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The paper analyzes the complex interactions between intra-industry trade (IIT) and the environment by extending the Krugman's model of monopolistic competition and trade. Both autarky and free trade equilibria are derived, where output, prices, number of varieties and pollution are determined endogenously. It is found that a unilateral increase in the exogenous
environmental tax by a country leads to a fall in output, increase in number of varieties and fall in aggregate pollution in that country. With IIT, if Home is a net exporter, an increase in environmental stringency by Home leads to a fall in its export-competitiveness and output of each variety (scale effect) on the one hand, thus reducing its export demand and raising its
import demand. On the other hand, higher prices and lower cost of production induce entry of rms in the Home industry (selection effect), reducing its import demand. Consequently, the aggregate effect on imports remains ambiguous, and the rst-order scale effect on exports dominates the second-order effect on imports implying a rise in Home's share of IIT in its overall
trade with Foreign. The opposite holds true in case Home is a net importer, where the share of its IIT falls to give way to more inter-industry trade with Foreign. Furthermore, the impact of a rise in environmental tax on aggregate welfare comprises the following effects: a fall in aggregate output (scale effect), rise in number of varieties (selection effect), lowering of aggregate
pollution and rise in environmental tax revenue in autarky. With free trade, two additional effects, namely, changes in the level of exports and imports, will also arise. The overall change in aggregate welfare, in both autarky and free trade, depends on the relative strength of these effects, and is in general ambiguous.
