External balance, dynamic efficiency, and the welfare effects of unilateral and multilateral permit policies in interdependent economies Birgit Bednar–Friedl a,b , Karl Farmer a, ⁎ a Department of Economics, University of Graz, Universitätsstrasse 15, A-8010 Graz, Austria b Wegener Center for Climate and Global Change, University of Graz, Leechgasse 25, A-8010 Graz, Austria abstract article info Article history: Accepted 19 May 2010 JEL classification: Q52 Q54 D91 Keywords: Emission permits Trade Overlapping generations Welfare This paper investigates domestic and foreign welfare effects of unilateral and multilateral permit policies in a two-country overlapping generations model with producer carbon emissions. We show that the welfare effects of a more stringent cap on emissions depend on the external balance of the policy implementing country, the dynamic (in)efficiency of the world economy, and the preference for environmental quality. Under dynamic efficiency, the global welfare loss of policy implementation in a net foreign creditor country is lower than of a policy in the net foreign debtor country. Moreover, although the country which has unilaterally implemented a permit policy would gain from a multilateral policy, the associated welfare loss for the other country is larger than that of a unilateral policy abroad. © 2010 Elsevier B.V. All rights reserved. 1. Introduction That some highly developed countries have unilaterally imple- mented climate policy within their boundaries to fulfill the Kyoto Protocol represents a well-known fact of this decade. Due to international interdependence, other Annex-I countries are however affected by this unilateral climate policy, e.g. the implementation of the European Union's Emissions Trading System (ETS), despite their withdrawal from the Kyoto Protocol. The withdrawal from the Protocol by some countries itself has been explained by different economic concepts: first, combating global warming is a global public good with a fundamental free-rider problem which has been discussed intensively in the game-theoretic literature (for a survey, see Finus, 2001 or more recently Endres, 2008). Moreover, from a political-economic perspective governments' decision to withdraw are based on the (low) preference of the median voter for mitigating climate change relative to the high costs of compliance (Böhringer and Vogt, 2004). This paper takes a somewhat different approach to explain the withdrawal of some highly developed countries by investigating the domestic and foreign welfare effects of implementing unilateral and multilateral climate policies. 1 We start by analyzing the sum of domestic and foreign welfare effects of a unilateral permit policy to see whether this global welfare effect is larger or smaller depending on the net foreign asset position of the policy implementing country. Next, we take the position of a country which has implemented a permit policy, to analyze the welfare gain within this country when a multilateral policy was achieved. Moreover, we show from the perspective of a country which has withdrawn from the Protocol under which conditions non-implementation is to be preferred to the consequences of a unilateral climate policy by the other country. Ultimately, this analysis of welfare effects can enrich the explanation why some Annex-I countries have withdrawn from the Kyoto Protocol and pertain their position against internationally accorded climate policy also for the Post-Kyoto era. Our approach is based on an earlier strand of literature after the unilateral fiscal expansion in the United States in the 1980s which aimed to understand the international consequences of unilateral fiscal policy among highly developed nations. In particular, unilateral fiscal expansion was shown to reduce capital accumulation domes- tically and abroad (Lipton and Sachs, 1983), and to change the terms of trade depending on the external balance (i.e., the net foreign asset position) of the debt expanding country (Frenkel and Razin, 1986). Economic Modelling 27 (2010) 980–990 ⁎ Corresponding author. E-mail addresses: birgit.friedl@uni-graz.at (B. Bednar–Friedl), karl.farmer@uni-graz.at (K. Farmer). 1 By domestic welfare effects we mean welfare effects incurred within the policy implementing country while foreign welfare effects refer to welfare effects that spill over to the other, non-implementing country. 0264-9993/$ – see front matter © 2010 Elsevier B.V. All rights reserved. doi:10.1016/j.econmod.2010.05.003 Contents lists available at ScienceDirect Economic Modelling journal homepage: www.elsevier.com/locate/ecmod