Cap and trade a sound market principle

Published in Standard-Examiner, July, 16, 2009

VIJAY K. MATHUR

The U.S. House of Representatives just passed cap and trade legislation limiting CO2 emissions. Opposition to this legislation misses the fundamental economic reason for cap and trade.

First, those who object to any kind of government regulation oppose the legislation because restrictions on CO2 emissions of industries using fossil fuels will impose significant cost on all of us. Second, those who are skeptics of climate change oppose it because they suspect that the legislation will not have much effect on global warming, especially when other large CO2-emitting countries like China, Russia and India will continue using fossil fuels in the foreseeable future to meet their energy needs.

Most Americans also would not be very enthusiastic about this legislation if they themselves do not see direct benefits from it. Many Americans do not realize that cap and trade policy is in their self-interest, is based upon market principles, and would directly benefit them more than the cost of such legislation.

Let me first discuss why government has to intervene by legislating CO2 emissions. There are two types of goods which we consume: private goods and public goods. Private goods benefit those who pay the price for those goods, for example, cars, food, and clothing. There is no leakage of consumption benefits to others who do not pay the price for private goods. Therefore, people who pay the price have property rights to those goods and their benefits. When property rights emerge and are enforced, markets will arise for those goods.

Private property rights can not be defined and enforced for public goods, since benefits of public goods can not be completely appropriated by persons who may be willing to pay the price. If goods are provided, it would also benefit those who do not pay for the goods. Therefore, there is no incentive for individuals to buy the goods and hence there will not be any supply of the goods. Private markets for the goods will not emerge. Hence, public goods have to be provided collectively; it implies that government has to be assigned the property rights, and it is the government that enforces and allocates those rights for all of us. For example, national defense is provided by the government because it is a public good, and our taxes support its provision.

Clean air is a public good and air pollution is a "public bad." Since government has the property right to the resource clean air on behalf of Americans, it can allow the use of that resource either by direct regulation of CO2 emissions (quantity control), or a tax-price per unit of CO2 emissions, or a combination of quantity control and a tax- price, or capping the quantity of emission rights and creating a market to regulate the allocation of rights (cap and trade). Self-interest of Americans demands that we all breathe clean air because our life depends upon it. Therefore, all of us must be willing to pay the price to obtain clean air.

Cap and trade policy is meant to create a market for CO2 emissions, where given emission rights are traded at a positive price. It is better than outright quantity control and better in many ways than a tax, because it removes uncertainty about the level of CO2 emissions, allows the market and its price mechanism to allocate rights, and as Paul Krugman argues, it is effective in achieving international cooperation. Also in a democracy, changing tax levels is time consuming if quantity goals are not met. Businesses that object to paying for emission rights want to be free riders. The public is paying for their use of the resource by tolerating depletion of air quality, property damages, and adverse health affects.
Monitoring and management costs will be minimized if this policy applies to major polluting industries. Cap and trade will cause prices of private goods to increase, but not by the full amount of the price of emission rights.

Competition in the private goods' markets will determine the extent of shifting the cost of emission rights to consumers. Substitutes emerge in the market to reduce price shifting. For example, the evidence in the case of gasoline shows that demand is very sensitive to price change in the long run, hence there is less shifting on consumers of any price increase.

Air quality is too precious a resource to waste. Utahns are frequently reminded of the scarcity of this resource with air pollution alerts. It is in the self interest of Americans to support cap and trade policy to obtain cleaner air and maintain healthy life styles.

Mathur is professor emeritus of economics at Cleveland State University, Cleveland, OH and adjunct professor of economics at Weber State University, Ogden, UT. His articles can be read at vijaykmathur.blogspot.com. He resides in Ogden.