W is a Benthamite social welfare function, Θ is a weighting parameter, and Ci is the contribution from interest group i.10 The variables p, q, and te represent producer prices, consumer prices, and emissions taxes, respectively. Each citizen is a generalist consumer, a shareholder in one industry (product), and is adversely affected by polluting emissions associated with production.

Aidt limits the government to only two policy instruments: taxes on emissions and product taxes/subsidies. The government can use these instruments both to control emissions and to redistribute income. Each citizen receives an equal lump-sum share of the tax revenue collected.

In the Aidt model, each interest group represents all those citizens that hold shares of a particular industry. However, rather than simply focusing on increasing the profit earned by the industry, the interest group faithfully represents all of its members’ interests. Thus, the interest group is concerned with each of the elements affecting its members’ welfare. The objective function for each interest group, Wi(p, q, te). is thus the sum of its members’ utility. Following Grossman and Helpman (1994), it can be shown that the optimal contribution for each interest group is equal to its objective function minus a constant, Ki:

(2)Cipqte =Wipqte− Ki.

With this in place, the insight of concern here, namely the existence of an efficient lobbying outcome, follows in a straightforward manner.11 If all N industries are represented by an interest group (and because each citizen holds shares of only one industry), then all citizens are represented by an interest group. In this case, the government’s objective function collapses to:

(3)Gpqte=Θ+lWp,q,te−∑Ki

and the optimal tax levels for the government are the same as those for the social welfare function: product taxes that equal zero and emissions taxes that equal marginal social damage.12

Deviations from efficient outcomes in this framework result from the failure of lobby groups to emerge to represent certain interests. Aidt does not examine the formation of interest groups. He simply takes their existence as given and assumes that they have overcome the free-rider and associated challenges that confront the organization of these groups. However, the basic theory of public goods leads us, in fact, to expect such failures in organization. In his classic work, Olson (1965) laid out a theory of special interest groups in which he explored the conditions under which effective lobby groups were likely to emerge. As Olson taught us, the basic free-rider problem limits the capacity for individuals with common interests to organize to obtain a collective benefit. Powerful lobbies are typically those that perform some function in addition to providing purely collective goods: they provide direct services to their members or have various tools of “coercion” at their disposal to enforce membership on those who benefit from their activities. So it comes as no surprise to find that certain interest groups – business trade associations, for example, that encompass relatively small and fairly homogeneous groups – are able to organize and represent their collective interests effectively, as compared to larger and more diffuse groups like consumers. Thus, it is easy to see how inefficient policy outcomes can emerge as a result of incomplete representation through interest groups.13

In fact, from this perspective what does seem surprising is the extent to which environmental advocacy groups have mobilized their constituencies so effectively. The benefits from programs to improve air quality on a national scale, for example, would appear to represent an Olsonian “large-group” case, where it would be extremely difficult to organize environmental interests. But in seeming contradiction to the prediction of the theory, environmental groups have proved to be a very powerful force in the policy arena. In the case of air quality management in the United States, for example, the efforts of these groups were clearly very important in obtaining at least some standards that appear to be more stringent than the economically efficient ones. Likewise in Europe, a variety of environmental groups have had great influence on measures for environmental protection. In several northern European countries, green interest groups have formed their own political parties and have become part of a governing majority.14