Optimal Allocation of Tradable Pollution Rights and Market Structures

Tradable environmental rights are increasingly pursed as a regulatory instrument, to control for environmental quality. However, in the presence of market power, regulation through an allocation of tradable rights generally yield inefficient outcomes. This article analyzes the effect of the initial distribution of tradable rights on the firms’ strategies and performance in abatement and production, and proposes an efficient criterion for the allocation of tradable rights among firms with market power and competitive fringe firms. The suggested criterion maximizes efficiency of the market based regulation. A simple numerical example illustrates the theoretical discussion.I am very grateful to Richard J. Sexton for useful comments and suggestions. I also wish to thank Giacomo F. Bonanno, the editor, anonymous referees, and participants at the CORE workshop “Industrial Economics and the Environment” (2004) for helpful discussions and comments that improved the paper.