Application: The economics of emissions taxes and emissions trading ('cap and trade') schemes

One of the most important points to emerge from the foregoing analysis is that when there is policy uncertainty or ignorance regarding the position of marginal costs and benefit schedules, no policy will be perfect - all instruments will create welfare losses, unless they just happen by chance to be right. So the policy question is therefore: which policy creates the lowest welfare loss on average? Or: which policy creates the lowest expected deadweight loss?

The analysis in section 4.6.3 can be easily applied to the question of the relative desirability of emissions taxes and emissions trading schemes. The key is to realise that instead of thinking about production of a pollutant, we can also think in terms of pollution abatement (that is, the absence of pollution). The marginal social costs of pollution in Figure 4.6.1 are equal to the marginal social benefits of abatement - if producing something results in social costs, then reducing production of it results in marginal social benefits. Similarly, the marginal social benefits of pollution in Figure 4.6.1 are equal to the marginal social costs of abatement - after all, once again, if producing something results in social benefits, then reducing production of it must result in marginal social costs.

Once we realise this, then applying our previous results to the issue of emissions taxes versus trading schemes becomes trivially straightforward: the results just get switched around. An emissions trading scheme is equivalent to controlling the aggregate quantity of abatement - and therefore the aggregate level of pollution that is produced - at an economy-wide level, rather than at the individual firm level. And an emissions tax is equivalent to a tax on all firms. Hence, applying the results in section 4.6.3, we obtain the following:

  • • If the marginal social cost curve for production of a pollutant is relatively steep compared to the marginal social benefit curve, then an emissions trading scheme (aggregate quantity regulation) has a lower expected deadweight loss than Pigouvian taxation.
  • • Hence, if the marginal benefit curve for abatement is relatively steep compared to the marginal social cost curve for abatement, then an emissions trading scheme (aggregate quantity regulation) has a lower expected deadweight loss than Pigouvian taxation.
  • • If the marginal social cost curve for production of a pollutant is relatively flat compared with the marginal social benefit curve, then Pigouvian taxation has a lower expected deadweight loss than an emissions trading scheme (aggregate quantity regulation).
  • • Hence, if the marginal benefit curve for abatement is relatively flat compared to the marginal social cost curve for abatement, then Pigouvian taxation has a lower expected deadweight loss than an emissions trading scheme.

Hence, if the marginal cost of abatement curve is very steep and the marginal benefit of abatement curve is relatively flat, then an emissions tax is preferred on the grounds that it has a lower expected deadweight loss.2

 
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