Economic Process of Cap and Trade
Cap and trade is a process of issuing permissions to private companies which pollute the air while producing goods. One of the examples is oil production. This page is not going to discuss the history of cap and trade, since the page on history is already available in wikipedia. However, the main purpose of this page is not only to present the way in which pollution permissions are assigned, but also to discuss how private companies trade the permissions between each other in economic basis. After the permits are issued to firms, firms are able to trade between each other those permits. In order to understand the process of trading permits, let us suppose a situation where two firms produce some goods whose production results in emissions. For simplicity, we will assume that these 2 firms produce oil. The firms in this example will be called: firm1 and firm2. The permits to pollute in fact give firms permissions to pollute air by a limited amount. Which means that in order to meet the conditions of the permissions they must now decrease production of oil. It is no surprise that reducing the amount produced negatively affects the economic conditions of the two firms. The main reason is that reducing the amount of goods produced reduces the revenue that could be attained through selling this good, which leads to an overall decrease in profits. The two firms can engage through the following scenario: if the cost of giving up one more unit of production is different to each of the firms. For example, if this cost is lower to firm 1 and higher to firm 2, the firm 1 will be willing to sell permits at a price which is higher than the cost of reducing production. Whereas the firm 2 will be willing to purchase the permissions only in the case when profits after purchasing permits and producing the amount will be positive. The two firms will end their trade when they face equal costs of reducing the production. As soon as the marginal of cost of reducing the production that 2 firms face will be equal to each other, there will no longer be a room for trade.