Pollution haven

The pollution haven hypothesis posits that, when large industrialized nations seek to set up factories or offices abroad, they will often look for the cheapest option in terms of resources and labor that offers the land and material access they require. However, this often comes at the cost of environmentally sound practices. Developing nations with cheap resources and labor tend to have less stringent environmental regulations, and conversely, nations with stricter environmental regulations become more expensive for companies as a result of the costs associated with meeting these standards. Thus, companies that choose to physically invest in foreign countries tend to (re)locate to the countries with the lowest environmental standards or weakest enforcement.

1. Pollution control costs have an impact at the margins, where they exert some effect on investment decisions and trade flows.

2. Pollution control costs are important enough to measurably influence trade and investment.

3. Countries set their environmental standards below socially-efficient levels in order to attract investment or to promote their exports.

Scales 1 and 2 have empirical support, but the significance of the hypothesis relative to other investment and trade factors is still controversial. One study found that environmental regulations have a strong negative effect on a country's FDI, particularly in pollution-intensive industries when measured by employment. However, that same study found that the environmental regulations present in a country's neighbors have an insignificant impact on that country's trade flows.

In the above formula, Y is economic activity, R is regulatory stringency, X is an aggregate of other characteristics that affect Y and ε is an error term. Theoretically, by changing your value of R, analysts will be able to calculate the expected effect on economic activity. According to the Pollution Haven Hypothesis, this equation shows that environmental regulations and economic activity are negatively correlated, because regulations raise the cost of key inputs to goods with pollution-intensive productions and reduce jurisdictions' comparative advantage in these goods. This lack of comparative advantage causes firms to move to countries with lower environmental standards, decreasing Y.

There is also an expanded formula, as shown below:

This expanded formula takes into account whether trade liberalization (i.e. the level of trade barriers that exist in a country, labeled as T) increases the negative correlation between economic activity (Y) and regulatory stringency (R). Some authors claim that trade barriers disproportionately effect the environment, and this equation attempts to quantify the interaction between trade barriers and regulatory stringency, and the corresponding effect with respect to output in an economy.

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