Krugman Picks Up the Ball

After I started discussing cap-and-trade, Krugman saw the need to explain the economics behind it (not the best ‘popular’ explanation of an economic idea, maybe, but fair enough; from the top of his head, I guess).

Anyway, in Krugman’s picture it is fairly easy to see the equivalence of a cap on emissions, which limits the amount of pollution allowed, and a tax on emissions, which increases the costs of pollution and thus indirectly limits pollution. A tax would be set equal to the permit price, polluters would pollute until their marginal benefit of more polluting activity equals the tax, and the deadweight loss would be the same as in Krugman’s picture.

As Kolstad pointed out, a cap may be better because the market knows best how to price pollution (a bureucrat would need to know the marginal benefits curves of all polluters to set the right tax). The right (or ‘optimal’) cap level, however, needs to be set by a bureucrat, and that is not necessarily any easier. (‘Really low’ is perhaps good enough in the current situation, though.) Main point is, there’s a lot of uncertainty around these things; how much do we need to reduce pollution, how much should we spend, what are the benefits; it goes on and on.

Hat-tip: Env-econ.

UPDATE: Jim Roumasset makes a lot of sense over on Env-Econ:

Taxes are better we are told because they generate more revenue. In contrast, cap and trade is said to be better because its primary purpose is to control pollution, whereas the primary purpose of emission taxes is to raise revenue. I’m afraid that these propositions cloud the waters.

[…] In the world of perfect competition, controlling quantity with price (Pigouvian taxation) is exactly equivalent to controlling price with quantity via transferable and auctioned permits. This remains true even if there is uncertainty about marginal damage costs but not about the marginal benefits of emissions (Weitzman, 1974).

[…] The equivalence perspective is also useful for understanding the implications of taxes vs. permits for revenue. In the world of certainty, there are none! Again, a specific tax on all emissions is equivalent to auctioning the permits. Same price, same quantity, same revenue. […] cap and trade can be designed to match the revenue-raising implications of carbon taxes and vice versa.

So much for blackboard economics. In the real world we have uncertainty about both costs and benefits. Clearly it is possible to design hybrid schemes that are superior to either taxes or permits, but I don’t think we have strong results about the optimal hybrid scheme.

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