North-South investment flows and optimal environmental policies

In the context of a simple North-South model that focuses on the internatio nal movement of capital, we show how neglect of pollution-generating effect s of foreign investment may lead to distorted and misleading policy recomme ndations. Such a neglect has recently received emphasis in the empirical li terature on East Asian economies, as in Bello and Rosenfeld (1990, "Dragons in Distress: Asia's Miracle Economics in Crisis," Food First, San Francisc o), and was shown to overlook resulting tendencies in these economies towar d specialization, away from agriculture and toward manufacturing. Our simpl e model formalizes this observation and allows us to show that even for an unspecialized capital-poor, resource-rich South, such pollution-generating effects provide incentives for the North to encourage, rather than to disco urage, foreign investment abroad and strengthen Southern incentives to rest rict foreign investment more sharply than is conventionally assumed. In a n utshell, it brings out the implications df Northern capital "creating its o wn demand" as a consequence of its adverse impact on the Southern resource base. Despite its simplicity, the model thus sheds light on three interrela ted aspects of international trading relations: production asymmetry, incom plete markets, and monopolistic advantage. (C) 2000 academic Press.