Scandinavian Working Papers in Economics

Discussion Papers,
Norwegian School of Economics, Department of Business and Management Science

No 2010/2: Trading for the Future: Signaling in Permit Markets

Bård Harstad () and Gunnar S. Eskeland ()
Additional contact information
Bård Harstad: Kellogg School of Management, Northwestern University, Postal: Northwestern University, 2001 Sheridan Rd, Evanston, IL 60208, USA
Gunnar S. Eskeland: Dept. of Finance and Management Science, Norwegian School of Economics and Business Administration, Postal: NHH , Department of Finance and Management Science, Helleveien 30, N-5045 Bergen, Norway

Abstract: Permits markets are celebrated as a policy instrument since they allow (i) firms to equalize marginal costs through trade and (ii) the regulator to distribute the burden in a politically desirable way. These two concerns, however, may conflict in a dynamic setting. Anticipating the regulator's future desire to give more permits to firms that appear to need them, firms purchase permits to signal their need. This raises the price above marginal costs and the market becomes inefficient. If the social cost of pollution is high and the government intervenes frequently in the market, the distortions are greater than the gains from trade and non-tradable permits are better. The analysis helps to understand permit markets and how they should be designed.

Keywords: Tradable permits; time inconsistency; the ratchet effect; rent-seeking; plan vs. market

JEL-codes: Q50

47 pages, March 26, 2010

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