A Theoretical Model on Trade and Environment in the Presence of FDI and Informal Sector

Abstract

The paper examines the impact of foreign direct investment on the level of emission as well as tradable emission permit rate in a small open economy with four sectors. The model of Copeland and Taylor (2004) has been extended by incorporating an informal sector that produces non-traded input for the formal manufacturing sector for a small open economy. Foreign capital is used solely by the foreign enclave. In this framework with exogenous tradable emission permit rate FDI causes a reduction in the level of pollution. However, when tradable emission permit rate becomes endogenous the model shows that FDI causes a fall in the level of pollution along with a decline in emission permit rate. This result has strong implications regarding environmental governance in developing countries.