Tradable pollution permits, also referred to as emissions allowances, represent an important innovation with a number of potential advantages over other approaches. In some respects tradable permits are like a CAC approach because emissions are
1Martin L. Weitzman, "Prices vs. Quantities," Review of Economic Studies 41 (1974): 477-491.
limited to a predetermined quantity (permits are issued for only a limited level of emissions), but they also have the advantages of a pollution tax because the permits can be bought or sold in markets, which creates incentives at the margin very similar to a pollution tax.
To illustrate how a tradable pollution permit scheme would work, consider again a situation with two polluters, firms 1 and firm 2, who pollute 100 tons of SO2 per day in the absence of any controls or incentives. The two firms have different abatement costs, as indicated by their marginal abatement cost curves in figure 10.4. If a limit of 120 tons of pollution is desired, government can issue permits for that amount. Both firms will need to either reduce pollution or acquire permits. We can evaluate what would happen by recognizing that this situation would create market forces that tend to move toward equilibrium. The supply is fixed and so the supply curve can be represented as a vertical line at Q = 120. The demand curve is the (horizontal) sum of the demands from each firm. Since firms would rather not incur abatement costs, their demand (or willingness to pay) for permits is identical to their MAC curve. If we add the two firm's demand (MAC) curves, we get the "kinked" demand curve for permits indicated by the dotted line.
If permits were free, each firm would want permits for 100 tons, or a total demand of 200. With only 120 available, excess demand would push up the price until demand equals supply. In figure 10.4 this will occur at price P, where demand equals the predetermined supply of 120 tons. Also from the diagram we can see how many permits each firm will acquire by looking at the individual demand curves. At a price of P, the demand by firm 1 is 70 and the demand by firm 2 is 50. Why do we expect firm 1 to end up with more permits? The reason is that firm 1's MAC is higher, and so it is more willing than firm 2 to pay for permits rather than incur its somewhat higher abatement costs. This is how the permit scheme achieves efficiency; the cost of buying a permit or the opportunity cost of not selling a permit generates the same kind of decentralized incentives as an emissions tax.
Tradable permits differ from pollution taxes in several important respects. Unlike a pollution tax, the quantity of pollution under a permit scheme is predetermined and fixed. The marginal
■ FIGURE 10.4 Tradable permit market allocation cost of polluting (the permit price) is not set but is instead determined by market forces. In this sense tradable permits substitute price uncertainty for quantity uncertainty.
Another attribute of permits is that they can be much less costly to firms than a pollution tax if government decides to given them away for free rather than auction them off. One of the main objections of polluting firms to pollution taxes is that in addition to incurring abatement costs, they also have to pay a tax on the remaining pollution they produce. As was indicated, these transfers from polluters to government do not represent social costs, but they do represent private or industry costs, which can affect the competitiveness of firms, for example, in international markets. With pollution permits, government has the option of just giving the permits away (e.g., equal amounts to each firm, or based proportionally on each firms historical emissions). Firms, of course, have a strong preference for a permit giveaway, and you will not be surprised to learn that there are few examples where firms are required to bid for permits from government.
Two additional aspects of tradable permits should be mentioned here. First, in a dynamic economy, we want policies that adjust to economic changes in a way that will maintain the initial policy goal. For example, in an inflationary economy, a nominal pollution tax may lose its incentive effects if the real (inflation adjusted) tax rate declines to levels that do little to discourage pollution. By contrast, a fixed number of pollution permits will let market forces push prices upward in response to inflation so that the market will always clear at the same pollution level. In a growing economy, too, the number of polluting firms may increase. Under a pollution tax policy the amount of pollution will also increase if a larger number of firms respond similarly to the pollution tax. By contrast, with a pollution permit scheme, the amount of pollution will stay the same. An increase in the number of polluters will bid up the price of permits, which in turn will encourage more abatement by each firm in order to keep emissions at the fixed level.
Finally, however, tradable permits often raise concerns that can be raised for any market: will the market be competitive, or will there be opportunities for one of a few firms to exert market power in a way that will be distorting or unfair? This is a real concern, and one that should be examined carefully, especially in cases where a small number of firms may be competing for permits. Indeed, in the case of a growing economy as just discussed, if permits are allocated (given away annually) on the basis of historical emissions, then new firms will be at a cost disadvantage because the pollution policy has created a barrier to entry.
Tradable permit policies are still relatively new, but the success of the SO2 tradable permit program in the United States (see box 7) has raised awareness and expectations for them in the future. Already there are a number of other emissions trading programs in Canada, the European Union, Chile, Singapore, and the United States for other air pollutants, ozone-depleting substances, particulates, and nitrous oxide.2
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