Tradeable pollution permit to solve market failure

Tradable pollution permits

Firms will be allowed to pollute up to a certain amount and any surplus on the permit can be traded between firms

Advantages

1. Encourages firms to use green production methods

2. Government can make revenue as they can sell these permits to firms. This revenue can be used again to reinvest in green technology.

3. If firms exceed their permit they have to purchase more permits from firms that did not use their permits. Raises revenue for green firms who may invest in more green production methods

Disadvantages

1. Firms may pass the higher costs of production onto consumers which can increase inflation

2. There might not be technology that is good enough to measure how much pollution a firm produces

3. Imperfect info for government as they may set higher cap level which leads to Gov failure

4. Some firms may relocate to other countries where they can pollute without limits reducing their production costs

Diagram

The government sets a cap on pollution at the socially optimum level q* and issues tradable permits. This restricts output from q1 to q* reducing the overproduction and gets rid of the deadweight loss. However prices do increase.