(8th edition) (the pearson series in economics) robert pindyck, daniel rubinfeld microecon 698

CHAPTER 18 • Externalities and Public Goods 673

introduce fuel-efficient hybrid vehicles. But prior to
its hosting of the Olympics in 2008, Beijing had a
problem. What could it do to reduce sulfur dioxide
emissions so as to offer a cleaner environment to
the Olympic athletes and to the visiting public?
Beijing’s choice was to shut down a large number of coal-fired plants. The air quality in Beijing
improved 30 percent in 2008 for the Olympics, at a
cost of about $10 billion. But a year after the Games,
when many of the environmental regulations were
no longer in effect, about 60 percent of the improvement was lost. Was the shutdown of plants the most
efficient policy choice? Our study of pollutionabatement strategies suggests not. For one thing,
we have experience with the use of standards for
regulating sulfur dioxide emissions in Philadelphia
(recall Example 18.1). In 1968, Philadelphia imposed
air-quality regulations that limited the maximum
allowable sulfur content in fuel oil to 1.0 percent
or less. This regulation decreased sulfur dioxide
levels in the air substantially—from 0.10 parts per
million (ppm) in 1968 to below 0.030 ppm in 1973.

EX AMPLE 18. 3

Improved air quality led to better human health, less
damage to materials, and higher property values.
Example 18.1 shows that the imposed standards
made sense on cost-benefit grounds.
Would the imposition of a system of emissions
fees—or better yet a regime of tradeable emissions
permits—do even better in Beijing? A study of

the regulation of electric-utility sulfur dioxide tradeable emissions shows that marketable permits in the
United States can cut in half the cost of complying
with a regulatory-based standard.7 Can similar gains
be achieved in Beijing? The answer lies in part on
whether the market for tradeable emissions will itself
work efficiently. But it also depends on the shape of
the marginal abatement cost and marginal external cost curves. As our prior discussion has shown,
the case for emissions fees (and for tradeable permits) is strongest (1) when firms vary substantially
in their marginal abatement costs; and (2)
when the marginal external cost of emissions curve
is relatively steep and the marginal cost of abatement curve relatively flat.

EMISSIONS TRADING AND CLEAN AIR

Controlling emissions cost companies approximately $18 billion during the 1980s, and it cost even
more during the first half of the 1990s.8 An effective emissions trading system could reduce those
costs substantially in the decades to come. The
Environmental Protection Agency’s “bubble” and
“offset” programs were modest attempts to use a
trading system to lower cleanup costs.
A bubble allows an individual firm to adjust its
pollution controls for individual sources of pollutants as long as a total pollutant limit for the firm is
not exceeded. In theory, a bubble could be used
to set pollutant limits for many firms or for an entire
geographic region; in practice, however, it has been
applied to individual firms. As a result “permits”
are, in effect, traded within the firm: If one part of

the firm can reduce its emissions, another part will
be allowed to emit more. Abatement cost savings

associated with the EPA’s program of 42 bubbles
have been approximately $300 million per year
since 1979.
Under the offset program, new sources of emissions may be located in geographic regions in
which air-quality standards have not been met, but
only if they offset their new emissions by reducing emissions from existing sources by at least as
much. Offsets can be obtained by internal trading,
but external trading among firms is also allowed.
A total of more than 2000 offset transactions have
occurred since 1976.
Because of their limited natures, bubble and
offset programs substantially understate the

7
Don Fullerton, Shaun P. McDermott, and Jonathan P. Caulkins, “Sulfur Dioxide Compliance of a
Regulated Utility,” NBER Working Paper No. 5542, April 1996.
8

See Robert W. Hahn and Gordon L. Hester, “The Market for Bads: EPA’s Experience with Emissions
Trading,” Regulation (1987): 48–53; Brian J. McKean, “Evolution of Marketable Permits: The U.S.
Experience with Sulfur-Dioxide Allowance Trading,” Environmental Protection Agency, December, 1996.