Transactions Costs in Tradable Permit Markets: An Experimental Study of Pollution Market Designs

Many countries have adopted or are considering incentive approaches to environmental regulation, such as tradable permit schemes to control pollution. Regulators influence the success of tradable permit programs by their choice of market rules and permit allocation mechanisms. This paper uses laboratory experiments to study how the transaction costs incurred by participants interact with the initial permit endowment mechanism to influence the costeffectiveness of overall emissions abatement. In a competitive market without transaction costs the initial distribution of permits affects equity but has no impact on the cost-effectiveness of final abatement responsibility. In the presence of transaction costs, however, even in a competitive market the initial distribution of permits can affect both abatement costs and equity. We study treatments in which marginal transaction costs are zero, constant and declining, all using the continuous double auction institution. Our results show that consistent with theory, when marginal transaction costs are declining prices deviate less from the competitive equilibrium if the “misallocation” of the initial permit distribution is greater. The deviation from the zero transaction cost competitive equilibrium does not vary with the initial permit endowment when marginal transaction costs are constant. JEL Classification: C91, Q20, Q28