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Thursday, November 1, 2001

Maximum Cooperation Means Minimum Cost

How Transferable Pollution Permits Would Work

There are two big advantages to a pollution-control policy that relies on transferable pollution permits. First, firms can reduce pollution any way they choose, which will be the cheapest way possible. Second, firms will coordinate their reduction with one another so that the pollution target is achieved as efficiently as possible. In last month’s column, I explained how that coordination causes firms to adjust their pollution so that the greatest possible value is created by the allowable pollution. I now emphasize the other side of the same efficiency coin—reducing pollution to the allowable level at least cost, or the least sacrifice in value.

With pollution permits any firm (or any polluter) can legally discharge a specified amount of the designated pollutant only if it owns the required permits. As long as the firm’s marginal cost of pollution reduction is less than the market price of a permit it will reduce pollution rather than buy the necessary permits. As the pollutant is reduced, however, the marginal cost of reduction increases and at some point will become equal to the permit price.

Reducing pollution another unit below that point will cost more than buying a permit allowing the unit to be discharged into the environment. So the firm will reduce pollution until the marginal cost of reduction equals the permit price, with enough permits being purchased to cover the remaining pollution.

Thus the market price of pollution permits will tend toward the marginal cost of reduction. If the price is higher, firms will do more to reduce pollution so they can sell permits, driving the price down. If the price is lower than marginal reduction cost, firms will buy more permits so they can reduce less, driving the price up.

Because firms have to pay to pollute, they will be alert to cheaper ways to cut their discharges. When they are successful they will sell permits, causing their price to fall. But some firms will be facing increasing demands for their products, and they may have to pollute more to meet that demand even with better reduction techniques, which can increase their marginal cost of pollution control. These companies will be buying permits, increasing their price.

Firms communicate and cooperate through the price for pollution permits. The firm whose marginal cost of control increases communicates that information by bidding up the permit price a little bit with its purchases. Other firms respond to this information by selling a few permits. They act as if they are saying, “Another firm is telling us that its marginal cost of pollution control is higher than ours, so we will reduce our pollution a little more so it can reduce its pollution a little less.”

Conversely, the firm that can lessen its marginal cost of reduction communicates that information by putting downward pressure on the permit price by selling some permits. Other firms, by buying a few more permits, will be acting as if they are saying, “Another firm is telling us that its marginal cost of pollution control is less than ours, so with it polluting a little less we can pollute a little more and still keep pollution within the allowable limit.”

Since the price of permits is the same for all firms and it pays each to reduce pollution until its marginal cost of doing so equals that price, the marginal cost of control is roughly the same for all. This “equating at the margin” means that all opportunities to lower costs by reallocating pollution reduction among the firms have been exploited through a process of mutual adjustment.

The Evidence

The argument for pollution permits doesn’t tell us how much the cost advantage is relative to the command-and-control approach. Numerous studies have estimated the actual cost of pollution reduction for different air pollutants and locations under current EPA policy and then compared those costs to what the same reduction would have cost with a pollution-permit approach.

Those studies all show that the permit approach is cheaper than the command-and-control approach, usually much cheaper. For example, the reduction of particulate air pollution over St. Louis is six times more costly than it needs to be; the reduction of sulfur dioxide from the air over the four corners region of Utah, New Mexico, Colorado, and Arizona is 4.25 time more costly than it needs to be; and the reduction of nitrogen dioxide air pollution over Chicago is 14.4 times more costly than it needs to be.1 With pollution control costing tens of billions of dollars annually, the possible cost reductions would save tremendous amounts of money, with more done to reduce pollution.

Also important are the motivation and freedom that permit prices give each polluter to decrease pollution cheaply. In the few cases where permits have been experimented with the price of the permits is typically far lower than anticipated because polluters found ways to reduce pollution more cheaply than anticipated. When Wisconsin Power and Light started trading sulfur dioxide permits with Duquesne Light of Pittsburgh as part of a test case, the permits were expected to sell for $600 to $700 per ton of pollutant. They sold for around $150 instead.2

Reducing Bad Taxes

If the government sells off pollution permits, it will raise lots of money: tens of billions of dollars or more. This is not necessarily desirable. Sure, if the government has more money it can do more good things. The problem is (1) the government often spends money on things that destroy rather than create wealth (for example, imposing trade restrictions, enforcing silly regulations, controlling prices, and subsidizing unproductive activities), and (2) even if the money is spent to create value, it comes out of the private sector where it would have probably produced more value.

But there will be a net gain if the government uses the revenue from permits to reduce taxes by the same amount. Most government revenue comes from taxing desirable activities, such as working, saving, and consuming. This is the reason for the dead-weight cost of taxation that I explained in my March 2000 column. Reducing this revenue by substituting revenue from a tax (the sale of permits) on an undesirable activity like polluting would reduce the dead-weight cost of taxation without reducing government revenue. The danger here is obvious: Government will take the revenue from selling permits without reducing other taxes.


  1. These and similar studies are summarized in Tom Tietenberg, Environmental Economics and Policy, 3rd ed. (Boston: Addison Wesley, 2001), pp. 270–73.
  2. Gregg Easterbrook, A Moment on the Earth (New York: Viking Penguin Books, 1995), pp. 177–78.

  • Dwight R. Lee is the O’Neil Professor of Global Markets and Freedom in the Cox School of Business at Southern Methodist University.