Economic Approaches to Reduce Externalities, Part 2: Cap-and-Trade Detailed

This is the second video in a two-part series.

In this second lecture on environmental economics, Dr. Sheila Olmstead presents an analytical example of cap-and-trade approaches to highlight the difference between market-based policies and prescriptive policies. She notes the cost-effectiveness of market-based policies in many scenarios and also identifies cases in which prescriptive policies are more appropriate. She ends with several examples of market-based approaches to environmental policy and the relative costs and benefits. 

In the lecture leading up to this—“Economic Approaches to Reduce Externalities, Part 1: Prescriptive vs. Market-Based”—Dr. Olmstead presents a summary of the use of economic approaches for dealing with environmental externalities such as pollution. She begins with prescriptive or command-and-control policies that include traditional regulatory approaches like “technical standards” and “performance standards.” The former requires use of specific technologies like scrubbers on smoke-stacks while the latter imposes an overall ceiling on pollution.  She next moves to market-based policies or regulations that include “price instruments,” “quantity instruments,” and “information-based approaches.” The price approach involves taxing negative externalities and subsidizing positive externalities, while the quality approach establishes a total cap on pollution for an entire group allocating permits to firms and allowing them to trade. The information-based approach provides information about the damages or benefits of a firm’s practices and products so that consumers can decide.