Tradable Discharge Permits:
A Student-Friendly Game
Amy W. Ando*
[email protected]
ph: (217) 333-5130
fx: (217) 333-5538
Donna Theresa J. Ramirez*
[email protected]
fx: (217) 333-5538
Mailing address for both authors:
Dept. of Agricultural and Consumer Economics
University of Illinois at Urbana-Champaign
326 Mumford Hall
1301 W. Gregory Dr.
Urbana, IL 61801
* Amy Ando is an Assistant Professor in the Department of Agricultural and Consumer
Economics at the University of Illinois at Urbana-Champaign. Donna Ramirez is a Ph.D. student
in the same department.
Abstract
An in-class game can be used to improve students’ understanding of how a TDP program might
work. There are, however, tradeoffs one must face in designing such a game. An exercise might,
in theory, demonstrate all the nuances of a TDP program and yet be so complex that students
learn little from the experience. We develop a game that is easy enough to play that even
students with limited economics and math backgrounds can participate fully. Instructors can use
this game to provide a diverse body of students with insights on the relative cost-effectiveness of
a permit system over a uniform standard, the nature of permit market equilibrium, and the
information requirements associated with varied regulatory regimes.
1
I. Introduction
Tradable discharge permit (TDP) programs have great potential to reduce pollution in a
cost-effective fashion. There are many interesting facets of the performance of such programs in
the real world. TDP programs can yield the efficient allocation of total pollution reduction
among firms. Under the auspices of a TDP program, there is hope that each firm accomplishes its
chosen level of pollution reduction with a cost-effective combination of compliance activities.
Initial permit allocations can be used to alter the distribution of wealth among firms that
participate in the permit market.
An in-class game can be used to improve students’ understanding of how a TDP program
might work. There are, however, tradeoffs one must face in designing such a game. An exercise
might, in theory, demonstrate all the nuances of a TDP program and yet be so complex that
students merely leave the class in a state of frustration and confusion. Any tractable game must
necessarily sacrifice some pedagogical richness.
Several classroom games have, in fact, been designed to provide a demonstration of TDP
programs. The cost effectiveness of pollution permits has been demonstrated by comparing a
tradable permit scheme with mandated uniform standards (Walbert and Bierna 1998) or with
mandated adoption of abatement technologies (Hazlett 1995, Nugent 1997). In the games
developed in these studies, initial permit holdings are either determined exogenously by the
regulator (Nugent 1997, Walbert and Bierna 1998,) sold through auctions (Walbert and Bierna
1998), or through a combination of both (Hazlett 1995). The equity issues associated with initial
permit allocation have also been investigated by Anderson and Stafford (2000). In separate
games, they altered initial permit holdings by firms that differ in their abatement costs to
illustrate the distributional effect of initial permit allocation while maintaining the same level of
2
efficiency. In all these previous studies, the role of the regulator is either that of an auctioneer or
a distributor of permits in a decentralized permit market where each firm is left to trade with
other firms.
This game presented in this paper differs from previous work in a number of ways. First,
unlike Nugent (1997) and Hazlett (1995), we do not allow the “firms” to choose whether to
reduce emissions by reducing output of installing cleaning equipment. Instead, we simplify the
firm’s problem to a choice between uni-dimensional “abatement” and permit purchases. Second,
as we illustrate the cost-effectiveness of a tradable permit scheme, we steer away from auctions
and assume exogenously determined initial permit holdings. Third, and in contrast to Anderson
and Stafford (2000), equity is not the focus of the exercise we develop. While one could play
multiple rounds of our game with varied permit allocations, the initial form of our game assumes
a uniform distribution of permits, with equity relegated to a discussion point of secondary
importance. Fourth, and most importantly, our game assumes that the regulator acts not only as
a permit distributor but also as a facilitator/auctioneer in the permit market after the initial
permits have been distributed. The regulator calls out proposed permit prices, to which firms
react by determining the level of permits they are willing to buy or sell at each called price. In
doing so, our game mimics a situation in which the regulator bears the burden of achieving
market clearing as it implements a permit system in which firms are not left to barter among
themselves to determine both prices and quantities.
The comparative advantage of our game is that it is simple to play because the permit
market is facilitated. Because it is relatively easy for students in introductory classes to
comprehend the rules of the game, the students can perform their roles in the game well. Only
two kinds of calculations need to be performed in our in-class tradable-permit game: calculating
3
total abatement costs given an abatement level and a marginal abatement-cost (MAC) curve, and
calculating how many permits a firm with a given MAC curve would like to hold at a given
price. Furthermore, since the market is facilitated, students do not need to negotiate a potentially
confusing series of sequential bilateral trades (as in Hazlett (1995) and Nugent (1997)), and the
market is guaranteed to clear.
In exchange for simplicity, some of the richness of more complex games is lost.
However, our exercise does illustrate what it means for a market in tradable permits to clear, and
how the abatement outcome that emerges from such a market can involve lower total abatement
costs than if a uniform standard is used to achieve the same total abatement. Furthermore, the
entire game can be completed and discussed (at least briefly) in a single 50-minute class period.
II. Directions for Playing the Game
We used this game in class discussion sections of about 30 students each; it could easily
be done in smaller classes, but would be difficult to manage and yield reduced benefits to
students in a very large course. Materials needed for the game are minimal. The instructor must
bring worksheets for the students and should encourage students to bring calculators to class. It is
useful for the instructor to have access to a laptop or classroom computer with a spreadsheet
program on it, to facilitate the process of adding up industry totals.
Students in the class are grouped into six “firms” as shown in Table 1. The instructor
gives a two-page worksheet to each firm with its own marginal abatement cost (MAC) curve
given, and a full-page graph of its MAC curve (for students to use as a visual aid in their problem
solving). The worksheet and graph given in the Appendix to this paper are samples. The values
of parameters such as the level of the uniform standard and the number of permits available in
4
total can be adjusted (though they must be the same for all firms playing the same game) to yield
the type of outcome that the instructor desires. A touch of realism can be added by explaining to
the students that they are firms participating in a real tradable permits market (we used the
Chicago market for volatile organic matter one year and the national SO2 market another), and
by putting realistic firm names on the worksheets. Alternatively, the instructor can increase the
humor value of the game by inventing an amusing pollutant and letting the students take on
entertaining polluter identities.
The game begins by asking the “firms” to suppose they are subject to a uniform standard
(1,480 tons for each firm, in this example). The members of each firm calculate and record the
abatement quantity and cost this standard imposes on their firm. The instructor then collects that
information by asking each firm their resulting abatement levels and abatement costs and adds up
industry totals that the students can fill in on their worksheets. The correct results of that exercise
are given in Table 2.
Now the instructor explains that the policy is instead one of tradable permits. Initial
permit allocations are uniform but permits may be bought and sold. In our example, each firm
was given 1,480 permits per firm, with each permit granting the right to emit one ton of
pollution.
The instructor will act as a market facilitator, with students filling in their worksheets as
the game goes along, as follows. The instructor calls out a price. Each firm calculates how many
permits it wants to buy or sell at that price. She collects that information from all firms, and adds
up the totals. If total demand equals total supply, that price holds and all firms are allowed to
buy/sell their desired quantities. If there is excess supply or demand, the facilitator calls out a
5
new price that is lower or higher (whichever is appropriate) and the process repeats until the
market clears.
If the students do the calculations correctly, the series of prices shown in Table 3 ought to
yield some interesting outcomes on the way to the market-clearing price. As the price adjusts in
the correct direction after each round (falling if there is excess supply, rising if there is excess
demand), some firms will find themselves switching between “buyer” and “seller” status, though
the two firms with the highest MAC curves will want to buy permits at any of the prices listed
here.
When the market has cleared, students do the calculations on the bottom of the second
page of the worksheet to figure out how much their firms abate, and what the net cost of
abatement is to their firms. Again the instructor gathers that information and generates industrywide tallies of abatement levels and costs. The instructor also asks for each firm’s revenue from
selling or total cost of buying permits and adds them up. Net costs of the entire industry
(abatement costs less revenue from permit sales) are then computed by the instructor. The
students put these numbers on their worksheets as well.
Depending on how quickly the students work and how much time is set aside for this
exercise, there are several easy variants of the game that can be tried. One can reduce the number
of permits issued in total to see what happens to abatement costs and the market-clearing permit
price. One can also make the initial allocation of permits non-uniform to see what happens to the
distribution of net abatement costs among firms.
If there is a web site for the course, it can be useful to post the “correct” results of the game
for students to review at their leisure. It can also be informative to provide links to web sites with
information about real-world tradable permit programs.
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III. Questions for Discussion
When game play is complete, a discussion should be led to help students to understand what
lessons they can learn from the results; many students will have been too mired in the
calculations to pick up the big-picture lessons. Depending on the computational speed of the
students, there may be enough time in a single 50-minute class to have at least some discussion.
Alternatively, discussion can be held in the following class period. The following questions are
good candidates for stimulating discussion about the features of TDP programs. They are
presented here in groups by subject matter. The questions in groups A and B are likely to be the
most important to explore with the students. If you want to discuss all of these issues, the
conversation will almost certainly spill over into another 50-minute class period.
A. Efficiency and cost-effectiveness.
1. “On a graph with all six MAC curves (Figure 1), show how the uniform standard can
be illustrated. What cost-effectiveness condition is violated?”
This question can effectively (and briefly) be discussed after the uniform standard scenario
and before the TDP scenario to review the condition which must be met for an allocation of
abatement among firms to be cost-effective, and to prepare the students to formulate ideas about
the result of the TDP game. Figure 1 can also be used at the end of the TDP game to talk about
who bought permits, who sold them, and why.
2. “How do abatement costs change when a TDP program is used instead of the uniform
standard?”
This is an opportunity to let the students discover that while abatement costs fall for the
industry as a whole, abatement costs rise for some individual firms under the TDP. Ask
representatives of those firms if they are upset about this; they should notice that while their
7
abatement costs have gone up, they received payments for their permits that more than made up
for it.
3. “Under the TDP program, what is the difference between industry-wide abatement costs
and industry-wide net costs?”
While abatement and net costs may be different for some individual firms, they should be the
same for the industry as a whole. This question gives the students a chance to understand that the
payments are pure transfers among firms, and cancel out to zero when industry aggregates are
examined.
B. Equilibrium and market-clearing
1. “What would happen to the equilibrium permit price of the initial allocation is reduced,
say to 1430 permits?”
Depending on how much the class has discussed this issue prior to the game, this may or
may not be a trivial question for the students. If it is too easy, the instructor can ask the students
to discuss what a regulatory agency might do to estimate the new market clearing price before
the market actually clears.
2. “Do you think the market would clear without a facilitator?”
This is meant to provoke a highly speculative discussion. At the end, the instructor may want
to present some facts from TDP markets in the real world that shed light on whether or not such
markets do seem to clear.
For example, for the pollution permit programs in the US, most trades were bilateral and the
role of the regulatory body was to approve trades, distribute initial permits, and impose fines. In
the Los Angeles area, the South Coast Air Quality Management District (AQMD) implements
the Regional Clean Air Incentives Market (RECLAIM)i through an electronic bulletin board
where firms post their proposed terms of trade for potential trading parties to see. Bilateral
8
negotiations that follow do not involve the regulatory body, AQMDii. In the case of the leaded
gasoline phase-out in the 1980’s, the market for lead permits was decentralized and confidential;
EPA did not facilitate the matching of buyers and sellers, and not the EPAiii. The role of the
EPA was to allocate permits initially, and to ensure that the banked credits are being retired
according to the mandated phase-out schedule. Similarly, trading in the US SO2 trading program
was largely bilateral, and prices were determined by the trading partiesiv.
C. Information/administrative issues
1. “Suppose a regulator wants to achieve a given level of total abatement. What
information does it need to accomplish that using:
a) a tax?
b) a uniform emission standard?
Discuss the difference between (a) and (b).”
If the class has not discussed emission taxes, you can help students to think about part (a)
by pointing out that setting a tax is like selling permits for a fixed price and not allowing firms to
trade the permits among themselves.
2. “Suppose the market is not facilitated, and firms simply trade permits directly with
other firms. How would that process occur?”
This can be broken down into sub-questions to help the students begin to think about what is
involved in such a system. For example,
(a) How would you find a firm to trade with?
(b) How would you know whether to buy or to sell?
(c) How would you know what price to charge (if you are selling) or at what price to
buy?
Through discussing this question, students should begin to appreciate the problems caused by
the presence of imperfect and/or asymmetric information between bargaining firms. To the
extent that one firm does not know the form of the abatement cost function of the other, it does
9
not know the value the other firm places on each permit. Hence, some firms will end up paying
more or less than others depending on which firm they bargain with, and depending on how
much information each firm has.
This is a good time to use real world examples of TDP trading (e.g. SO2 trading at the
Chicago Board of Trade, trades of permits for volatile organic matter under the new Emissions
Reduction Market System (ERMS) in Chicagov, and even cross-media credit trading under
AQMD in Los Angeles). The instructor might refer to economic studies of features of permit
markets that are not highlighted by this game, but which influence the success with which a
permit system can be implemented. Such topics include temporal emission reduction credits and
early reduction programs, permit banking, market power and price setting, and non-compliance
in permit trading experiments (Muller and Mestelman (1998) and Isaac and Holt (1999)). Permit
banking, for example, was especially useful in the leaded gasoline phase-out in the 1980’s. It
allowed firms some time to develop new technologies during the interim period, while setting an
expiration date for banked permits to ensure timely achievement of the target.
IV. Conclusion
Instructors can use the game presented in this paper to demonstrate three concepts that
are important to understanding the merits of a tradable permit scheme. First, the calculations
associated with game play illustrate the cost-effectiveness advantage of the permit system over a
mandatory uniform standard. Second, the game highlights the nature of market equilibrium, the
manner in which markets might clear, and the forces that might nudge the permit market price
toward equilibrium. Third, the game demonstrates the different information requirements
associated with a uniform standard and a permit system. While contrasting decentralized and
10
facilitated markets, the game demonstrates that a market-clearing price might be achieved more
easily if a regulator can act as a facilitator
The game is designed primarily to be easy to play. Even introductory students and those
with limited math backgrounds can participate fully, without getting bogged down in complex
calculations or a chaotic series of bilateral negotiations. By demonstrating the connection
between this stylized game and real world pollution permit trading systems, the instructor can
provide a diverse range of students with insights on the functioning of tradable permit systems.
11
References
Anderson, L.R. and S.L. Stafford. (2000). “Choosing winners and losers in a classroom permit
trading game.” Southern Economic Journal 67(1): 212-219.
Cason, T.N. and L. Gangadharan. (1998) “An experimental study of electronic bulletin board
trading for emission permits.” Journal of Regulatory Economics 14:55-73.
Environmental Protection Agency (2003). Clean Air Markets - Programs and Regulations – Acid
Rain Program. Available at http://www.epa.gov/airmarkets/arp/index.html.
Hazlett, D. (1995). “An EPA-style auction of pollution permits.” Classroom Expernomics. In
http://www.marietta.edu/~delemeeg/expernom/s95.html.
Isaac, R.M. and C. Holt. (1999). Research in Experimental Economics. Vol 7: Emissions Permit
Experiments. JAI Press: Stamford, Connecticut.
Illinois Environmental Protection Agency. (2003). Emissions Reduction Market System: What is
ERMS? Available at http://www.epa.state.il.us/air/erms.
Kerr, S. and D. Mare′. (1998). Transaction Costs and Tradable Permit Markets: The United
States Lead Phasedown. Motu Economic Research Discussion Paper. Available at
http://www.motu.org.nz/pdf/transaction_costs.pdf.
Muller, R.A. and S. Mestelman (1998). “What have we learned from emissions trading
experiments?” Managerial and Decision Economics 19:225-238.
Nugent, R. (1997). “Teaching tools: A pollution rights trading game.” Economic Inquiry 35(3):
679-685.
South Coast Air Quality Management District (SCAQMD). 2000. Regional Clean Air Incentives
Market. Available at http://www.aqmd.gov/reclaim/reclaim.html.
Walbert, M.S. and T.J. Bierna. (1998). “The permits game: Conveying the logic of marketable
pollution permits.” Journal of Economic Education 19(4): 383-389.
12
Table 1: Firms in the Tradable Permit Game
Firm
Initial Emissions
MAC Curve
1
2,000
MAC=4,000-2E
2
2,000
MAC=8,000-4E
3
2,000
MAC=10,000-5E
4
4,000
MAC=4,000-E
5
4,000
MAC=8,000-2E
6
4,000
MAC=10,000-2.5E
Total
18,000
Table 2: Results of Uniform Standard Scenario
Initial
Firm Emissions
MAC Curve
1
2,000
MAC=4,000-2E
Final
Emissions
1,480
Tons
Abated
520
Cost of
Abatement
$270,400
2
2,000
MAC=8,000-4E
1,480
520
$540,800
3
2,000
MAC=10,000-5E
1,480
520
$676,000
4
4,000
MAC=4,000-E
1,480
2,520
$3,175,200
5
4,000
MAC=8,000-2E
1,480
2,520
$6,350,400
6
4,000
MAC=10,000-2.5E
1,480
2,520
$7,938,000
Total
18,000
8,880
9,120
$18,950,800
13
Table 3: Permit Demands at Varied Permit Prices
Price
$4,000
$1,000
$3,400
$3,000
$3,200
Firm 1 permits demanded
-1,480
20
-1,180
-980
-1,080
Firm 2 permits demanded
-480
270
-330
-230
-280
Firm 3 permits demanded
-280
320
-160
-80
-120
Firm 4 permits demanded
-1,480
1,520
-880
-480
-680
Firm 5 permits demanded
520
2,020
820
1,020
920
Firm 6 permits demanded
920
2,120
1,160
1,320
1,240
-2,280
6,270
-570
570
0
Total excess demand
Table 4: Results of Tradable Permit Policy Scenario when Market Clears
MAC Curve
Firm Initial
E
1 2,000 MAC=4,000-2E
Final
Tons
Emissions* Abated
400
1,600
Cost of
Revenue from
Abatement Permit Sales
$2,560,000
$3,456,000
Net Cost
-$896,000
2
2,000 MAC=8,000-4E
1,200
800
$1,280,000
$896,000
$384,000
3
2,000 MAC=10,000-5E
1,360
640
$1,024,000
$384,000
$640,000
4
4,000 MAC=4,000-E
800
3,200
$5,120,000
$2,176,000
$2,944,000
5
4,000 MAC=8,000-2E
2,400
1,600
$2,560,000
-$2,944,000
$5,504,000
6
4,000 MAC=10,000-2.5E
2,720
1,280
$2,048,000
-$3,968,000
$6,016,000
9,120
$14,592,000
$0
$14,592,00
Total 18,000
8,880
0
*Same as the number of permits desired at P=$3,200
14
Appendix: Sample Worksheet for Tradable Permits Game
The Handout has two pages. One is a single sided graph of the firm’s marginal abatement
cost curve. The second is a double sided worksheet for calculations and class-wide tallies.
15
MAC ($)
10000
9600
9200
8800
8400
8000
7600
7200
6800
6400
6000
5600
5200
4800
4400
4000
3600
3200
2800
2400
2000
1600
1200
800
400
0
0
200
400
600
800
1000
1200
Emissions
16
1400
1600
1800
2000
Worksheet for Tradable Permits Game
Firm: Illinois Power (Firm 3)
Students’ names:
________________________
________________________
________________________
________________________
________________________
________________________
Initial Emissions:
E = 2000 (tons)
Marginal Abatement Cost:
MAC = 10,000 - 5E
NOTE: Items in italics will be filled in by the whole class once industry tallies are made.
Part 1: Uniform Emission Standard
Your firm must emit no more than 1480 tons.
Tons your firm abates
________
Total cost to your firm:
______
Industry abatement:
________
Industry cost:
______
17
Part 2: Tradable Permits
Your firm is given 1480 permits; there are a total of 8880 permits in the program.
Price
Optimal #
of Permits
to Hold
Initial #
Permits
Desired #
Permits to
Buy
Desired #
Permits to
Sell
Total
Industry
Demand
Total
Industry
Supply
1480
1480
1480
1480
1480
1480
1480
1480
Final permit price:
________
Outcome for your firm:
Initial # of permits:
__1480__
# permits you sold:
________
Revenue from permits sold: ___________
# permits you bought:
________
Cost of permits bought:
___________
Cost of abatement:
___________
Total net cost to your firm:
___________
Total cost of abatement:
___________
Total net cost:
___________
Your firm’s final emissions: ________
Your firm’s initial emissions: ________
Tons your firm abates:
________
Industry totals:
Tons abated:
________
18
i
Details can be found at SCAQMD (2000) for further discussion in class.
Such a scheme has been investigated by Cason and Gangadharan (1998) in an experimental study and found that
the bulletin board serves as an effective avenue to facilitate trade between firms and that it mimics a pollution permit
market well.
iii
See Kerr and Mare (1998) for discussion and estimation of the transaction costs associated with this market.
iv
For a richer discussion details on the SO2 trading program, see EPA (2003).
v
Details can be found at IEPA (2003).
ii
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