Why Emissions' Trading Is a Compromise between Pigovian Taxation Approach and Coase Theorem Approach - Essay Example

Emission trading and Pigouvian taxation are both approaches for reducing the emissions of greenhouse gases by providing incentives to firms and individuals. The Pigouvian tax involves the increase of the cost of production of carbon by the government, and the market determines the efficient quantity. On the contrary, the emission trade entails the regulation of the amount of emission by the government with a market-determined price of the carbon, based on the reallocation of polluting permits (Mabey 2001 p. 61). A Pigouvian tax effectively requires a polluter to internalize the cost of pollution by imposing taxes. This tax represents the cost to society, because of polluting the environment.

            The emission trade and the Pigovian approach can lead to the same reduction of pollutants. Emissions trade though is more advantageous, because the rights to pollute are given through a market to those who can make efficient use of them (Lane 2009 p. 145). For companies to trade their carbon credits, they have to reduce their emission. However, companies that generate higher emissions will have to buy more credits (Tiwari & Dubey 2010 p. 316).

            Coase's theorem describes the financial effectiveness of an economic allocation or the result in the presence of an externality. According to this theorem, if there is the possibility of externality, and there are the absences of transaction costs, bargaining can cause an efficient result without considering the first allocation of property rights. Poor definition of property rights can obstruct the coastal agreement (Callan & Thomas 2009, p.69).

The Coase theorem is the motivating principle behind emission trade because when there is the absence of transaction expenses, the involved individuals can negotiate a jointly beneficial result (Fine & Milinakis 2009 p. 101) Bargaining for a mutually helpful outcome can be expensive because the transactions costs are rarely zero. This concept is very important for market-based environmental policy. Reduction of transaction costs is a fundamental factor in facilitating people to use markets to handle and optimize pollution. Coase's theorem rests upon restraining assumptions like the small size groups and near-zero transaction costs. However, in practice, transaction costs are often prohibitive and the government has to intercede (Harris 2003 p. 39).

Two major approaches to environmental regulations are the use of command and control together with economic instruments (Gokcekus, Umut & LaMoreaux 2011 p.257). Command and control methods like pollution standards and targets are commonly found in developing and developed countries. Actors who fail to meet the levels that were specified by the standard are liable to sanctions. This is in contrast to economic instruments, which work by modifying markets and the incentives of agents to achieve a publicly desirable amount of pollution (Levin 2009 p. 741).

Market creation for the emission trade is an efficient method of lowering transaction costs. In reducing transaction expenses, it is important to define and enforce property rights so that a company that has a right to emit a certain amount per year can trade away some or all the rights, and will be held accountable for the amount that it emits. Therefore, if the company can make more money is selling the rights, it can do it, and the emissions will be reduced. It is vital to note that this trade creates value by putting the emissions rights in the hands of the people who value it (Free 2010, p. 763).

The purpose of Private Property Rights is to reduce transaction expenses. The presence of private property rights means that transaction expenses are above zero. If the transaction costs are zero, any property rights system will result in equal resource distribution, and the assumption of private rights is not necessary. Therefore, nil transaction expenses and private property rights cannot logically coexist. If transaction costs were high and the property rights were fully defined, it would lead to efficient results because the company owners would continue to emit and pay for the damages (Free 2010, p. 763).