Public Policy: Using Market-Based Approaches - Department for ...

However, the conditions required for this sort of trade are very restrictive and
include well-defined property rights, low bargaining costs, perfect competition, 42
perfect information and the absence of wealth and income effects. These
conditions rarely hold in the real world. For example, although the source of air
pollution may be easy to identify, the victims are likely to be numerous.
Reaching a solution between many individuals will not be straightforward, and
any solution may be vulnerable to ‘free rider’ problems: any individual could
withhold his contribution, hoping that everyone else will contribute and he will
benefit from their actions. Such a solution would therefore be difficult to enforce
without government intervention.
Nevertheless, the intuition that private sector agents can arrive at an equilibrium
outcome through bargaining, whatever the initial assignment of property rights, is
central to the idea of marketable permit schemes. 43 Under marketable permits, the
government sets a limit to the total amount of pollution allowed, and then assigns
permits to firms which give them the right to produce set amounts of the pollutant.
Firms are then allowed to trade permits among themselves, so that those who
pollute less than their quota can sell the remainder. Firms will therefore sell
permits as long as the marginal cost of reducing pollution is less than the market
price of the permit. In equilibrium, therefore, every firm will pollute at a level such
that the marginal cost of pollution reduction equals the market price of the permit.
BENEFITS
Section 7 – Market-Based Mechanisms
Evidence suggests that this mechanism can achieve the desired objective with
lower compliance costs and greater incentives for innovation than under the
command-and-control alternative. 44 The use of marketable permits offers two
main benefits compared with non-tradable quotas. These are that it allows
pollution to be reduced at the lowest cost and that it allows the market to
determine the appropriate price for pollution.
42 Perfect competition is required for an efficient outcome to obtain that is independent of initial property right
allocations. If one party to the trade enjoys bargaining power as an extension of market power, for example, an
inefficient agreement is likely to be reached. Coase (1960) argued that assuming zero transactions costs was a
suitable proxy for perfect competition, but this assumption does not preclude the existence or exercise of such
bargaining power. Furthermore, firms operating in anything other than a perfectly competitive market will not
necessarily face the same incentives to reduce inefficiency and are therefore unlikely to exhaust the entire gains
from trade.
43 Montgomery, D. (JET, 1972) ‘Markets in Licenses and Efficient Pollution Control Programs’, Journal of Economic
Theory 5.
44 Incentives for innovation are likely to be stronger than under a direct control or technological standard approach
because firms can expect to keep some or all of the gains from innovation in the form of reduced abatement
costs and payments for permits. For example, Burtraw (2000) looks at how the sulphur dioxide allowance market
in the US affected the nature and pace of innovation. He finds evidence that the incentives and flexibility
provided by the scheme led to organisational innovation at firm, market and regulatory level as well as process
innovation by electricity generators and upstream fuel suppliers.
See also Downing, P. and L. White (1986) ‘Innovation in Pollution Control’, Journal of Environmental Economics
and Management 13(1); Jung, C, K.Krutilla and R. Boyd (1996) ‘Incentives for Advanced Pollution Abatement
Technology at the Industry Level: An Evaluation of Policy Alternatives’, Journal of Environmental Economics and
Management 30(1); Milliman, S. and R. Prince (1989) ‘Firm Incentives to Promote Technological Change in
Pollution Control’, Journal of Environmental economics and Management 17(3).
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