Market Power in Laboratory Emission Permit Markets

Many proposals suggesting the use of markets tocontrol pollution assume markets will becompetitive. When markets do not exhibitcompetitive characteristics, however, shouldthey still be expected to result in efficiencyimprovement relative to traditional approaches? This paper employs experimental economicmethods to examine the effect of marketstructure on the use of marketable emissionspermits. Results indicate that in a market withone dominant firm and a number of fringe firms,strategic manipulation occurs repeatedly in thelaboratory as predicted by market power models,undermining the allocative and dynamicefficiency benefits such markets offer. Whenfirms compete in a downstream product marketdominated by the same single firm, marketefficiency can actually be reduced with theimplementation of permit markets. Final marketefficiencies reflect initial endowments and areinfluenced by competitive conditions elsewherein the economy, indicating that policy-makersshould carefully consider whether markets areappropriate in such circumstances.