Carbon leakage undermines the effectiveness of unilateral carbon pricing. Taxes on import-embedded emissions, like the EU’s CBAM, prevent leakage but their product coverage is limited due to strong information asymmetries. We propose an alternative policy (LBAM) that sterilizes carbon leakage without requiring information on foreign carbon intensities. In a quantitative trade model, LBAM tariffs significantly improve over the EU’s CBAM in terms of global emissions and EU welfare. Importantly, LBAM avoids large welfare losses among EU trading partners that would result if CBAM were extended to all sectors. Combining LBAM tariffs with equivalent export subsidies reinforces these advantages.
We demonstrate that the estimation of gravity equations of trade flows suffers from an omitted variable bias when firms are granular and behave oligopolistically. We show how to correct for this bias in the estimation of both firm- and industry-level gravity. Using French and Chinese export data, we find that the oligopoly bias leads to a substantial underestimation of the effects of distance on trade flows. In a calibrated version of the model, the welfare gains from a trade liberalization are found to be almost twice as large under oligopoly as under monopolistic competition.
Trade and industrial policies restricting critical inputs can inadvertently promote foreign downstream industries via a directed technological response. We provide evidence for this mechanism by examining rare earth elements (REEs) – critical manufacturing inputs with highly concentrated production and low substitutability. We show that China’s REE export restrictions in 2010 induced a surge in global innovation increasing REE input-efficiency and exports in REE-intensive industries. A quantitative trade model with Heckscher-Ohlin-based comparative advantage, directed technological change and input-output linkages rationalizes how input-supply restrictions induce REE-enhancing innovation and expand REE-intensive industries abroad. This directed technological response substantially mitigates foreign welfare losses.