Strategic enhancement and destruction of fisheries and the environment in the presence of international externalities

JOURNAL OF ENVIRONMENTAL ECONOMICS AND MANAGEMENT

19, 212-226 (1990)

Strategic Enhancement and Destruction of Fisheries and the Environment in the Presence of International Externalities BRIAN

R.

COPELAND*

Department of Economics, University of British Columbia, Vancouver, British Columbia, Canada V6T lW5 Received August 1, 1989; revised October 19, 1989 This paper considers enhancement of fisheries and the environment in the presence of international externalities. By enhancement we refer to investments which affect the costs and benefits of controlling fish harvest rates or pollution emission levels. In a two-country, two-period model, it is shown that enhancement may be used strategically to influence the behavior of rival governments, and that the strategic effect may either offset or reinforce the standard free rider problem associated with such investment. In some cases, countries may have an incentive to invest in environmental destruction (i.e., negative enhancement) if policies are not coordinated internationally. © 1990 Academic Press, Inc.

1. INTRODUCTION

There is much literature on the regulation of natural resources and the environment in the presence of international externalities. International fisheries and transboundary pollution provide two important examples of this problem: in the former case, fish stocks may be harvested by agents from two or more countries, and in the latter case, the activities of one nation harm another's environment. It is well known that non-cooperative regulation in such cases tends to be inefficient, and that there are incentives for nations to reach negotiated solutions. l Recent concerns over acid rain, oil spills, ozone layer depletion, and declining fish populations highlight the importance of these problems. This paper considers the enhancement of fisheries and the environment in the presence of international externalities. 2 By enhancement we mean investments which affect the costs and benefits of controlling fish harvest rates or pollution emission levels. For example, in some fisheries, such as salmon, countries can invest in fish hatcheries or streambed protection in an effort to increase the stock of fish. In the case of pollution, a country may invest in lake or river cleanup, or may undertake research into new methods of pollution control. Most of the previous literature on international spillovers has focused on cooperative or 'Part of this paper was written while the author was visiting the Economics Department at the University of Alberta. The author thanks members of that department for their hospitality and is also grateful to Gordon Munro, the referees, and an Associate Editor for helpful comments which improved the paper. IOn international fisheries, see Chan [5), Munro [16,17,18), Kaitala [11), Levhari and Mirman [14), and others. On transboundary pollution, see Scott [21), Markusen [15), Conrad and Scott [6), van Egteren [23), and others. 2Anderson [1) examines stock enhancement in recreational stream fisheries. Munro (18) discusses enhancement in the context of international fisheries. Kitabatake [13) considers enhancement of the environment in the absence of international externalities. 212 0095-0696/90 $3.00 Copyright © 1990 by Academic Press, Inc. All rights of reproduction in any form reserved.

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non-cooperative games where governments attempt to engage in the direct control of harvest rates or emission levels (through the use of taxes, quotas, and other instruments). Here we are concerned with investments which can enhance or damage the resource and which can indirectly affect the gamein harvest levels or emissions. In an environment with international externalities, there is a free rider problem since enhancement can benefit more than one country. For example, the salmon enhancement program in British Columbia benefits both Canadian and American fishermen if fish released from Canadian hatcheries swim into American waters. Because of this spillover effect, the investing country will not reap the full benefits, and hence it is often argued that countries may be reluctant to make the investment. However, this argument overlooks one potentially important aspect of such behavior. By undertaking such actions, a country can make a credible commitment which affects the future costs and benefits of polluting or fishing for both itself and foreign countries. That is, a domestic investment in enhancement today will have both a direct effect on domestic and foreign welfare (which leads to the free rider problem) and an additional indirect strategic effect, since it will affect the choice of fishing or pollution levels by both governments in subsequent periods. Depending on the structure of the problem, the strategic effect may be positive or negative. If it is positive, it may pay for the country to “overinvest” in enhancement. For example, if enhancement of fish stocks lowers the marginal cost of fishing to domestic fishermen significantly more than it lowers the cost to foreign fishermen, then such an investment could result in less fishing by foreigners and thus give an additional boost to domestic welfare over and above the direct effect of enhancement. The purpose of the present paper is to investigate the strategic effects of enhancement in the context of international externalities and to determine conditions under which over- or underinvestment in such an activity is likely to occur. In order to highlight the strategic effects of enhancement, a simple two-period, two-country model is developed. That is, we consider a two-stage game. In the first period, governments invest in enhancement; and in the second period, they control the harvest of fish.3 When choosing enhancement levels, governments rationally anticipate the effects of this investment on both their own and foreign behavior in the second stage of the game. We consider both cooperative and non-cooperative outcomes in the second period and find that in either case, enhancing investments may be used strategically. In the case of fishing, we find that the more enhancement lowers domestic relative to foreign fishing costs, the more likely that governments will overinvest in enhancement. On the other hand, the greater the spillover in enhancement, the more likely that the strategic effect will reinforce the free rider problem. In fact

“Thus the externalities generated by fishing or pollution are static, since all fishing or pollution occurs in the second period of the model. Such static representations of the externality have been used previously to investigate fisheries and the environment (see, for example, Gordon [lo], Markusen[lS], Anderson [2], and Karpoff [12]; however these previous studies do not consider the strategic aspects of enhancing investments. The use of dynamic models opens up the possibility of much richer strategies (see, for example, Munro [16] and Kaitala [ll]), but we leave the analysis of strategic enhancement in the context of such models for future research.

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the strategic effect can be so strongly negative that countries may choose to invest in strategic destruction of the fishery or environment in order to deter fishing or pollution in the other country. This possibility suggests that the costs of non-coordination of environmental regulation may be more severe than previously thought. The idea that investment can have strategic effects has been used extensively in the industrial organization literature to analyze entry deterrence (Dixit [S], Fudenberg and Tirole [9]), investment in R&D (Brander and Spencer [3]), investment in advertising (Fudenberg and Tirole [9]), and other issues.4 Thus, this paper brings together ideas from both the fisheries literature and the industrial organization literature in an effect to increase understanding of international conflict in common property situations. With a suitable relabeling of variables, this analysis could also be interpreted as an investigation of strategic investment by two firms exploiting the commons. The next section considers enhancement in international fisheries, while the implications of the analysis for transboundary pollution are discussed briefly in Section 3. 2. ENHANCEMENT

OF FISHERIES

2.1. The Model

Two countries, Home and Foreign, share a stock of fish. All foreign country variables are denoted by an asterisk (*>. The price of fish, p, is assumed to be fixed (i.e., the countries are small players in the world market for fish). All prices and costs are discounted to period 1 values. We assume that there is a static externality in fishing, and that each country regulates its own fishermen efficiently, given the level of foreign harvesting.5 Hence the relevant externality is transnational. The cost function for fishing for the home country is C(H, H*, E, E*), where H and H* are the domestic and foreign harvest rates, respectively, and E and E* are the domestic and foreign enhancement levels. It is assumed that total and marginal harvesting costs are increasing in H and H*, and, unless otherwise stated, that total and marginal harvesting costs are decreasing in E and E*. It is also assumed that C, > CHH* (where subscripts denote partial derivatives); i.e., that own effects on marginal harvesting costs are stronger than cross effects. This latter assumption, which ensures stability of the non-cooperative Nash equilibrium in harvest levels, may be justified by arguing that an increase in either domestic or foreign fishing will increase marginal cost through the externality, but that the effect will be stronger in the case of an increase in domestic harvest, either because the effects are more immediate in time or location or because less efficient fishermen begin harvesting as the harvest rate increases.6 The foreign cost function, C*(H*, H, E*, E), is defined analogously. 4See Tirole [22] for an excellent survey and exposition. 5This could he accomplished, for example, with individual harvest quotas. Here we follow much of the formal literature on international externalities and abstract from the difficulties that the government may face in implementing an efficient domestic regulatory scheme. We also follow much of the literature in assuming that the government attempts to maximize rent from the resource, thus sidestepping the issues of the distribution of these rents among the general public and diverse competing interests within the fishery. 6See Brander and Spencer [3] for further discussion of stability in two-stage models.

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It is assumed that an investment in enhancement requires some time to affect harvest costs, since we have in mind activities such as cleaning up and protecting stream beds where fish spawn, reducing water pollution, and the operation of fish hatcheries. To capture this time lag, it is assumed that there are two periods. In the first period, enhancement levels are determined, while in the second period, harvesting occurs. Investments in enhancement may therefore be regarded as sunk costs, as they could only be recaptured by selling fishing rights to foreigners, an option which we rule out by assumption for the present.7 When governments choose enhancement levels, they will rationally anticipate the effect of their investment on both their own and foreign behavior in the next period: that is, we look for a sub-game perfect equilibrium. We first consider the enhancement decision of one country, given fixed enhancement levels abroad, and then investigate non-cooperative choice of enhancement by both countries. 2.2. Non-cooperative One Country

Choice of Harvest Levels and Enhancement

by

We begin with the second stage of the game. The home government chooses domestic harvest levels to maximize total social surplus generated by the fishery, given previously chosen enhancement levels, ~;;[PH-

C(H,H*,E,E*)],

and the foreign government solves a similar problem. The first-order from optimization by both countries yield

conditions

p = X( H, H*, E, E*)/aH,

(1)

p = aC*( H*, H, E*, E)/aH*.

(2)

Given previously chosen enhancement levels, (1) and (2) trace out the harvest reaction functions H = R(H*; p, E, E*) and H* = R*(H; p, E*,E). These are plotted in Fig. 1 and labeled R and R*, respectively. By our assumptions on cost functions, the reaction functions are downward sloping. These assumptions also ensure that a unique Nash equilibrium exists and is stable (i.e., in Fig. 1, the home reaction function is steeper than the foreign reaction function). Let us suppose that there is an interior equilibrium, so that both countries engage in fishing.8 In Fig. 1, the equilibrium is at point a. If we allow enhancement levels to vary, then the equilibrium harvest levels will also vary. Thus (1) and (2) implicitly determine harvest functions H(p, E, E*) and H*(p, E*, El. Let us now turn to the first period of the game and examine the choice of enhancement levels. It is useful to begin with the case where only one country (say, Home) can invest in enhancement. This may be a reasonable assumption if, for example, the fish stocks in question are salmon, and most of the spawning takes ‘This may be justified in many cases since the political costs of transferring management of a domestic fishery to foreigners are often prohibitive. However, see Chan [5] and Munro [17], who argue that in some cases this may be a superior method of exploiting the resource. ‘A sufficient (but not necessary) condition for this is that each country’s marginal fishing cost is less than p, for any level of foreign fishing. This would be the case if, for example, some fraction of the stock was specific to the waters of each country.

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FIG. 1. If domestic enhancement shifts out the home reaction function, R, more than it shifts out the foreign reaction function, R*, then the strategic effect of enhancement can be positive, since foreign harvesting is deterred.

place in rivers located in the home country. Alternatively, one can interpret the analysis of this section as applying to the home choice of enhancement given fixed levels of foreign enhancement. The domestic social cost of enhancement (excluding effects on the fishery) is L&F). We normalize so that the status quo is E = 0, and hence cp(O) = 0. We assume that cp is non-negative, convex, increasing for E > 0, decreasing for E < 0, and stationary for E = 0 (i.e., cp is roughly U-shaped). Note that E < 0 is to be interpreted as an investment in environmental destruction. Hence, according to our specification, both enhancement (an increase in E, for E > 0) or destruction (a decrease in E, for E < 0) of the environment is costly. Home’s return from enhancement, if it is recalled that prices and costs are measured in present (period 1) values, is T =M(p,E,E*)

- C[H(p,E,E*),H*(p,E*,E),E,E*]

-p(E),

where E” is treated as fixed under the assumption that only Home invests in enhancement. Maximizing Home’s return from enhancement and using (1) yields

arr z+

&r dH* --=(). aH* dE

(3)

The net marginal benefit from an increase in enhancement has two components. The first term, &r/aE = -X/aE - q’(E), measures the reduction in harvest costs, net of enhancement costs, due to a marginal increase in enhancement. This may be called the direct effect of enhancement. The second term above, (&r/aH*XdH*/dE), is the indirect strategic ejj+kt. This measures the change in

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Home’s cost of fishing due to the change in the foreign equilibrium harvest level induced by increased domestic enhancement. As is well known, the presence of strategic effects means that Home will not choose enhancement levels to minimize costs for given levels of domestic and foreign harvesting (i.e., in general, -aC/aE - cp’ # OX9 Rather, enhancement levels will be chosen both to affect harvesting costs directly and to attempt to influence the amount of fishing activity undertaken by the foreign country. Also, note that if the home government were to choose enhancement to maximize world social benefit, the first-order condition would be

ac ---~=

ac*

,

aE

aE

cp’

(4)

if we assume that discount rates are the same across countries.‘O The term -aC*/aE (the direct spillover effect> does not appear in either (3) or the domestic cost minimizing solution, reflecting the free rider problem: countries ignore the direct beneficial effect of their enhancement on foreign welfare. We now wish to determine whether the strategic effect reinforces or works against the free rider problem. Since ar/aH* < 0, the strategic effect in (3) is positive if domestic enhancement results in a decline in the foreign harvest rate (i.e., if dH*/dE < 0) and negative otherwise. Recalling that the foreign reaction function is H* = R*(H; p, E*, E), we can decompose the change in H* as dH* aR* -=aE+aHz> dE

where aR*/aH rewritten as

aR* dH

(5)

< 0 is the slope of the foreign reaction function. Hence (3) can be

aT z+--

aT aR* aH*

aE

Lhr aR* dH + ---= aH* aH dE

0.

(6)

The strategic effect has thus been decomposed into two sub-components: the indirect spillover effect (the second term in (6)) and the commitment effect (the third term in (6)). The indirect spillover effect measures the effect on domestic surplus of the change in foreign harvesting induced by an increase in domestic enhancement, holding domestic harvesting fixed. In other words, it measures the effect of the enhancement-induced shift of the foreign reaction function. Since aR*/aE = -C&/C&$*, the indirect spillover effect has a positive influence on foreign harvesting (and a negative effect on domestic surplus) if and only if domestic enhancement lowers foreign marginal harvesting costs. Figure 1 illustrates such a case: an increase in enhancement by the home country shifts the foreign reaction function out from R* to R*‘. ‘See, for example, “If discount rates

Dixit [8], Brander and Spencer [3], and Fudenberg and Tirole [9]. differ, Home and Foreign may disagree about optimal enhancement

rates.

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The commitment effect” measures the effect on domestic surplus of the change in foreign harvesting due to the enhancement-induced shift in the domestic best response function (i.e., enhancement commits the domestic country to a new best response function). In Fig. 1, the commitment effect arises from the shift of the home reaction function from R to R’. The sign of the commitment effect has been extensively studied in the industrial organization literature. In the language of Fudenberg and Tirole [9], enhancement makes the domestic country “tough” in the harvest game if dH/dE > 0 and “soft” otherwise. In the absence of spillover effects, if enhancement makes the domestic country tough in the harvest game, it will have an incentive to overinvest in enhancement, since increased domestic enhancement lowers foreign harvesting and thus lowers domestic harvesting costs through the externality. To determine whether enhancement makes the domestic country tough we decompose dH/dE, dH -.---+ dE

aR aE

aR dH* aH* dE ’ --

c-t>

t-1

(3

where aR/aH* < 0 is the slope of the domestic best response function. Substituting (5) into the above expression, we obtain

II

A,

(7)

where A = 1 - (aR/aH*)(aR*/aH) > 0 by the stability assumptions. Hence it can be seen that the smaller the spillover effect, the more likely domestic enhancement is to make the home country tough. Figure 1 illustrates a case where enhancement makes the home country tough-the spillover effect is relatively small, since R shifts out by more than R*. At the new equilibrium, a’, the domestic harvest rate is higher than that at the old equilibrium, a. To determine the net influence of these various effects, substitute (7) into (6) and rearrange to write Home’s first order condition for E as aT aE+-

aT aR* aR* aR aH* [ -+aHaE aE

II

A=oy

(8)

where the first term is the direct effect of enhancement, and the second term is the strategic effect. There are two cases to consider. First, if spillovers have a negative effect on foreign harvesting (i.e., if aR*/aE < 01, then the spillover effect reinforces the commitment effect, leading to a positive strategic effect. In this case, the strategic effect works against the free rider problem, leading to more enhancement than would be predicted if the strategic effect were ignored. Such a case might arise if, ‘IThis terminology is not standard. Typically, what we call the commitment effect is simply called the strategic effect in the industrial organization literature. This is because in most of that literature, the commitment effect and the strategic effect are one and the same because of the absence of spillover effects.

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for example, a reduction in water pollution at home encouraged fish to spend more time there, thus raising the costs of fishing in foreign waters. The more interesting case is that where the spillover effect has a positive effect on foreign harvesting. For example, an investment in a fish hatchery could increase the total stock of salmon available to both domestic and foreign fishermen, or an investment in stream enhancement could increase the survival probability of fish, leaving a larger stock available to both. This would lower harvest costs in both the home and the foreign countries. In this case the spillover effect works against the commitment effect. As can be seen from (8), the larger the spillover effect, the more likely the strategic effect of an enhancing investment is to work against the domestic country, both because of the direct positive effect of spillovers on the foreign country and because large spillovers tend to make the domestic country soft in the harvest game. On the other hand, if enhancement lowers home fishing costs substantially more than it lowers foreign costs (i.e., if spillover effects are relatively low), the home country can obtain a strategic advantage by such investment. In such a case Home is able to make a credible commitment to catch more fish (i.e., it becomes tougher), and the foreign country has no choice but to respond by reducing its catch. This is illustrated in Fig. 1, where the equilibrium harvest rate for the foreign country is lower after domestic enhancement at a’ than it was initially at a. To summarize, if spillover effects are strongly positive, the free rider effect is reinforced by the strategic effect, leading to further underenhancement, while if spillover effects are small or negative, the strategic effect reinforces the direct own-cost reducing effect, tending to (locally) increase the amount of enhancement. In this latter case if ---

K

dH*

aH*

dE

>--

ac* aE ’

then there will be local overinvestment (given harvest levels) relative to the joint cost minimizing level of enhancement given in (4). 2.3. Strategic Destruction of Fisheries There is no reason why the optimal enhancement level must be positive in the above analysis. Suppose that the marginal benefit from enhancement is negative for E 2 0 but positive for some E < 0. Then the home country may find it optimal to invest in strategic destruction of the fishery. This will be the case if at E = 0 (using (3) and (8)), aE+taH

for dE < 0. The direct effect of a large positive spillover effect aR/aE), then a reduction in E strategic benefit to the home strategic effect is stronger than

aR* aR

I)

dE/A>O,

destruction is always negative. However, if there is (i.e., if aR*/aE is positive and large relative to (i.e., destruction of the environment), will yield a country by deterring foreign harvesting. If the the direct effect, the home country benefits from

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environmental destruction. Note that since the direct effect of enhancement is always positive, the possibility of destruction arises only because of the strategic effect. Another way of illustrating this result is to note that negative enhancement shifts both harvest reaction functions inward since fishing costs increase in both countries. However, if the foreign country is affected more adversely by the destructive investment than the home country, then the Foreign reaction function shifts relatively more than that of Home. In this case, the destructive investment deters foreign fishing and can increase domestic fishing and hence provides a strategic benefit to the home country. The point of this analysis is not, of course, to advocate destruction of the environment. Rather, it illustrates that, in the presence of spillover effects, the costs of non-coordination may be greater than would be implied by the standard free rider analysis. The free rider problem would suggest that countries have an incentive to underinvest in enhancement. However, the present analysis suggests that strategic effects could reinforce the free rider problem to such an extent that they actually result in destruction of the environment. 2.4. Two-Country

Choice of Enhancement

Levels: Non-cooperative

Harvesting

We now turn to the more general case where both countries choose enhancement levels. As in the single-country enhancement problem, neither country’s enhancement level will be cost minimizing because each chooses enhancement strategically in an attempt to influence the non-cooperative equilibrium of the harvesting game. All of the results of the previous section apply to the two-country enhancement case, if we interpret the previous section as an analysis of the enhancement decision of one country given the enhancement level of the other country. However, equilibrium enhancement levels now depend on the interaction between the two countries. To investigate whether there is local under- or overenhancement in equilibrium, we consider the following bargaining problem. Suppose that the two countries can bargain on enhancement levels, but not on harvest levels. When they start at the non-cooperative equilibrium, will they agree to increase or to decrease enhancement? If both E and E* are changed simultaneously, we have

ac

dr=;dH-

-dH* aH*

- ZdE

ac

- -dE* aE*

- Cp’dE,

(10)

where dE and dE* are to be interpreted as mutually agreeable exogenous changes. Evaluating (10) at the non-cooperative enhancement equilibrium yields dT=

-

X dH* -aH* dE*

dC dE*. + aE* I

To a first-order, a small mutual change in enhancement levels away from the non-cooperative equilibrium will affect Home only through the change in foreign enhancement. There are two channels for this effect: first, the direct cost change

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due to foreign enhancement (the direct spillover effect12), and second, the cost effect of the induced change in foreign harvesting (a strategic effect). All other effects are of second-order importance because of Home’s subsequent optimizing behavior in harvesting and because Home initially optimized in E in the non-cooperative equilibrium. To analyze (ll), first note that if there was no strategic effect, then a mutual increase in enhancement levels would always be welfare improving, provided the direct spillover effect is positive. Once again, this is the source of the standard argument that, in the absence of international agreement, the non-cooperative equilibrium in harvesting and enhancement leads to underinvestment in the resource (see, e.g., Munro [IS]). On the other hand, suppose that there are no spillovers (i.e., C,, = C,,, = 0). Then we have dH*/dE* > 0. In this case, a mutual agreement to reduce enhancement levels is called for: locally, countries overinvest in enhancement in the non-cooperative equilibrium. The possibility that countries may negotiate a reduction in enhancement levels may seem perverse, but in fact is a simple consequence of the subsequent non-cooperative game in harvesting. In the absence of spillovers, the situation is not unlike that of two firms which overinvest in R&D or advertising (Brander and Spencer [3], Fudenberg and Tirole [9]). In more realistic cases, we have both a strategic effect and a direct spillover effect, with the net result depending on the relative strength of the spillovers. Note that we may still obtain a prediction of overinvestment in the resource in the presence of relatively strong spillovers. Suppose that the countries are symmetric, and that there are perfect spillovers in enhancement, so that C,,. = C&. Then dH*/dE* > 0. If, in addition, a small change in enhancement at the non-cooperative equilibrium point affects marginal harvesting costs and only weakly affects total harvesting costs, then (10) will again be positive for dE* < 0, and countries will agree to reduce enhancement levels. 2.5. Two-Country

Choice of Enhancement

Levels: Negotiated Harvesting

The undesirable consequences of competitive harvesting of a common-property resource are widely recognized, and governments frequently attempt to negotiate agreements to control the externalities. However, fishing treaties often take a long time to negotiate, and hence enhancement can play an important role in affecting the bargaining outcome. For example, the west coast salmon treaty between Canada and the United States took several years to settle, and Munro and Stokes [19] argue that Canada engaged in a policy of deliberately overexploiting the resource in order to affect the bargaining process. In this section, we investigate the effects of non-cooperative enhancement under the assumption that harvest levels are determined cooperatively. To investigate this issue, we assume that enhancement takes place before bargaining over harvest levels, and that the bargaining outcome can be represented by the Nash bargaining solution, with the non-cooperative harvesting equilibrium ‘*Note that the direct spillover referred to here arises from the effect of one country’s enhancement on another’s total harvest cost, while the (indirect) spillover effect in Section 2.2 was driven by the effect of one country’s enhancement on the other’s marginal harvest costs. Note that the indirect spillover effect still plays a role here in affecting the sign of dH*/dE*.

222 as the disagreement

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point. Harvest levels are determined

$IE~) [ QT(H, H*, E, E*) - Fr( E, E*)] [r*(

by solving

H*, H, E*, E) - tT*( E*, E)] ,

where ?F and +* are the returns to the home and foreign countries, respectively, at the disagreement point. The first-order conditions are

a%-* aT -Arr* aH*

-AT dH

= 0,

a++ + -AT aH*

= 0,

(12)

where AT = r - ?Y and AT* = rTT*- 77*. Now, once again, suppose that enhancement is initially chosen non-cooperatively, and consider the effects of a mutual agreement to change enhancement levels. The effect of small changes in enhancement is again given by (lo), with dH and dH * and interpreted as the change in harvest rates in the Nash bargaining solution. Evaluating at the non-cooperative level of enhancement levels, we have &r dH - -_---aH dE*

de dH* aH* dE*

de aE*

1

dE*,

(14)

where again, harvest responses are those which result from application of (12) and (13). In addition to the differing harvest responses, the form of (14) differs from that of (11) only in the presence of the additional term (ar/aH)(dH/dE*). From (12), ar/aH > 0, and hence the additional term is positive if an increase in foreign enhancement results in an increase in domestic harvesting in the cooperative harvesting solution, and it is negative otherwise. Once again, enhancement plays a strategic role: countries can attempt to influence the outcome of bargaining over harvest levels by strategically investing in enhancement. To gain more insight into the sign of (141, let us assume that the countries are symmetric. Then AZ- = Arr*, and aC/aH* = aC*/aH. Using (12) and these symmetry assumptions, (14) can be written as

(15) (+I

(+I

c-1

Since the Nash bargaining solution is Pareto efficient, an increase in foreign enhancement must result in an increase in combined domestic and foreign harvesting. Hence (15) has two opposing effects: from the domestic perspective, an increase in enhancement will directly lower harvesting costs, but will also result in increased harvesting, which induces higher costs. If there are no spillovers in enhancement, or if a reduction in enhancement locally affects marginal costs much more than total costs, then the indirect effect dominates, and the countries will agree to reduce enhancement levels.

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3. POLLUTION

In this section we briefly discuss the implications of our analysis for transnational pollution. l3 In the context of pollution, enhancement can be interpreted in several different ways. One possibility is that enhancement refers to research and development aimed at reducing the costs of pollution control. Another form of enhancement is lake cleanup. This will not alter the cost of controlling the flow of new effluent into the environment, but could reduce the damage caused by such effluent. For brevity, we restrict ourselves to considering R & D in pollution control technology. We assume that countries first invest in R&D and then play a non-cooperative game in pollution levels. The outcome of the research can be specific to a particular industry or region (no spillovers in R&D), or may be generally applicable to many technologies and regions (spillovers in R & D). We also assume that effluent levels of each country are strategic substitutes (Bulow et al. [4]): this is reasonable if marginal damage is increasing with total (domestic and foreign) emission levels. An investment in R&D will have two effects: a direct cost reducing effect, which will benefit the investing country by lowering the costs of pollution control, and a strategic effect, which measures the effect of domestic R & D on foreign pollution levels. As in Section 2, the strategic effect may be decomposed into two components: the commitment effect and the indirect spillover effect. The commitment effect shifts the investing country’s pollution reaction function inward. In response to this implicit commitment by the investing country to pollute less, the foreign country increases its emission levels, which tends to harm the investing country. Hence the commitment effect reinforces the free rider problem, leading to further underinvestment in R&D. The second component of the strategic effect is the spillover effect: a domestic investment in R & D may also lead to lower pollution control costs in the foreign country. This will shift the foreign pollution reaction function inward, reduce pollution originating from the foreign country, and benefit the domestic country. Hence, in this case, the spillover effect works against the free rider problem. It should be stressed that there are two types of spillovers in this example: pollution spillovers and spillovers in technology. These spillovers have opposite effects on enhancement. The stronger the spillover in pollution, the smaller the incentive to invest in the socially efficient amount of cost reducing enhancement, leading to the free rider problem. On the other hand, the stronger the spillover in cost reducing technology, the greater the incentive to invest in it, because there is a beneficial strategic effect as the foreign country uses domestic technology to improve pollution control. If we go beyond the present analysis, we would expect that if the home country were confronted with a menu of cost reducing enhancements, then it would tend to favor investments that transfer easily to the foreign country, so that foreign costs would be similarly reduced, and the home country would reap the benefits of a positive strategic effects. Finally, the possibility of strategic destruction of the environment also arises in the case of pollution if the net marginal benefit from enhancement is sufficiently 13A more

[71.

detailed

analysis

of international

pollution

using

this framework

can be found

in Copeland

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negative. As an example, politicians at home may make a political commitment to allow a new pollution-intensive pulp mill to open, especially if most of the pollution flows abroad. This increases control costs and pollution emissions at home, forcing the foreign country to respond by cutting back its own pollution. Home would gain form this if the benefit from reduced Foreign pollution offset the increased control costs and the increased damage from domestic pollution. 4. CONCLUSIONS In the presence of international externalities, there is a free rider problem which affects the incentives of governments to enhance fisheries and the environment. The possibility of such investments, however, considerably complicates the regulatory problem since they may be used strategically. If countries fail to coordinate their harvesting or pollution control policies, then enhancing investments can be undertaken with a view toward influencing the non-cooperative equilibrium. Moreover, bargaining over harvest or pollution levels will not eliminate this incentive, since enhancement can then be used to influence the bargaining solution. There can be no presumption that there will be under- or overinvestment in enhancement, since either case is possible, depending on how enhancement affects average and marginal costs. However, one can say the smaller the spillover in fisheries enhancement, the greater the likelihood of overinvestment in enhancement. In the case of investments in R & D to reduce pollution control costs, small spillovers in R & D tend to result in under investment. In addition, one cannot rule out the possibility of strategic destruction of the environment. That is, it may pay for countries to deliberately or passively invest in environmental destruction in order to obtain a strategic advantage in the fishing or the polluting game. This latter possibility suggests that the costs of non-coordination of environmental regulation may be more severe than previously thought. In practice, governments are unlikely to have all of the information assumed in this model and may have objectives which are inconsistent with social surplus maximization. Nevertheless, this analysis has important implications for policy. The main points of the paper are that in interjurisdictional fisheries or environmental regulation, governments have an incentive to make binding commitments about their future regulatory policies, that investments in enhancement are an indirect way of doing this, and that the strategic effects of these investments can be more important than the direct effects. In particular, when one government makes a such an investment, it may systematically change the behavior of another government. This will occur whether or not countries act to maximize social surplus. For example, suppose that the home and foreign countries share a lake, and that the foreign country sets an arbitrary water quality target of n parts per million (ppm) of some toxic substance. Suppose further that the outflow from the home country contributes xi ppm to the toxin level, and that the outflow from the foreign country contributes the remaining x2 ppm. If the home country makes a control cost reducing investment which reduces its toxin contribution to xi - (Y, then the foreign country can meet its water quality target by increasing its contribution to x2 -I- LY.The home country is made worse off by such an investment, since it bears the cost of the investment, but the pollution level in the lake is unchanged. Recognizing this, the home country may choose not to make the

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investment. The important point here is that it is not the free rider problem which inhibits the investment, but rather the strategic effect: the change in pollution by the foreign country induced by the home investment renders the investment unattractive to the home country. Thus strategic effects can be important even in very simple models, where governments use rules of thumb to guide regulatory policy. Strategic effects often seem to be particularly important as precursors to negotiations. For example, Canada’s harvesting and enhancement behavior after the U.S. Senate failed to ratify a salmon treaty in 1983 was motivated, at least in part, by an attempt to affect the resolution of the dispute (Munro and Stokes [19]). As problems involving transboundary externalities-such as maintaining the cod fishery in the North Atlantic and dealing with acid rain, ozone layer deterioration, and rain forest depletion-become more serious over the next few years, incentives to manipulate the negotiation process by making strategic investments are likely to become increasingly important.

REFERENCES 1. L. G. Anderson, The demand curve for recreational fishing with an application to stock enhancement activities, Land Econom. 59, 279-286 (1983). 2. L. G. Anderson, “The Economics of Fisheries Management”, Second ed. Johns Hopkins Univ. Press, Baltimore (1986). 3. J. A. Brander and B. J. Spencer, Strategic commitment with R&D: The symmetric case, Bell J. Econom. 14, 225-235 (1983). 4. J. Bulow, J. Geanakoplos, and P. Klemperer, Multimarket oligopoly: Strategic substitutes and complements, J. P&t. Econom. 93, 488-511 (1985). 5. K. S.-Y. Chan, The economic consequences of the 200-mile seabed zone, Canad, J. Econom. 11, 314-318 (19781. 6. J. M. Conrad and A. D. Scott, “Transfrontier Pollution: Cooperative and Non-cooperative Solutions,” Discussion Paper 88-30, Department of Economics, University of British Columbia (October 1988). 7. B. R. Copeland, “Endogenous Spillovers, R & D, and Transboundary Pollution,” Research Paper 90-5, Department of Economics, University of Alberta (February 1990). 8. A. K. Dixit, The role of investment in entry deterrence, Econom. J. 90, 95-106 (1980). 9. D. Fudenberg and J. Tirole, The fat-cat effect, the puppy-dog ploy, and the lean and hungry look, Amer. Econom. ReL’. 74, 361-366 (1984). 10. H. S. Gordon, The economic theory of a common property resource: The fishery, J. Polif. Econom. 62, 124-142 (1954). 11. V. T. Kaitala, “Game Theory Models of Dynamic Bargaining and Contracting in Fisheries Management,” Institute of Mathematics, Helsinki University of Technology (1985). 12. J. M. Karpoff, Suboptimal controls in common resource management: The case of the fishery, J. Polit. Econom. 95, 179-194 (1987). 13. Y. Kitabatake, Optimal exploitation and enhancement of environmental resources, J. Emiron. Econom. Management 16, 224-241 (1989). 14. D. Levhari and L. J. Mirman, The great fish war: An example using a dynamic Cournot-Nash solution, Bell J. Econom. 11, 649-661 (1980). 15. J. R. Markusen, Cooperative control of international pollution and common property resources, Quart. J. Econom. 88, 618-632 (1975). 16. G. R. Munro, The optimal management of transboundary renewable resources, Cunad. J. Econom. XII, 355-376 (1979). 17. G. R. Munro, The management of shared fishery resources under extended jurisdiction, Marine Resource Econom. 3, 271-296 (1987).

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18. G. R. Munro, “International Co-operative for Resource Management: Fisheries, ” Discussion Paper 88-08, Department of Economics, University of British Columbia (April 1988).” 19. G. R. Munro and R. L. Stokes, The Canada-United States Pacific Salmon Treaty, in “Canadian Oceans Policy: National Strategies and the New Law of the Sea,” (D. McRea and G. R. Munro, Eds.), Univ. British Columbia Press, Vancouver (1989). 20. J. F. Nash, The bargaining problem, Econometrica IS, 155-162 (1950). 21. A. D. Scott, Transfrontier pollution: Are new institutions necessary? in “Economics of Transfrontier Pollution”, (OECD, Ed.), OECD, Paris (1976). 22. J. Tirole, “The Theory of Industrial Organization,” MIT Press, Cambridge, MA (1988). 23. H. van Egteren, “Long-term Bilateral Monopoly and Transfrontier Pollution,” mimeo, Department of Economics, University of British Columbia (1988).