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The Basic Economics of Carbon Permits Versus Carbon Taxes

The Basic Economics of Carbon Permits Versus Carbon Taxes

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Published by dianewarth

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Published by: dianewarth on Dec 10, 2009
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07/10/2013

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The Basic Economics of Carbon Permits versus Carbon TaxesMaybe a few simple diagrams will penetrate the fog of confusion that enshrouds discussion of carbon capsand taxes. Maybe not, but here goes.The starting point is this, a highly simplified demand curve for carbon inputs (primarily fossil fuels), drawn asif we actually knew what it looks like.We start out at a high quantity of carbon use, Q
1
, and a low price, P
1
. Our goal is to reduce carbon use to themuch lower target Q
2
. There are two ways we can do this. We could introduce a permit system, and cap thenumber of permits at Q
2
. The shortage of permits, in conjunction with the demand D, will drive the carbon priceup to P
2
. This is true whether the permits are sold or given away; their scarcity makes them valuable.The second approach would be to introduce a carbon tax. When the tax is set high enough to make the totalprice of carbon equal to P
2
we once again arrive at a total use of Q
2
.In this very simple world there is no difference between the price and quantity effects of either a carbon capor a carbon tax. Which you choose is a matter of convenience.Now introduce uncertainty. We really don’t know very much about what the demand curve for carbon inputsin all their shapes and uses looks like, especially as we travel further from our initial starting point at Q
1
and P
1
.There is an enormous empirical literature on this question, and the uncertainty is large. The next diagramillustrates this.
 
The shaded purple area represents the range of possible demand curves; it gets wider the further we go fromwhere we are today. If we set a carbon cap at Q
2
we don’t know just how low or high the carbon price will turnout to be.If we use a tax, we are facing a situation like this:If we set the tax so that the carbon price is P
2
, we don’t know exactly how much carbon will be used.In an uncertain world, the choice between a tax and a cap depends on which kind of uncertainty worries youmore. Many economists are terrified that we may impose too large an economic burden by underestimatinghow high prices have to go to reduce consumption. If this is your main fear, you should support a tax, since
 
this nails down the price with near certainty. (A price ceiling combined with a cap is almost the same, sincea ceiling functions like a tax when it is triggered.)On the other hand, suppose your greatest fear is that we will not take stringent enough measures to reduceour carbon consumption, and that catastrophic, uncontrollable climate change awaits our children andgrandchildren. In that case, you would support a tight cap that guarantees we will meet our carbon targets andallows prices to find their own level.This distinction ought to be clear in the minds of everyone who debates carbon policy.Then there is another wrinkle: suppose we face interaction effects among consumers that produce multipleequilibria. As someone who thinks a lot of economic behavior is driven by social norms, I expect to see thiswherever I look. For example, take the case of flying to business meetings versus videoconferencing. At thepresent time the norm is to meet in person. Videoconferencing seems “cheap”, “limited”, a compromise. If youare the only firm or conference organizer who switches to video, your reputation will likely suffer. Once enoughorganizers make the switch, however, and videoconferencing becomes the new normal, asking people to flyin to a meeting will seem extravagant, spendthrift, and suitable for only the most special occasions. This is a“tipping point” story, characteristic of interactive behavioral models.Suppose we depict just one sort of interaction in a fully certain world. If we use a carbon cap to changebehavior, the diagram looks like this:As the cap is lowered, the price rises until a tipping point is reached. After this the price collapses, then risesagain as demand is lowered along the left portion of the curve, coming to a stop at P
2
. (Technical note: thisis called a multiple equilibrium model, since a supply curve drawn through both halves of the demand curvewill intersect it twice.)Now let’s tell the same story, but with a rising carbon tax.

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