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Cournot, Pigou, and Ricardo Walk into a Bar: Unilateral Environmental Policy and Leakage with Market Power and Firm Heterogeneity

We study the determinants of emission leakage using a two-country general equilibrium model with heterogeneous firms and Cournot competition. We show that firms from the nonregulating country respond to the implementation of Pigouvian emission taxes on their competitors abroad and the subsequent gain in comparative advantage by increasing markups rather than output. We find that this effect, jointly with the exit of the least productive and most emission-intensive firms, can provoke a reduction of emissions in the nonregulating country and thus increase the effectiveness of the unilateral emission tax. Border emission taxes dampen the market power gains of nonregulated firms and thus reduce the effectiveness of a unilateral emission tax.