The government has decided that thepareto optimal amount of CO2 is 100 cubic ton

Question

The government has decided that thepareto optimal amount of CO2 is 100 cubic tons peryear.

Currently there are 20 firms and theyproduce a total of 150 cubic tons per year. Some of these15

firms pollute more than others. Thegovernment is going to reduce CO2 levels by acap-and-trade

policy. In this policy, the governmentwill issue 100 permits for 1 cubic ton of pollutioneach.

Whoever owns this permit gets topollute 1 ton. If a firm owns 3 permits then it gets to pollute 3tons.

The government is considering twoallocations for these permits. In the first allocation,the

government will auction the 100permits to the highest bidders. In the second allocation,the

government will give each of the 20polluting firms 5 permits each. Firms may then sell theirpermits

or buy the permits of otherfirms.

a. Explain the CoaseTheorem.

b. For this example, explain why themethod the government chooses has no effect onefficiency.

c. Explain how the method thegovernment chooses does have distributioneffects.

Explanation / Answer

a.) The Coase Theorem: With well defined property rights andno transactions costs, the allocation of resources is invariant tothe assignment of property rights. Furthermore, theallocation is efficient. Essentially, this is implying that in low to no transactions costsettings, people will negotiate in such a way that resources willalways move to the highest valued use - so long as there is anestablished property right. If there wasn't a right, no onewould have any bargaining power. b.) So, in this example, assuming no transactions costs... In scenario 1 the government basically has the proper right, andthey are negotiating with the firms via an auction. Whoevervalues the permits the most will win the auction - thereforetransferring the permits to the highest valued use - and thus thisis efficient. In scenario 2 the government assigns the property rights to all ofthe firms, equally. We can then assume that, because somefirms value the permits more than others, there are gains fromtrade to exploit, and therefore the firms will negotiate in orderto exploit it. If one firm (firm 1) values a permit more thananother one (firm 2), he simply needs to pay them at leasttheir valuation. Because firm 1 values it more, he is willingto pay at least that price, and firm 2 is willing toaccept at least that much. The price may benegotiated, but ultimately the gains from trade is exploited andthe resource moves to its highest valued use. Thus, this isequally efficient. c.) The decision made has distributive effects because if thegovernment gives the permits out equally (scenario 2), then theyare transferring resources to everyone - and even if they selltheir permits, they are now better off than they were before. If the government uses scenario 1, only those who win the auctionsreceive the resources, and the rest receive nothing. Bothscenarios, as outlined above, are equally efficient because theymove resources to their highest valued uses, but scenario 2 is moreefficient because of the way resources are moved around before theyend up at their highest valued use.

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