Cap and Trade under Transactions Costs and Factor Irreversibility
We study production capacity utilization and emission permit utilization in a model where firms jointly produce a valued good and an environmental bad, pollution. Firms are ex ante identical but experience random productivity shocks after factor employment. A regulator imposes a cap-and-trade policy to control pollution emissions. Trade in emission permits entails transactions costs which follow two specifications: constant per unit trading costs or fixed trading costs. Under constant per unit trading costs, the equilibrium outcome depends only on the total unit trading costs; the incidence of costs borne by buyers and sellers does not matter. Under fixed costs, both buyers' and sellers' costs matter. Under proportional costs permit trade always occurs, with either full or partial market clearing, as long as the total trading costs are below the permit trade surplus. With fixed costs, trade is either partial or non-existent. The implication is that firms fully utilize their production capacity for a range of proportional trading costs; capacity is never fully utilized under fixed costs. Under proportional costs, trade is impeded most, even with small costs, when the emission cap is either relatively high or low. There exists a non-monotonic relationship between the aggregate emissions cap and a lower bound for trading costs that obstruct or preclude trade. Under fixed costs, a similar relationship between emission cap and the cost threshold that precludes trade holds only if the output variance is exogenously fixed. Otherwise, the higher the emission cap the higher is this cost threshold. In contrast to proportional costs where capacity utilization decreases with productivity variance, the result is the opposite under fixed costs.
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- Stavins Robert N., 1995. "Transaction Costs and Tradeable Permits," Journal of Environmental Economics and Management, Elsevier, vol. 29(2), pages 133-148, September.
- Singh, Rajesh & Weninger, Quinn, 2012. "Harvest Efficiency and Discards under Harvest Uncertainty and Trading Frictions," Staff General Research Papers 35039, Iowa State University, Department of Economics.
- Heindl, Peter, 2012. "Transaction costs and tradable permits: Empirical evidence from the EU emissions trading scheme," ZEW Discussion Papers 12-021, ZEW - Zentrum für Europäische Wirtschaftsforschung / Center for European Economic Research.
- Lata Gangadharan, 2000. "Transaction Costs in Pollution Markets: An Empirical Study," Land Economics, University of Wisconsin Press, vol. 76(4), pages 601-614.
- Montgomery, W. David, 1972. "Markets in licenses and efficient pollution control programs," Journal of Economic Theory, Elsevier, vol. 5(3), pages 395-418, December.
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