Environmental Economics

Global warming is a huge externality that affects everyone and this is significant as according to Lovgren (2004) it would eventually lead to sea level rises which would cause catastrophic effects. As the global climate is a public good, anyone that contributes largely to this externality should be made accountable. For example CO2 emissions from factories which is one major pollutant of greenhouse gases. Such an effective proposal demonstrating this would be the Emissions Trading Scheme in Australia which allows parties to buy and sell permits for emissions, ultimately reducing the accumulation of Greenhouse gases in the atmosphere. This will be explained through the theory of externalities and compared with other market interventions. Additionally the effectiveness of the Emissions trading scheme will be examined and diagrams will be used to illustrate this.

The following paragraph is based on Frijters, Dulleck and Torgler. (2008). The theory of externalities is concerned with additional benefits or costs to someone other than the person who purchased the good. There are two type of externalities; positive and negative. The most obvious negative externailty is pollution and this will be elaborated upon. The main problem with a negative externailty is the inefficient allocation of market supply in the free market as too many goods are traded, considering not all costs of buying a good is carried by the buyer. The diagram below illustrates this.

The graph shows that the efficient quantity is lower when considering the social marginal cost, thus it is observed that too much of a good is consumed in a market. For this reason governments create economic instruments such as tradeable permits that enforces a certain behaviour to reach the real market efficient allocation. (Frijters et al, 2008).

Tradeable permits is an economic instrument which the government has used to control pollution, this is done by setting a limit or cap to firms in the form of emissions permits. Firms which wish to increase their emission permits must therefore purchase them from other firms who require fewer permits (Stavings 2001). Thus trade permits limit the total emissions from firms and encourages firms to reduce pollution so they are able to continue their factory operations. According to Australian Institue of Mangement (2008) 62% of respondents to a survey felt that the Emissions Trading Scheme was justified. This shows that the implementation of such an economic instrument will be favourable.

The following section is based on Garnut Climate Change Review. (2008). The main benefit that arises from using tradeable permits is that it acts as a tradeable instrument with inherent value that can be exchanged between buyers and sellers in an "emissions market". This leads to higher efficiency of the environmentally market. However a disadvantage that comes with using tradeable permits is that it involves