What this lesson teaches
I can explain how taxes, subsidies, quotas, tradeable permits, provision, rules and public education correct market failure.
Syllabus 8843, 2.2.3(b). Microeconomic Policies: Policy measures including taxes and subsidies, quotas and tradeable permits, joint and direct provision, rules and regulations, public education in achieving efficiency and equity
Make a guess
Two firms must cut 10 tonnes of emissions between them. Firm A can cut cheaply; firm B finds it costly. With tradeable permits, who does most of the cutting?
- Neither, because permits let firms pollute as much as they like.
- Firm A, then sells its spare permits to firm B.
- Both cut exactly 5 tonnes, as the rules require.
Show the answer
Firm A, then sells its spare permits to firm B.
Cutting is cheaper for A, so it cuts more and earns money from B. The same total is cut at a lower total cost.
Tradeable permits cap total pollution and let firms that can cut it cheaply do more of the cutting.
A quota limits how much of an activity is allowed, such as how much a firm may pollute.
Tradeable permits set a total cap, then let firms buy and sell the right to pollute. A firm that can cut pollution cheaply cuts more and sells its spare permits. A firm that finds cutting expensive buys permits instead.
The total cut is the same, but it is achieved at a lower total cost.
Permits need accurate monitoring and a working market for permits. The cap also has to be set at the right level.
- Cap
- Fixes total pollution.
- Trading
- Cuts happen where they are cheapest.
| Approach | A cuts | B cuts | Total cost |
|---|---|---|---|
| Equal cuts | 2 | 2 | $20 |
| With trading | 4 | 0 | $8 |
Worked example: Two firms, one cap
Two firms must cut 4 tonnes of emissions between them. Firm A can cut at $2 a tonne; firm B at $8 a tonne.
- Equal cuts (2 tonnes each): cost = (2 x $2) + (2 x $8) = $20.
- With trading, A cuts all 4 tonnes: cost = 4 x $2 = $8.
- B pays A for permits at a price between $2 and $8, so both gain.
- The same 4 tonnes are cut at $12 less cost.
Watch out for this
Trading permits lets firms pollute more in total.
The total cap is fixed. Trading changes who cuts pollution, not how much is cut.
Check your understanding
Why do tradeable permits reduce the cost of cutting pollution?
- They let total pollution rise, so firms have less pollution to cut overall.
- The government pays firms for each tonne of pollution they cut.
- Firms that can cut cheaply do more cutting and sell spare permits.
Show the answer
Firms that can cut cheaply do more cutting and sell spare permits.
Right. Cuts happen where they are cheapest.