Source: Homework 6, Prof. McLeod, Penn State
Difficulty: Intermediate
Prerequisites: Concept of externalities, marginal cost, and the idea that firms minimise costs.
Big picture: Tradeable (or marketable) pollution permits are a market-based approach to reducing pollution. Instead of telling each firm exactly how much to cut, the government caps total pollution and lets firms trade permits so that abatement happens where it is cheapest. This topic sits within the externalities and market failure unit of intermediate micro. You need to understand why trading permits lowers total abatement costs compared to a uniform standard.
When two firms have different marginal abatement costs, they can trade pollution permits so the low-cost firm does more of the cleaning and sells spare permits to the high-cost firm. Total pollution stays at the cap, but the combined cost of getting there drops. The firm with lower cleanup costs sells permits; the firm with higher cleanup costs buys them.
Pollution permit (emission permit, allowance)
A government-issued right to emit one unit of pollution. The total number of permits equals the pollution cap.
Think of it as a ticket that lets a firm pollute one unit. No ticket, no pollution.
Marginal abatement cost (MAC)
The cost of cleaning up one additional unit of pollution. Typically rises as a firm cleans more, because the cheapest reductions are done first.
In simple terms, this is how much it costs the firm to scrub away the next unit of its emissions.
Cap-and-trade
A system where the government sets a total pollution cap by issuing a fixed number of permits, then allows firms to buy and sell those permits. Firms that can clean cheaply sell permits; firms that find cleaning expensive buy them.
Cost-minimising allocation
The distribution of abatement across firms that achieves the pollution target at the lowest possible total cost. Achieved when the marginal abatement cost is equalised across all firms.
Two firms, A and B, each produce 6 units of pollution.
Government wants total pollution to drop from 12 to 6, so it issues 3 permits to each firm.
Without trading, each firm must clean up 3 units (from 6 down to 3).
Firm A's MAC for units 1 through 6: $6, $14, $25, $40, $60, $90.
Firm B's MAC for units 1 through 6: $35, $70, $120, $180, $280, $390.
Firm A is far cheaper to clean than Firm B at every level.
Firm A's cost: $6 + $14 + $25 = $45.
Firm B's cost: $35 + $70 + $120 = $225.
Total cost: $45 + $225 = $270.
The cheapest abatement overall comes from having Firm A do more cleaning and Firm B do less.
Compare the MACs: Firm A's 4th unit costs $40, its 5th costs $60, its 6th costs $90. Firm B's 3rd unit costs $120, its 2nd costs $70, its 1st costs $35.
The efficient outcome: Firm A cleans 5 units (costs: $6 + $14 + $25 + $40 + $60 = $145) and Firm B cleans 1 unit (cost: $35). Total abatement is still 6 units.
Alternatively, check: Firm A's 6th unit costs $90 and Firm B's 2nd unit costs $70, so cleaning the 6th unit of A is more expensive than B's 2nd. The optimum is where the next unit of A's cleaning costs roughly the same as the next unit of B's. Firm A cleans 5 (next would be $90), Firm B cleans 1 (next would be $70). Since $70 < $90, it might seem B should clean one more, but then A only cleans 4: A's 5th is $60 < B's 2nd at $70, so 5 and 1 is the right split.
Total cost with trading: $145 + $35 = $180 (savings of $90 versus no trading).
Without trading: each firm holds 3 permits and cleans 3 units.
With trading: Firm A holds 1 permit (pollutes 1, cleans 5) and Firm B holds 5 permits (pollutes 5, cleans 1).
Firm B buys 2 permits from Firm A.
Firm A sells 2 permits and does 2 extra units of cleaning.
Firm B buys 2 permits and avoids 2 units of cleaning.
The EU Emissions Trading System (EU ETS) is the world's largest cap-and-trade programme for carbon dioxide. Firms that can cut emissions cheaply (through efficiency upgrades or fuel switching) sell permits to firms where abatement is expensive, achieving the overall emissions target at lower total cost than uniform regulation would.
The US SO2 (sulphur dioxide) trading programme under the 1990 Clean Air Act is the textbook example. It reduced acid rain far more cheaply than command-and-control regulation was expected to.
Students often think trading permits increases total pollution. It does not. The total number of permits (and therefore total pollution) is fixed by the cap. Trading only changes which firm does the polluting.
A common error is assuming the government should just tell each firm to cut equally. Equal cuts are only efficient when both firms have identical marginal abatement costs, which is rare.
Students sometimes confuse the number of permits traded with the total number of permits. Permits traded is the difference between a firm's initial allocation and its final holding.
Some students think the firm that pollutes more is behaving badly. In a cap-and-trade system, buying permits and polluting more is the intended, efficient outcome for the high-cost firm.
Expect a table of marginal abatement costs. You will be asked to figure out who sells, who buys, how many permits trade, and what the total savings are.
The logic is always the same: rank all abatement opportunities from cheapest to most expensive, then have the cheapest ones done first, regardless of which firm they belong to.
Be able to explain in words why trading reduces total cost: it reallocates cleaning from high-cost firms to low-cost firms.
Know the difference between command-and-control (equal cuts) and market-based (permit trading) approaches.
True or false: Trading pollution permits increases total pollution. (False.)
Fill in the blank: The firm with ______ marginal abatement costs sells permits. (Lower.)
True or false: The cost-minimising allocation is achieved when marginal abatement costs are equalised across firms. (True.)
Fill in the blank: In the homework problem, Firm B buys ______ permits from Firm A. (2.)
Q: Each firm starts with 3 permits. Without trading, what is the total cost of abatement?
A: Firm A cleans 3 units ($6 + $14 + $25 = $45). Firm B cleans 3 units ($35 + $70 + $120 = $225). Total: $270.
Q: With trading, how should abatement be allocated to minimise total cost?
A: Firm A should clean 5 units and Firm B should clean 1 unit. Total cost: $145 + $35 = $180.
Q: How many permits are traded, and in which direction?
A: 2 permits are traded. Firm A sells 2 permits to Firm B.
Q: How much money is saved by trading compared to the no-trading allocation?
A: $270 – $180 = $90 saved.
Q: Why does Firm A sell rather than buy?
A: Firm A has much lower marginal abatement costs. It is cheaper for A to do extra cleaning and sell the permits than for B to do its own cleaning.
This connects to Pigouvian taxes, which are the other main market-based tool for correcting externalities. Both aim to internalise the external cost, but permits fix the quantity of pollution while taxes fix the price.
The Coase theorem is the theoretical foundation: if property rights are well defined and transaction costs are low, parties will trade to an efficient outcome. Tradeable permits are a structured version of this.
This also links back to the tax incidence material, since both topics examine how government policy changes market outcomes and who bears the cost.
Tradeable pollution permits, cap-and-trade, emissions trading, emission allowances, marginal abatement cost, MAC, cost-effective pollution control, permit trading, Coase theorem, Pigouvian tax vs permits, environmental economics, externalities, market-based regulation, ECON 102, intermediate microeconomics, Penn State, McLeod