The idea that environmental trade policy can be used to achieve competitive advantage in international markets has important implications for the way we conceive free trade. This paper considers strategic environmental policy in a model that makes explicit the vertical structure that supports production of the traded good. Including intranational vertical relationships in the analysis of strategic environmental trade policy has substantial qualitative effects. When vertical contracts are allowed, the optimal policy to levy on a polluting input under both quantity and price competition in the international market is the Pigouvian tax.



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