Why Is Trading So Important in Cap and Trade? The Role of Economies of Scale and Productivity

Economists have long established the cost effectiveness of cap and trade (CAT) owing to the cost heterogeneity between firms. I offer a new value of CAT: cost reduction within firms owing to productivity improvement and economies of scale. Overcoming the unobserved-cost challenge, I extend the literature on production function and introduce a method to estimate economies of scale using data on output and input quantity. I combine this method with the difference-in-difference strategy to exploit the policy transition from non-tradable cap to cap and trade in Norwegian cod fishery to identify the causal impacts of trading fishing quotas. I find trading increased vessels' productivity and facilitated the realization of existing economies of scale: vessels acquired quotas, expanded their operation, and moved toward the minimum average cost levels. Vessels realized economies of scale by upgrading their sizes and going fishing more often. I decompose the output-based value of traded quotas and find economies of scale played a main role in the first few years after a big vessel acquired quotas. These results highlight (i) flexibility through tradability in environmental regulations can reduce production costs of a firm, (ii) cost reduction is gained by both boosting existing production factors and advancements beyond scale economies, and (iii) consolidation can be a sign of cost efficiency owing to economies of scale rather than market power abuse.