Most economic analyses of “cap-and-trade” policies – under which the government sets a target amount of emissions and then issues tradable permits totaling that amount – take it for granted that it would not make any difference, in the reduction of emissions, if the government were to sell the permits or give them away. A 2008 report on cap-and-trade climate policies from the MIT Center for Energy and Environmental Policy Research puts it like this: “Economic theory suggests that the method of distributing emission allowances, i.e., through grandfathering or auctioning, will not affect an individual source’s output decisions or emissions.”

If firms always make optimal decisions, maximizing their profits, as mainstream “neoclassical” economists assume they do, this conclusion should be correct. It shouldn’t make any difference to a profit-maximizing firm whether, by reducing its emissions, it avoids the cost of buying emissions permits or reaps the benefit of selling permits. Either way, it will reduce emissions as long as the cost of doing so is less than the price of the permit.

But are real-life firms really the perfectly rational profit maximizers of the neoclassical economists’ imagination? Some insights from behavioral economics suggest they may not be, and therefore that they may react differently to a policy that makes them buy emissions permits compared to one that gives them permits for free.

The neoclassical story may seem strange to many non-economists. After all, if the government were to give away permits, allowing companies to keep polluting without having to pay for the privilege, why would they reduce their emissions at all? Continuing to emit as they have, it would seem, would not really cost them anything.

The answer, for neoclassical economists, lies in the concept of “opportunity cost.”

When we talk about “costs” in everyday speech, we are usually thinking of out-of-pocket expenses, paid for with money. Economists call these “accounting costs.” The accounting costs of going to a movie, for example, might include the cost of the gasoline used to drive to the theater, the cost of parking while attending the movie, and the cost of the movie tickets themselves.

Opportunity cost, on the other hand, is the value of the best alternative “forgone” (that is, the next most enjoyable thing you could have done, but didn’t do). For example, going out to a movie means not being able to stay home and watch a game on TV. Assuming that this is the next-best option, then whatever value one puts on watching the game is the opportunity cost of going to the movie.

How does this apply to climate policy?

Suppose that the government sells emissions permits (per ton of CO2) for $100. A company will have to pay this additional expense for each ton of CO2 emitted. Alternatively, it can save $100 by reducing its emissions by a ton. So if it can cut a ton of emissions at a total cost of less than $100, it will (assuming it is a profit-maximizing firm).

Now suppose that, instead, the government gives away the permits (say, by giving each company permits equaling their emissions for the last year) and the permits end up being traded at a price of $100 (per ton). The $100 that the company could make by selling the permit is the opportunity cost of emitting one ton of CO2. Now, a company can make $100 by selling a permit, but will have to forgo this benefit if it decides to go ahead and emit the ton of CO2. If it can reduce its emissions for less than $100, then, once again, it will do so. Here’s the key: To not do so “costs” it $100. The result in terms of CO2 emissions, therefore, is the same whether the government sells the permits or gives them away.

Neoclassical economists recognize that there are distributional differences between the two cases. In one case, the companies get the permits for free, and can keep any proceeds from their sale; in the other, the government gets the proceeds from the initial sale of the permits, and may distribute some or all of these proceeds to the public. (Neoclassicals, however, claim not to have any preference between one distribution and another.)

The neoclassical story assumes that firms treat accounting costs and opportunity costs the same. Indeed, that is what a firm should do in order to maximize its profits. But is that what firms actually do?

The field of “behavioral economics” is overflowing with examples showing that people are not typically the perfectly rational calculators assumed in neoclassical theory (a good introduction to some basic concepts can be found here). One way in which observed behavior often differs from that predicted by neoclassical economics is known as “loss aversion.” This means, simply, that people may weigh what they perceive as losses more heavily than what they perceive as gains (a loss of, say, $100 subtracts from a person’s subjective well-being more than a gain of $100 adds to their subjective well-being). Another is known simply as “habit” or “inertia.” This means that people will often just continue to behave the way they are accustomed as long as it yields satisfactory results, rather than switch to some other course of action, even if the latter would yield a greater payoff.

These concepts bear directly on how firms might respond to permits sold versus permits given to them for free.

First, loss aversion: Suppose that a firm’s decision-makers viewed what the firm had to pay for permits as “losses,” but what it could make by selling permits it had been given for free as (potential) “gains.” If they exhibit loss aversion, this mean they would regard an increase in accounting costs more seriously than an increase in opportunity costs. It is plausible that at least some firms would reduce emissions more if they had to pay for permits than they would if they were given permits for free.

Second, habit: Suppose that a firm has used a certain production process for some time. That is what managers and workers are used to. Perhaps a change in policy, such as a carbon tax or the requirement that they pay for emissions permits, could cause the firm’s decision-makers to reconsider their way of doing things, especially if these additional costs were large. But suppose that they are given emissions permits for free, allowing the firm to continue emitting the same quantity of carbon dioxide – in short, to continue acting just as it is accustomed – without facing any additional out-of-pocket cost. Again, it is plausible that at least some firms would go on with business as usual, even if the profit-maximizing course of action would be to reduce emissions and sell permits.

Neoclassical economists, to be sure, have a response to this line of argument. The shareholders of a firm that squanders opportunities to profit, they would argue, would surely force the management to shape up or would replace it with a new management. Alternatively, entrepreneurs would recognize that a firm could be more profitable, and would offer to buy it (for more than it is worth to the current owners, due to their failure to maximize profits, but less than it would be worth if it did maximize profits).

Again, however, this account assumes perfectly rational, calculating (and perfectly informed) decision-makers. Stockholders may not know much about the inner workings of companies whose stock they own, and may not be aware of opportunities for profit that management is squandering. Even if entrepreneurs were able to identify and offer to buy underperforming firms, the owners may not be willing to sell, perhaps for emotional rather than hard-headed business reasons. In short, while these additional pressures to maximize profits undoubtedly exist, they might not get us back to the neoclassicals’ world of perfect profit-maximization.

In fact, if we observe the real world, there are plenty of examples of firms’ failure to maximize profits. This failure is sometimes termed “X-inefficiency.” Here is a study suggesting that firms are more likely to cut X-inefficiency (or “fat”) when they are under “financial pressure.” This finding suggests that firms might react differently to a policy that imposes new out-of-pocket expenses, and therefore puts it under financial pressure, than to a policy that does not.

On the environmental front, researchers at the Toxics Use Reduction Institute at the University of Massachusetts-Lowell have identified numerous opportunities for businesses to reduce their use (and emission) of toxic substances while reducing costs and increasing profitability. That alone strongly suggests that firms are not always the perfect profit maximizers of neoclassical theory. If they were, no such opportunities would exist, since the firms would have already taken advantage of them.

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