Environmental regulation in the car market varies widely across countries. Gasoline taxes still differstrongly between the US, EU and Asian countries. The link between environmental policy andinternational trade policy makes it difficult to understand what drives current policies. In this paper, westudy how governments can use gasoline taxes and R&D subsidies to reach strategic trade policyobjectives and environmental objectives.We use a two country model where each country has a home producer that sells cars in both markets.Each car generates emissions via its fuel consumption. Governments use a fuel tax to control pollution.Our model is a variant of the Ulph and Ulph (2007) model, which is solved in three stages. First, bothgovernments set gasoline. Second, each of the producers decides on fuel efficiency. Finally, producerscompete in a Cournot game in both markets. Extensions of the model include asymmetric parameters andthe introduction of a subsidy on R&D costs for fuel efficiency.The numerical simulations show encouraging insights. Our theoretical model is able to explaindifferences in tax policies as a result of market structure, spillovers in R&D and pollution valuation.Another interesting result is that a subsidy on R&D can only be welfare improving if governmentscooperatively set optimal policy measures.
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