Question

1. If society wishes to reduce pollution, why is it more efficient to tax the pollution rather than set a limit on pollution?
2. If the government issues tradeable pollution permits (ie., a cap-and-trade policy), does it matter for economic efficiency (social welfare) whether all firms receive the same amount of permits, or whether some firms receive more permits than others?

Answer 1

If the society wishes to reduce the pollution it is better to tax the pollution rather than setting a limit on pollution.Pollution is a negative externality which needs to be controlled.By taxing the pollution the polluters will reduce the emissions to the minimum level but while setting a limit polluters will always have a tendency to go beyond this threshold limit as they do not have to make any payments for the extra emissions.while taxing the pollution the marginal cost for polluting the environment will increase and the polluters will resort to minimum emission of pollutants.An example for taxing pollution is carbon tax.When the polluters starts emitting carbon beyond a particular level the polluters have to pay taxes
When the government issues tradeable pollution permits it will increase the social welfare as the firms will be allowed to pollute the environment only up to a certain limit.Not all firms are provided with the same number of permits it depends upon the extend of pollution each firms produces.Whenever firms produces less pollution than permitted it can sell its permits to other countries producing more pollutants.