Note that at units of pollution abatement, the marginal costs for Firm
B exceed the marginal costs for Firm A—pollution abatement is more
difficult for Firm B than for Firm A. Suppose the two firms could agree on
a price at which to buy and sell permits. Who would buy, and who
would sell? Firm B, the high-abatement-cost firm, would rather buy
permits at and avoid having to reduce pollution at high marginal costs.
By buying X pollution permits from Firm A, Firm B ends up abating
units of pollution and reduces its costs by area (1). Firm A, the low-
abatement-cost firm, would rather sell its permits at and abate more
pollution at low marginal cost. By selling X permits to Firm B, Firm A ends
up abating units of pollution and increases its profits by area (2).
Therefore, with low-abatement-cost firms selling pollution permits to
high-abatement-cost firms, both types of firms are better off than when
they are subject to direct regulatory controls even though the total
amount of pollution abatement is unchanged. Since the marginal cost of
abatement is now equal across firms, we know from our earlier discussion
that the given amount of pollution abatement is being achieved at the
lowest possible cost.
With a cap-and-trade system, profit-maximizing firms will reduce pollution until their
marginal abatement costs equal the price of pollution permits. The costs of a given amount of
pollution abatement will be minimized.What determines the equilibrium market price for pollution permits? The
total supply of pollution permits is determined by the government policy
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