What is a cap-and-trade policy? (Be certain to mention marketable permits.) Suppose there are two firms in an area, each emitting tons of sulfur

Question

The government decides on a target level of 200 tons of sulfur, and gives each firm a permit to emit 100 tons of sulfur. Suppose Firm A is very efficient and can reduce pollution by 100 tons with an abatement cost of $500. Firm B has an older plant, so it will cost Firm B $1,000 to reduce emissions by 100 tons. What will occur with marketable permits?

Answer 1

A cap-and-trade policy involves the government issuing marketable permits to firms that allow a firm to emit a certain amount of pollution. Firms are allowed to buy and sell these permits.
Firm A can reduce pollution by 100 tons with an abatement cost of $500, while it costs Firm B $1,000 for the same reduction. Marketable permits can be bought and sold. Hence Firm A can reduce its emissions at the cost of $500 and sell its permit to Firm B for some price higher than $500. Firm B has an incentive to buy the permit for any price less than $1,000 rather than reduce its emissions at the cost of $1,000. Hence with marketable permits, Firm A will sell its permit to Firm B.