If you're seeing this message, it means we're having trouble loading external resources on our website.

If you're behind a web filter, please make sure that the domains *.kastatic.org and *.kasandbox.org are unblocked.

Main content

Types of market-oriented environmental tools

Read about the main types of market-oriented regulation, including "cap and trade".

Key points

  • The three main categories of market-oriented environmental policies are pollution charges, marketable permits, and better-defined property rights.
  • A marketable permit program is a program in which a city or state government issues permits allowing only a certain quantity of pollution. These permits to pollute can be sold or given to firms free.
  • A pollution charge is a tax imposed on the quantity of pollution that a firm emits.
  • Property rights are the legal rights of ownership on which others are not allowed to infringe without paying compensation.

Three types of market-oriented environmental tools

There are three main categories of market-oriented environmental tools: pollution charges, marketable permits, and better-defined property rights.
In this article, we'll look at each of these tools in depth.

Pollution charges

A pollution charge is a tax imposed on the quantity of pollution that a firm emits. A pollution charge gives a profit-maximizing firm an incentive to figure out ways to reduce its emissions—as long as the marginal cost of reducing the emissions is less than the tax.
For example, consider a small firm that emits 50 pounds per year of small particles, such as soot, into the air. Particulate matter, as it is called, causes respiratory illnesses and also imposes costs on firms and individuals.
The graph below illustrates the marginal costs that a firm faces in reducing pollution. The marginal cost of pollution reduction, like most marginal cost curves increases with output, at least in the short run. Reducing the first 10 pounds of particulate emissions costs the firm $300. Reducing the second 10 pounds would cost $500. The third ten pounds would cost $900, the fourth 10 pounds $1,500, and the fifth 10 pounds $2,500. This pattern for the costs of reducing pollution is common—the firm can use the cheapest and easiest method to make initial reductions in pollution, but additional reductions in pollution become more expensive.
This graph shows the incentive for a firm to reduce pollution in order to avoid paying a pollution charge.
Image credit: Figure 1 in "Market-Oriented Environmental Tools" by OpenStaxCollege, CC BY 4.0
Imagine the firm now faces a pollution tax of $1,000 for every 10 pounds of particulates emitted. The firm has the choice of either polluting and paying the tax, or reducing the amount of particulates they emit and paying the cost of abatement as shown in the graph above.
How much will the firm pollute and how much will the firm abate? The first 10 pounds would cost the firm $300 to abate. This is substantially less than the $1,000 tax, so they will choose to abate. The second 10 pounds would cost $500 to abate, which is still less than the tax, so they will choose to abate. The third 10 pounds would cost $900 to abate, which is slightly less than the $1,000 tax. The fourth 10 pounds would cost $1,500, which is much more costly than paying the tax. As a result, the firm will decide to reduce pollutants by 30 pounds because the marginal cost of reducing pollution by this amount is less than the pollution tax. With a tax of $1,000, the firm has no incentive to reduce pollution more than 30 pounds.
A firm that has to pay a pollution tax will have an incentive to figure out the least expensive technologies for reducing pollution. Firms that can reduce pollution cheaply and easily will do so to minimize their pollution taxes, whereas firms that will incur high costs for reducing pollution will end up paying the pollution tax instead. If the pollution tax applies to every source of pollution, then no special favoritism or loopholes are created for politically well-connected producers.
For an example of a pollution charge at the household level, let's consider two ways of charging for garbage collection. One method is to have a flat fee per household, no matter how much garbage a household produces. An alternative approach is to have several levels of fees, depending on how much garbage the household produces and to offer lower or free charges for recyclable materials. As of 2006, the US Environmental Protection Agency had recorded over 7,000 communities that have implemented pay-as-you-throw programs. When people have a financial incentive to put out less garbage and to increase recycling, they find ways of doing so.
A number of environmental policies are really pollution charges, although they often do not travel under that name. For example, the federal government and many state governments impose taxes on gasoline. We can view this tax as a charge on the air pollution that cars generate as well as a source of funding for maintaining roads.
Similarly, the refundable charge of five or 10 cents that some states have for returning recyclable cans and bottles works like a pollution tax that provides an incentive to avoid littering or throwing bottles in the trash. Compared with command-and-control regulation, a pollution tax reduces pollution in a more flexible and cost-effective way.

Marketable permits

When a city or state government sets up a marketable permit program—for example, cap and trade—it must start by determining the overall quantity of pollution it will allow as it tries to meet national pollution standards. Then, a number of permits allowing only this quantity of pollution are divided among the firms that emit that pollutant. These permits to pollute can be sold or given to firms free.
Now, add two more conditions. Imagine that these permits are designed to reduce total emissions over time. For example, a permit may allow emission of 10 units of pollution one year, but only 9 units the next year, then 8 units the year after that, and so on down to some lower level. In addition, imagine that these are marketable permits, meaning that firms can buy and sell them.
To see how marketable permits can work to reduce pollution, consider the four firms listed in the table below. The table shows current emissions of lead from each firm. At the start of the marketable permit program, each firm receives permits to allow this level of pollution. However, these permits are shrinkable, and next year the permits allow the firms to emit only half as much pollution.
Let’s say that in a year, Firm Gamma finds it easy and cheap to reduce emissions from 600 tons of lead to 200 tons, which means that it has permits that it is not using that allow emitting 100 tons of lead. Firm Beta reduces its lead pollution from 400 tons to 200 tons, so it does not need to buy any permits, and it does not have any extra permits to sell. However, although Firm Alpha can easily reduce pollution from 200 tons to 150 tons, it finds that it is cheaper to purchase permits from Gamma rather than to reduce its own emissions to 100. Meanwhile, Firm Delta did not even exist in the first period, so the only way it can start production is to purchase permits to emit 50 tons of lead.
The total quantity of pollution will decline. But the buying and selling of the marketable permits will determine exactly which firms reduce pollution and by how much. With a system of marketable permits, the firms that find it least expensive to do so will reduce pollution the most.
How marketable permits work
Firm AlphaFirm BetaFirm GammaFirm Delta
Current emissions—permits distributed free for this amount200 tons400 tons600 tons0 tons
How much pollution will these permits allow in one year?100 tons200 tons300 tons0 tons
Actual emissions one year in the future150 tons200 tons200 tons50 tons
Buyer or seller of marketable permit?Buys permits for 50 tonsDoesn’t buy or sell permitsSells permits for 100 tonsBuys permits for 50 tons

Better-defined property rights

A clarified and strengthened idea of property rights can also strike a balance between economic activity and pollution.
Ronald Coase, who won the 1991 Nobel Prize in economics, offered a vivid illustration of an externality: a railroad track running beside a farmer’s field where the railroad locomotive sometimes gives off sparks and sets the field ablaze. Coase asked whose responsibility it was to address this spillover. Should the farmer be required to build a tall fence alongside the field to block the sparks? Or should the railroad be required to put some gadget on the locomotive’s smokestack to reduce the number of sparks?
Coase pointed out that this issue cannot be resolved until property rights are clearly defined—that is, the legal rights of ownership on which others are not allowed to infringe without paying compensation. Does the farmer have a property right not to have a field burned? Does the railroad have a property right to run its own trains on its own tracks? If neither party has a property right, then the two sides may squabble endlessly, nothing will be done, and sparks will continue to set the field aflame. However, if either the farmer or the railroad has a well-defined legal responsibility, then that party will seek out and pay for the least costly method of reducing the risk that sparks will hit the field. The property right determines whether the farmer or the railroad pays the bills.
The property rights approach is highly relevant in cases involving endangered species. The US government’s endangered species list includes about 1,000 plants and animals, and about 90% of these species live on privately owned land. The protection of these endangered species requires careful thinking about incentives and property rights.
The discovery of an endangered species on private land has often triggered an automatic reaction from the government to prohibit the landowner from using that land for any purpose that might disturb the imperiled creatures. Consider the incentives of that policy: if you admit to the government that you have an endangered species, the government effectively prohibits you from using your land. As a result, rumors abound of landowners who follow a policy of “shoot, shovel, and shut up” when they find an endangered animal on their land. Other landowners have deliberately cut trees or managed land in a way that they knew would discourage endangered animals from locating there.
A more productive policy would consider how to provide private landowners with an incentive to protect the endangered species that they find and to provide a habitat for additional endangered species. For example, the government might pay landowners who provide and maintain suitable habitats for endangered species or who restrict the use of their land to protect an endangered species. Again, an environmental law built on incentives and flexibility offers greater promise than a command-and-control approach, which tries to oversee millions of acres of privately owned land.

Self-check questions

Four firms called Elm, Maple, Oak, and Cherry, produce wooden chairs. However, they also produce a great deal of garbage—a mixture of glue, varnish, sandpaper, and wood scraps. The first row of the table below shows the total amount of garbage, in tons, currently produced by each firm. The other rows of the table show the cost of reducing garbage produced by the first 5 tons, the second 5 tons, and so on. First, calculate the cost of requiring each firm to reduce the weight of its garbage by one-fourth. Now, imagine that marketable permits are issued for the current level of garbage, but the permits will shrink the weight of allowable garbage for each firm by one-fourth. What will be the result of this alternative approach to reducing pollution?
ElmMapleOakCherry
Current production of garbage, in tons20406080
Cost of reducing garbage by first 5 tons$5,500$6,300$7,200$3,000
Cost of reducing garbage by second 5 tons$6,000$7,200$7,500$4,000
Cost of reducing garbage by third 5 tons$6,500$8,100$7,800$5,000
Cost of reducing garbage by fourth 5 tons$7,000$9,000$8,100$6,000
Cost of reducing garbage by fifth 5 tons$0$9,900$8,400$7,000
The rows in the table below show three market-oriented tools for reducing pollution. The columns of the table show three complaints about command-and-control regulation. Fill in the table by stating briefly how each market-oriented tool addresses each of the three concerns.
Incentives to go beyondFlexibility about where and how pollution will be reducedPolitical process creates loopholes and exceptions
Pollution charges
Marketable permits
Property rights

Review questions

  • What is a pollution charge and what incentive does it provide for a firm to take external costs into account?
  • What is a marketable permit and what incentive does it provide for a firm to take external costs into account?
  • What are better-defined property rights and what incentive do they provide to take external costs into account?

Critical-thinking questions

  • Will a system of marketable permits work with thousands of firms? Why or why not?
  • Is zero pollution possible under a marketable permits system? Why or why not?
  • Is zero pollution an optimal goal? Why or why not?

Want to join the conversation?

  • leaf grey style avatar for user arrowsaday
    I know we should save the environment and stuff like that but, who is getting all of the money from these "permit to pollute" things? And what are they doing with the money the " save the environment "? Does anyone else find this weird?🎯
    (2 votes)
    Default Khan Academy avatar avatar for user
  • female robot ada style avatar for user Jei-Cyn Kendrick
    The third paragraph under 'Pollution Charges' is very confusing.

    It says,"Reducing the first 10 pounds of particulate emissions costs the firm $300. Reducing the second 10 pounds would cost $500. The third ten pounds would cost $900, the fourth 10 pounds $1,500, and the fifth 10 pounds $2,500."

    Wouldn't the second 10 pounds cost $200 ($500 - $300), the third 10 pounds cost $400, the fourth 10 pounds $600 and the fifth 10 pounds $1000?
    (1 vote)
    Default Khan Academy avatar avatar for user
    • male robot hal style avatar for user Donny
      $500 is the marginal cost, not the total cost. So in order to reduce 20 pounds from 0 it would cost $300 + $500 = $800. The respective tax would otherwise be $1000 + $1000 = $2000. The firm saved $2000 - $800 = $1200 by reducing pollution instead of electing the tax option.
      A firm behaving "rationally" will continue reducing pollution until the marginal cost for reducing 10 pounds is equal to the tax for emitting 10 pounds.
      (6 votes)
  • male robot johnny style avatar for user Who do you think you are.I AM A GOD!
    is a zero pollution possible under a marketable permits system. Why or Why not
    (1 vote)
    Default Khan Academy avatar avatar for user
    • male robot hal style avatar for user Donny
      0 pollution is possible but would be extremely expensive.
      One variation would be to allow cap and trade "credits" to firms who clean up pollution. Suppose there is a tax for every tree I cut down. Instead of paying the tax or planting new trees myself, I could pay another firm to plant trees on my behalf in order to cancel out the impact of my cutting down of the trees. That other firm would create cap and trade credits for benefiting the environment which could be sold to other firms in order to offset their pollution.
      (3 votes)
  • piceratops tree style avatar for user Jm-punk
    What happens when a pollution charge is imposed alongside with the issuance of the marketable permit?
    (1 vote)
    Default Khan Academy avatar avatar for user
  • blobby green style avatar for user Billie Patterson
    Zero pollution is an unrealistic goal because there are too many people who don't go by the rules anyway.
    (1 vote)
    Default Khan Academy avatar avatar for user
  • leafers seedling style avatar for user 김찬웅
    I cannot understand why pollution charge has incentives to go beyond. It is no longer an incentive over a certain criteria(number, or point), isn't it?
    (0 votes)
    Default Khan Academy avatar avatar for user