2003b. Should consumers be priced out of pollution-permit markets?,Journal of Economic Education

Abstract: The authors present a simple diagrammatic exposition of a pollution-permit market in which both firms that generate pollution and consumers who are harmed by pollution are allowed to purchase permits at a single market price. They show that the market equilibrium is efficient if and only if the endowment of permits is equal to the efficient level of pollution. Furthermore, if consumers actually participate in the market, then the equilibrium is not efficient. Welfare can be improved by decreasing the endowment of permits and thereby pricing consumers out of the market. Key words: diagrammatic, efficiency, environmental policy, pollution permit markets, retired permits JEL codes: H41, Q25 The analysis of pollution-permit markets has traditionally focused on markets in which polluting firms trade permits amongst themselves. Such markets are one sided in the sense that only those who generate pollution, not those who are harmed by it, participate in the market. The welfare properties of one-sided pol-lution-permit markets are well known. These markets generally enable firms to attain aggregate emission-reduction targets in the least-cost manner, that is, the manner that minimizes total abatement costs (Montgomery 1972). As discussed in the extant permit-market literature, Montgomery’s result indicates that one-sided markets attain a type of productive efficiency. However, one-sided markets do not generally attain full social efficiency (minimization of the sum of abate-ment costs and damages) because total emission of pollution is equal to the total number of permits issued. Unless the permit-issuing agency has perfect informa-tion about the costs and benefits of pollution, it is likely to issue a socially inef-ficient number of permits. Many real pollution-permit markets are two sided in that they allow both pol-luters and pollutees to purchase permits. For example, in the Environmental Pro-tection Agency’s (EPA) acid-rain program, some market participants buy, and then do not use, pollution permits. An unused permit is said to be “retired.” Because the total availability of permits is fixed by the EPA, retiring a permit reduces the aggregate level of emissions. The EPA’s acid-rain Web pag