We analyse the effects of transboundary pollution on trade patterns and welfare in a general equilibrium trade model. Pollution is modeled as a production externality: the production of a "dirty" good reduces labour productivity in the production of a "clean" good. The extent to which pollution crosses borders is parameterized and we present results illustrating the effects of transboundry pollution on trade patterns. Transboundary pollution can offset the benefits to the spatial separation of incompatible industries, both directly, through the pollution that continues to cross borders, and indirectly, through changes in the terms of trade. We find that the pattern of trade depends significantly on the extent to which the pollution crosses borders and on the relative strength of demand for the clean versus the dirty good. In addition, we analyse the patterns of gains and losses from trade for the different potential equilibria of the model. We present the results for identical countries, countries that differ by size, differences in the direction of pollution, and differences in the pollution intensity of polluting industries.

Some of the results are surprising. When countries differ in size, it is possible that a trading equilibrium will entail incomplete specialization by both countries, even though the production possibilities set is non-convex for both countries. When pollution flows in only one direction (as may be the case with acid rain), terms of trade effects may render a "downwind" country worse off with trade even though the pattern of trade entails complete elimination of the cross-border pollution.