By Sean Riley,2014-12-02 11:17
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     María Luz Campo **


    This paper focuses on the effects that the environmental policy chosen by governments has on the performance of both firms and unions when there is a negative environmental externality from production of a good which only affects the country where the firm is located. I assume that governments choose an upper limit on emissions, unions choose the wage rates and firms choose the employment level. Specifically , I analyze the effect that unionized labor markets have on environmental policy.

Keywords: monopoly union model, emission standards.

    JEL Classification: J30, J51.

    * I thank Juan Carlos Bárcena for valuable comments and suggestions. Financial support from UPV/EHU HB-8238/2000, BEC 2000-0301 and grupos de investigación UPV/EHU are gratefully acknowledged.

    ** Dpto. de Fundamentos del Análisis Económico I. UPV-EHU. Avda. Lehendakari Aguirre 83, 48015 Bilbao, Spain; Phone: (34) 946013833; Fax: (34) 946013799; e-mail:

    1. Introduction

     Concerns about environmental quality have always been important in the decisions of governments. Environmental regulations in the European Union have focused on emission control to protect the quality of air, water and soil: for instance, laws that limit the maximum levels of pesticide residues in drinking water, fruit and vegetables. But in recent years this concern about environmental problems has been growing.

     Thus, on the one hand, governments may be interested in toughening their environmental policies because of increased pollution produced by the expansion of consumption, production and trade, leading them to protect the environment. But, on the other hand, governments may have incentives to relax their environmental policy to give their domestic producers an advantage in competitive international markets. The resulting reduction in cost may lead to increased investment by producers, thus increasing output and employment.

    This paper analyzes the interaction between environmental policy and union-firm bargaining, and seeks to analyze the effects that unionized labor markets have on the environmental policy set by governments. I assume that environmental damage is strictly local.

     In debates about environmental policy the possible effects of environmental regulations on employment often play an important role. Hoel (1998) analyzes the relationship between labor market and environmental policy, among others. In his paper he examines the effect that environmental taxes and other forms of quotas and direct regulations have on employment. He gets the result that, if wages are exogenous, employment is higher with environmental taxes than with other forms of environmental regulations. In a context with perfect competition and transboundary pollution, Hoel (1997a) analyzes whether there may be reasons for coordinating environmental policies across countries, when wages are determined through bargaining between firms and


    unions. An important conclusion is that policy coordination is unnecessary in many cases. Bárcena-Ruiz and Garzón (2002) study how the existence of wage incomes influences the choice of environmental policy by governments when firms’ location is endogenous. Governments want polluting firms to locate in their countries because of the positive incomes that these firms generate, even though they damage the environment.

    Ulph (1996) studies the choice of environmental policy when both governments and producers can act strategically. He shows that if producers act strategically this reduces but does not eliminate the incentives for governments to relax their environmental policy. Welfare is greater when only one party acts strategically. If only governments act strategically, output and emissions are greater when governments use emission taxes rather than emission standards.

    I adopt the same framework considered by Ulph (1996) but assume that all workers are unionized. In this framework I analyze the choice of environmental policy by governments when firms compete in an international market. These firms are unionized and unions set wages (i.e., I consider the monopoly-union model). For the

    sake of reference, I compare this case with the situation in which wages are exogenous.

    1 The environmental policy used in this analysis is emissions standards.

    The results obtained in the paper are the following. If unions set the same value on wage and employment the environmental policy set by governments is less strict when unions choose wages, if the market is small enough than if wage is exogenous. The government allows greater environmental damage due to the increase of the union’s utility than by compensating the lower consumers’ and producers’ surplus and, as a result, social welfare is higher if the union chooses the wage. If the market is large enough, the environmental policy is stricter if the union chooses the wage than if the wage is exogenous, with lower social welfare resulting in the former case. Although the

     1 The results do not change if I assume that the government imposes environmental taxes.


union’s utility is higher and the environmental damage is lower when the union chooses

    the wage, the welfare will be higher if wages are exogenous due to the weight of the consumers’ surplus and producers’ surplus.

    Therefore, the conclusions obtained depend on market size, which in turn depends on (i) valuation of the environment, (ii) reservation wage and (iii) valuation of employment.

     The results obtained in the paper do not change if countries differ in their valuation of the environment or if the reservation wage differs from one country to the other or if unions have different valuations of employment.

     The rest of the paper is organized as follows. Section 2 presents the model. Section 3 examines the choice of environmental standard if the union chooses the wage, while section 4 analyses the situation if wages are exogenous. Section 5 presents the main result of the paper, comparing the two cases, and section 6 concludes.

    2. The model

     There are two firms, 1 and 2, that produce a homogeneous good with the same

    2 Both firms sell its technology. Each firm is located in a different country (1 and 2).

    good on a world market. For the sake of simplicity, the cost of transport and other costs related to the selling of the product abroad are taken as being zero. I assume that both firms are unionized and wage bargaining takes place at firm level.

     The inverse demand function of country i is

     p = a 2y, i =1,2, i

     2 I assume that the location of firms is fixed. For analyses of the effect of environmental policy on the location of firms see, for instance, Hoel (1997b), Markusen (1997) and Bárcena-Ruiz and Garzón (2002).


     is the amount where p is the world market price of the good, a is the market size and yi

    of the good sold in country i. Therefore, the demand of the world market is given by the following inverse demand function

    p = a - q - q, i ? j, i, j =1,2, ij

where y+y = q+q; q is the output level of firm i (i = 1,2). I assume that a>a*; where ijiji

    3a* = r+1.051; with r being the reservation wage of the workers.

    Consumers buy the good on the world market. The consumers’ surplus of country i is

    2CS= (y ), i, j =1,2. 1 i i

    There is a pollutant associated with the production of q. Specifically, each unit

    of output produces one unit of pollutant. Technology exhibits a constant return to scale

    such that q = L, where L denotes the employment level that the firm i hires en the iii

    country i. Net emissions of the firm, e, are: e = q x, where q are the emissions iiiii

    generated by firm i, as function of the level of output, and x is the level of abatement of i

    firm i. Thus, to control environmental damage government i chooses the environmental

    4standard, an upper limit on the emissions that may be emitted by firm i.

    Firm i must not exceed the limit in the standard set by the government i, thus it

    5has to pay a pollution abatement cost. Following Ulph (1996), total costs of abatement

    12are C(x)=(x), x 0. On the other hand, each firm hires L workers with a wage rate ?iiii2

    w. It therefore bears a wage cost Lw, so the profit function of firm i is: iii

     3 It is assumed that a > a* to assure that output and pollution abatement level are positive. 4 The total emissions of firm i are equal to the maximum emissions allowed by the government, so that profits increase with emission levels because pollution abatement costs are lower. 5 Investments made to diminish emissions are, for example, the use of filters that decrease the toxicity of

    solid waste.


    12 = a-q-q-w q(q- e), i?j , i,j=1,2. 2 iijiii i2

     The next step is to specify the union’s utility function. This depends on both

    6employment and wage. I assume that the union maximizes the total rents given by the

    7product of the level of employment times the wage rates. That is

    ( (1-UR = (w-r) L, 0 < ( < 1, 3 iii

where wis the wage per unit of employment, r ? 0 represents the alternative wage i

    which workers may expect to earn elsewhere and is the same for all workers. The parameter ( is the weight that union i gives to employment relative to wage.

     In the relevant literature decisions on employment and wage have been modeled in different ways. Generally, the union has more power in decisions about wages than about employment. To model this, I can use the right-to-manage model, in which

    unions and firms bargain over wages and firms choose the employment level that maximizes profits. A special case of this model is the monopoly-union-model, where the

    8union sets the wage while the employer sets employment.

    I follow the assumption commonly made in the relevant literature that the environmental damage function is a quadratic form and that it depends only on the

     6 Empirical studies of unionized labor markets have used total rent (Brown and Ashenfelter (1986)), or a Stone-Geary utility function (Dertrouzos and Pencavel (1981)) to represent the objective function of the labor union. 7 This assumption is made in many papers analazing wage bargaining. See for example, De Fraja (1993) or Dobson (1994) among others. 8 An alternative model is the efficient bargaining model. This model has the drawback that at he negotiation stage there would have to be complete agreement between union and firm owners that employment should be set at its profit maximizing level. Then the interaction between product market and labor market imperfections would be lost. On the other hand, the empirical evidence suggests that this model does not reflect the way in which firms actually behave (Oswald and Turnbull (1985)).


     9 i.e. the pollutant causes damage only to the local emissions generated in that country;

    economy. The total environmental damage of country i due to emissions generated in

    that country are

    12D = (e) , i =1,2. 4 ii2

    To set its environmental policy the government maximizes social welfare, which comprises the consumer surplus (CS), the producer surplus (PS) and the union rents ii

     (UR),less environmental damage (D), as is standard in the relevant literature. Social ii

    welfare is given by the following function

     10W = CS + PS + UR - D, > 1.3, i = 1, 2, 5 iiiii

    where is a parameter that measures the valuation of the environment by government. I assume that both governments have the same valuation of the environment. The above welfare function includes the union rents as that part of the producer surplus which is absorbed by the union (see, for example, Brander and Spencer (1988), Mezzetti and Dinopoulos (1991), Naylor (1998) and Bughin and Vannini (1995)).

     In equation 5, given that there is only one firm in each country and there are no fixed costs, PS=. When wages are exogenous, UR=0, because I assume that workers iii

    obtain their reservation wage and therefore this component does not exist in the social welfare function.

    I analyze the effect of the environmental policy set by the governments when wages are endogenous. In order to highlight the results of the model, I will compare it with the case of exogenous wages.

     9 This function assumes that environmental damage is a convex function of the emission level. See, for example, Falk and Mendelsohn (1993), Van der Ploeg and Zeeuw (1992) and Ulph (1996). 10 In order to simplify the exposition of the results I assume, without loss of generality, that > 1.3.


    The timing of the game is as follows. In the first stage, each government sets emission standards. In the second stage, the union chooses the wage (if it is not exogenous) and in the third stage the firm chooses its output (employment). I solve each game in the usual way by backward induction.

     3. The unions choose the wage

     The aim of the paper is to analyze the effect that the environmental policy set by the government has on union rents when the wage is endogenous. In this section, I assume that the governments of countries 1 and 2 set their environmental standards

    independently and simultaneously when the unions choose the wages. As a reference, I also analyze the case in which the cost of production is exogenous (that is, the wage is fixed). In this section, given that there is no international cooperation, the emission level is set by the Nash equilibrium of a non-cooperative game where both countries choose their emissions by maximizing their social welfare function.

     I shall first solve the third stage of the game in which firms choose their output (employment) level. Firm i chooses the output level that maximizes its profit function, given by 2. From the first-order conditions it is obtained the output levels for both firms,

    233aw;w;eeijij = L= , i?j, i, j = 1, 2. 6 qii8

    The standard set by the government affects both the firm’s output and abatement emissions. If the government sets a high standard the firm increases their output and employment. However, the higher the standard set by government the lower the

    11abatement emissions. Thus, the higher the pollution allowance level the higher the

?(qe)5ii11 0. ?e8i


    output of that country and the lower the output of the other country. Also we can see that the higher the wages paid to workers are, the lower the output of the firm and the

    higher the output of the rival firm.

     In the second stage, union i chooses the wage rate that maximizes its utility function.

    (1- ( (w) = arg max w - r] [q w i=1,2, ijii


where q is given by 6. Solving this, it is obtained the wage reaction functions i

    α(2a;w;3ee3r)jij w = r + , i?j, i, j = 1, 2. 7 i3

     From 6 and 7, it is obtained how wages and employment will react to changes in the emission standards chosen by the government.

    ((((((2(3;);9(1);(3(1)();(9))arreejiw =, i?j, i, j = 1, 2, 8 i29(

    ((((3(1)(2(;3)(9)();3(1)())arereijL = q =, i?j, i, j = 1, 2. 9 ii28(9()

     The equations above show that the higher the pollution allowance level chosen by government i and the lower the standard chosen by government j, the higher the

    12wage chosen by union i.

    ((((?w?w3(1)(9)ii12 > 0, < 0. 22?e?e(9i(9j


     There is a positive relationship between the standard chosen by the government i

    and the output (employment) level of firm i. The higher the weight given to wages by

    the union, the lower the increase in employment will be. Moreover, an increase in the standard chosen by government j will decrease the output of firm i. The lower the

    13 weight given to wages by the union, the higher this decrease will be.

     It remains to solve the first stage of the game. Due to the existence of free trade each government takes into account the decision of the other government when it chooses its environmental standard. Therefore, there is strategic interaction between the two countries because the decision taken by one country affects the other. In the first stage, both governments simultaneously choose the environmental standard that maximizes their social welfare as given by equation 5.

    Substituting 8 and 9 in 5, it is obtained the social welfare of country i, as a

    function of the standards, eand e, whose expressions are shown in appendix A.1. Now, i j

    maximizing equation 5 with respect to e for country i (i=1,2), it is obtained the i

    standard reaction function, that shows the negative relationship between the standards of the two countries. The standards are strategic substitutes, i.e. if one country decides to increase its standard, the best answer of the other country is to decrease its own standard. The reason why the reaction functions are downward sloping is that when government j toughens its emission limit that will force firm j to cut its output and allow firm i to expand its output. From the reaction functions it is obtained the equilibrium

    SSstandards chosen by each government (e, e). I use superscript S to denote the ij

    variables if the union chooses the wage. The expressions of the standards chosen by governments are collected in appendix A.2.

    ((((?L?L3(1)(9)3(1)(33)ii13 > 0, < 0. 22?e?e8((9)8((9)ij


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