Trading Pollution: How Pollution Permits Paradoxically Reduce Emissions

In an effort to reduce pollution, the government tried two policy prescriptions under the Clean Air Act Amendments of 1990. The first—command and control—mandated that each power plant lower its pollution by a determined amount. However, different firms face different cost curves and, because information is dispersed, policymakers don’t always know those costs. The second policy prescription—tradable pollution permits—empowered firms to use knowledge of their cost curves to buy or sell pollution permits as needed. Under this policy, the invisible hand of the market helped discover the lowest cost way of reducing pollution. 

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- [Narrator] When gasses
like sulfur dioxide

and nitrogen oxide
are emitted into the atmosphere,

they react with water, oxygen,
and other chemicals

to form sulfuric and nitric acid,
and when these acids precipitate,

we get acid rain.

Acid rain can kill trees,
plants, and fish,

as well as erode automobile paint,
buildings, and stone.

The Clean Air Act Amendments
of 1990 introduced a novel way

to combat acid rain --
tradable permits.

Here's how they work.

Let's consider two power plants
or factories that are polluters.

They emit this much polluting gas.

The government
could control pollution

by just commanding that all factories
install certain technologies,

like scrubbers.

Using this command
and control method,

suppose that pollution
would be reduced to this.

Okay, but now imagine
that one of the plants

can reduce pollution
at a lower cost than the other.

Perhaps it's newer
or it uses a different type

of coal or maybe there
is some other technology

for reducing pollution

that the government
didn't consider.

Or perhaps the product produced
in one of these factories

has a less polluting substitute
that we can easily switch to.

Ideally, we want
to reduce pollution here

where reducing pollution
has a low cost,

and less here,
where reducing pollution

has a high cost.

If we do this,
we can reduce pollution

by exactly the same amount
as before but we can do it

while wasting
fewer other resources.

Great, but wait.

Unfortunately, the government
doesn't know which plant

is the low cost plant.

Remember there are lots of ways
of reducing pollution,

lots of substitutes, and lots
of substitutes for substitutes.

No one person knows
all the trade-offs.

Information is dispersed.

So how can we draw
on this dispersed information

and harness the energy
of entrepreneurs to discover

the best ways to reduce pollution?

Instead of commanding
how to reduce pollution,

suppose the government issues
pollution permits --

rights to emit pollution.

One permit gives you the right
to emit say one ton

of polluting gases.

Pollution permits don't sound
very environmentally friendly,

but the government only issues
a limited number of permits,

and that equals the same
total reduced pollution

as under command and control.

So in the end, pollution
reduction is the same.

By allowing the permits
to be bought and sold,

the profit seeking self-interest
of power plant owners

is harnessed for the social good.

The owner of the power plant
with the low cost

for reducing pollution thinks,
"I don't have to use my permits.

I can reduce pollution
at my plant for less money

than I can get by selling
my unused permits

and make a tidy profit."

[business man] Oh yeah.

- Meanwhile, the power plant owner
with the high cost

wants to buy permits,
and is willing to pay a lot,

because it's cheaper to buy permits
than reduce pollution at high cost.

So the power plant
that can cheaply reduce pollution

sells permits, and the power plant
where it's expensive

to reduce pollution buys permits.

Both firms increase their profit.

In this way, the invisible hand
of the market gets us

to the ideal solution.

We reduce pollution more here,
where reducing pollution is cheap,

and less here, where reducing
pollution is expensive.

The total amount of pollution,
however, is reduced just as much

as with command and control,
but at a lower cost.

In fact, the tradable permit
approach worked so well,

it reduced air pollution
at a much lower cost

than any expert had anticipated.

Why should we care about the cost
of reducing pollution?

Spending less on reducing pollution
means that we have more to spend

on other goods.

But also, don't forget
the law of demand.

The lower the price of pollution
reduction, the more pollution

we want to reduce.

Tradable permits
uses the invisible hand

of the market to discover
the lowest cost way

of reducing pollution
and that's good for everyone.

If you want to test yourself,
click "Practice Questions."

Or, if you're ready to move on,
just click "Next Video."

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