Correcting the overuse or underprovision of important assets

Creating markets: property rights and trading permits

Sometimes it is possible to define and allocate property rights that are supported through regulations and institutional arrangements, which then create markets and allow the advantages of efficiency. Indeed, this approach (tradable permits for pollution emissions) has been a major innovation in the last decade.⁸¹ The use of command and control to regulate the overall allowable pollution levels, together with tradable permits, creates a market for pollution abatement that would not otherwise exist. Making permits tradable gives firms an incentive to look for the most cost-effective solutions for pollution abatement, because firms that lower their pollution more effectively or at a lower cost than do other firms can sell their excess credits to those firms. Firms then face an opportunity cost of pollution, which creates incentives to find cheaper abatement methods, encourages less pollution in aggregate, and ensures dynamic efficiency.

In OECD countries, tradable permits are seen as a way of harmonizing environmental protection with economic efficiency.⁸² The U.S. sulfur dioxide reduction scheme to reduce acid rain is an example, relying on tradable rights and credible threats in cases of noncompliance. Similarly, Iceland and New Zealand have revived fish stocks by assigning fishing rights at a sustainable level and allowing fishers to trade their quotas freely.

These arrangements, despite their advantages in providing the right incentives to adopt least-cost solutions, can still be costly to administer and implement. Finding the right balance between giving free play to market forces and monitoring and enforcement is a big challenge.