This document provides an overview of tradable pollution permits (also known as cap and trade systems). It defines tradable pollution permits as legal allowances for firms to pollute up to a certain annual level. The government sets the total pollution limit to correspond with socially optimal production levels. Firms can trade permits, allowing flexibility in choosing to cut pollution themselves or buy permits from less costly firms. This market-based approach reduces total pollution at lowest cost while creating incentives for polluters to invest in cleaner technologies. Examples of cap and trade systems discussed include the EU Emissions Trading Scheme covering over 11,000 industrial installations.

1. Tradable
Pollution
Permits (Cap &
Trade)
Lower 6th Micro
Government Intervention

2. Intro and
Analysis of
Tradable
Pollution Permits
Tradable Pollution Permits
Mr O’Grady

3. Tradable Pollution Permits
Definition: legal allowances for firm to pollute up to a certain level each year
Firms exceeding their permitted level can face heavy fines
The government sets the total level of pollution permitted to correspond with the level of
pollution expected at the socially optimal level of production
Firms must therefore cut their output (towards QSO), or improve their production processes
(increase the quantity which QSO occurs)
Combats negative production externalities
The importance of tradability:
The ability to trade permits gives each polluter has flexibility to choose whether to cut
pollution (through cutting output or investing in greener production) or to buy more permits
Firms can therefore choose what is most cost efficient to them, improving efficiency
If firms couldn’t trade, both, firms which found cutting pollution to be cheap and firms which
found it to be expensive, would have to cut their individual level of pollution.
However, through trade both firms can benefit:
The low cost firm: cuts pollution further, sells its now excess permits at a profit
The high cost firm: buys extra permits of the low cost firm, at a price lower than the cost of cutting
pollution itself
Result: total pollution is still reduced to the desired level, but in the least costly way possible

4. S
Quantity
Price
Analysing the market for Permits:
Supply of permits: The government issue a fixed
amount of pollution rights in the economy (Q0).
Therefore, supply is perfectly inelastic as it cannot
change.
Demand for permits: A firm would be willing to pay for
a permit provided that is cheaper than cutting their
pollution by a corresponding amount
Equilibrium: The price of a permit equals P0 (S=D)
Firms buy permits for P0 if this is cheaper than cutting their
pollution
Firms sell permits for P0 if this price is higher than cutting
their pollution
An increase in demand for pollution permits: Demand shifts from D to D1
Increased price of tradable permits results (P1), but the same quantity trades
Firms will either pay more for the right to pollute or they will be incentivised to reduce pollution.
Those who do not need their permits can sell them on the market.
Key Example: The EU has implemented Emissions Trading Scheme (ETS)
The ETS covers more than 11,000 factories, power stations, and other installations
D1
D
P0
Q0
P1
= Q1

5. Pros and Cons
of Tradable
Pollution
Permits
Tradable Pollution Permits
Mr O’Grady

6. Pros and Cons of Tradable Pollution Permits
Pros:
Internalise the external cost: Firms have an incentive to invest in cleaner technologies
whenever they find the cost of investment is less than the revenue that they would receive
from selling their permits
Prioritise important industries: Permits are rationed to firms producing the most
valuable/profitable goods. Allocatively efficient for society.
Gov. Revenue: Selling permits raises funds that can be used to clean up the environment
Dynamic: Permits can be gradually cut over time as part of a coordinated plan to cut overall
pollution
Provides commercial flexibility: firms can bank their excess permits for use in future years
Cons:
Recessions: If production falls, firms pollute less and there is a glut of cheap permits. Limited
incentive for firms to cut their emissions.
Complex: Difficult to determine how many permits to allow.
Example: at the start of ETS, permit prices were driven near zero as the EU misjudged how many to offer
Hard to punish cheaters: Difficult and costly to measure how much a firm is polluting
Transaction costs: Firms waste time and resources in buying and selling permits
International competitiveness: firms move production abroad, where it is cheaper to pollute

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