Tradable Pollution Permits

Returning to our example of the paper mill and the steel mill, let us suppose that despite the advice of its economists the EPA adopts the regulation and requires each factory to reduce its pollution to 300 tons of glop per year. Then one day after the regulation is in place and both mills have complied the two firms go to the EPA with a proposal. The steel mill wants to increase its emission of glop by 100 tons. The paper mill has agreed to reduce its emission by the same amount if the steel mill pays it $5 million. Should the EPA allow the two factories to make this deal.

From the standpoint of economic efficiency allowing the deal is good policy. The deal must make the owners of the two factories better off because they are voluntarily agreeing to it. Moreover the deal does not have any external effect because the total amount of pollution remains the same. Thus social welfare is enhanced by allowing the paper mill to sell its right to pollute to the steel mill.

The same logic applies to any voluntary transfer of the right to pollute from one firm to another if the EPA allows firms to make these deals it will in essence have created a new scarce resource pollution permits.

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