Optimal Environmental Policy in Open Economies

Abstract

The existence of externalities in economies cause markets to operate inefficiently. Intervention from the third party is thus necessary for market to function at the maximum possible efficiency. However, it is a challenge for third party, such as the government to choose the best policy to maximize the best policy for the market. Depending on the source of market failure, trade policy and environmental policy have different effects in minimizing the distortion by externality. The trade policy is second best policy for domestic externality as it carries more deadweight loss. The more efficient method to optimize domestic externality is to regulate with environmental policy. In turn, domestic environmental policy may not be an ideal solution for the transboundary externality such as cross-border pollution.