6.4 Tradable Pollution Permits and Market Failure Flashcards
What is a tradable pollution permit scheme?
A tradable pollution permits scheme is a system that combines government regulation and market forces to reduce pollution levels to socially optimum levels. In this scheme, a cap on the maximum level of CO2 allowed in a country is set by the government or international bodies, and permits are issued that allow firms to emit only to the level of the number of permits they have. Firms can then invest in green technology or reduce production to reach the permitted level, or buy excess permits from companies that have been more successful in reducing pollution than they needed to be.
What is the incentive for firms in a tradable pollution permit scheme?
In a tradable pollution permit scheme, firms have an incentive to invest in green technology for the long-term best interest of both the firm and society. This is because there is a price on each ton of CO2 emitted, and firms that invest in green technology have a good chance of having excess permits that can be sold on, increasing revenues. Firms that do not invest in green technology will need to buy permits in the market, which will increase demand and push up the price.
Pollution permit Diagram Analysis
- The level of permits is fixed in supply by the government at S1, a pollution cap that matches the socially optimum level of pollution at Q1*. Where demand for permits meets the supply of permits, a price of P1 is generated. Firms can then decide at this price whether to invest in green technology to reduce pollution or to buy excess permits at the market price. If the price of P1 is too low, firms will decide to buy permits in the market increasing demand for them from D1 to D2, pushing up the price from P1 to P2. For many firms the incentive will now change to investing in green technology.
- The fact that firms have this choice to reduce the cost burden on them is a large benefit compared to blanket regulation which may destroy the profitability of a firm and lead to unintended consequences of the firm shutting down or producing elsewhere in the world.
- If the scheme is successful over time with firms finding a way to efficiently become greener, the government can increase the cap and reduce the number of permits, shifting the supply curve from st to S2 and reducing quantity from 01* to Q2*, increasing the price of permits from P2 to P3, promoting an even stronger incentive to become green in production.
- In this way the socially optimum level of output can be reached solving the misallocation of resources and the overproduction issues. Allocative efficiency and welfare maximisation will result.
What is the disadvantage of regulation in terms of cost?
Cons/Evaluation
Regulation is very costly to enact. Administration of drawing up the regulations and getting them through the political process is costly as is the strict enforcement that is needed. There is a substantial opportunity cost involved therefore if surplus tax revenue does not exist. One can also question whether this is the most effective use of tax payers money, particularly if a less costly and more effective alternative policy could have been used instead. Once more if the government cannot afford to properly police the regulation, individuals would know that ignoring it is unlikely to be caught thus regulation will not work at all. If the cost of the regulation outweighs the gains in welfare, there will be government failure and a worsening of the misallocation of resources.
What is the difficulty in setting the regulation at the right level?
Cons/Evaluation
It is difficult to set the regulation at the right level. This is because measuring the value of the externalities is difficult in reality and because knowing the exact impact of certain regulations altering the behaviour of economic agents is imperfect. As a result, regulations might be set too lax where behaviour is not altered enough to bring quantity in the market to the social optimum. Another way of looking at this is that enforcement is weak where rational individuals (consumers or producers) ignore the regulation taking a perceived low risk action thus continuing to over or under consume/produce.
Con: Effectvive enforcement may not be possible
Cons/Evaluation
- If enforcement is weak, perhaps due to funding problems in government, rational producers will ignore the cap and take a perceived low risk action of polluting beyond their permitted level thus continuing to over pollute and excessively harm third
parties. - Another issue is whether it is possible to perfectly measure emissions and enforce this policy even if the government can fund both the technology needed to measure pollution and have enough officers on the ground to check emissions. If the technology is not perfect or firms use their own technology to reduce recorded pollution levels, pollution reducing to the social optimum is not a guarantee. The market failure may persist.
Con: Pollution is an international market failure that requires an international solution
Cons/Evaluation
- Pollution is an international market failure that requires an international solution. This is very important but extremely difficult to organise in reality. This is because it is always in one country’s best interest not sign the international agreement (such as the Kyoto Protocol) to embark in a pollution permits scheme.
- By not signing the scheme, firms are not burdened by higher costs yet citizens benefit from less pollution in the global air and a lower risk of the third party costs of climate change and rising sea levels due to the pollution reducing actions of countries who have signed up to the scheme.
- However if one country acts this way, other countries will feel unfairly held responsible to reduce pollution and may follow in not signing the agreement leading to pollution levels staying high across the globe and a significant and highly dangerous global market failure persisting in the long run.
