Question

In: Economics

With the aid of diagrams, write a short essay on the use of Cap and Trade...

With the aid of diagrams, write a short essay on the use of Cap and Trade markets (a.k.a. tradable allowances) to deal with pollution problems.

Solutions

Expert Solution

To curb the pollution problem Cap-and-Trade method is popularly used. Cap is like the upper limit on the greenhouse gas emissions. And if any company exceed this cap, it has to pay penalties. On the other hand Trade is like a market for companies to buy & sell this allowances that permit them to emit only a certain amount. Trading acts like a strong incentive for the companies to save money by cutting emissions.

The diagram below shows the cap & trade. So there is the limit that is set by the government, vertical cap line (named “cap”). The abatement cost to the low abatement cost firm (green ) is equal to area C. The abatement cost to the high abatement cost firm (blue) is D + F + G + K.

Suppose the high cost firm (blue) might have a permit than pay those high costs. If it recognizes that its marginal abatement cost is more than the marginal abatement cost of the low cost firm (green) it could propose a trade.

We see the blue line over area D, F & G as a demand curve for permits and the green line is a supply curve for permits. Anywhere in between the blue and green line is a permit price that is mutually agreeable between both firms. Therefore, trading reduces overall abatement costs by area D + F.

Thereby resulting in the efficient abatement level is of e* and the abatement cost to polluting firm is also minimized.


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