Correct ( and misleading ) arguments for cap and trade ∗ Larry Karp

Cap and trade (CAT) results in lower abatement costs relative to command and control, but might increase industry marginal abatement cost, resulting in higher equilibrium emissions. With lumpy investment, command and control leads to multiple investment equilibria and “regulatory uncertainty”. CAT, a first best policy, eliminates this uncertainty. Command and control policies cause firms to imitate other firms’ investment decisions, leading to similar costs and small potential gains from permit trade. CAT induces firms to make different investment decisions, leading to different abatement costs and large gains from trade. In a “global game”, the unique equilibrium is constrained socially optimal.