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The Annals of Regional Science

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30-10-2023 | Special Issue Paper

Carbon tax vs. emission trading in a monopolistically competitive market with heterogeneous firms

Authors: Kefu Lin, Rui Pan, Dao-Zhi Zeng

Published in: The Annals of Regional Science | Issue 2/2024

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Abstract

We establish a general-equilibrium model to compare the efficiency of two emission regulation policies used worldwide: the carbon tax (CT) and the emission trading scheme (ETS). Assuming monopolistic competition and heterogeneous firms, we show that the ETS is better in an economy with a high degree of heterogeneity, and the CT is better otherwise. We also explore how the market distortions under these two regulation policies are different. Moreover, we find that the excessive input of an immobile resource in manufacturing production may result in market inefficiency.

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The “ETS” and the “cap-and-trade system” are interchangeable in our paper to indicate the trade of emission allowances.

See the website of the European Commission (https://reurl.cc/eWvLVx).

Many studies investigate the differences in specific design and operating elements between two policies, such as the government’s acting strategy (Ishikawa and Kiyono 2006; Wirl 2012; Kiyono and Ishikawa 2013; Eichner and Pethig 2015), transaction cost (Stavins 1995; Baudry et al. 2021), and footloose capital (Lai 2022).

Some specific examples and empirical facts are given in their paper (pp. 6–7).

The selection effect means that entrants with lower productivity are driven out of the market (Melitz 2003; Melitz and Ottaviano 2008). In this paper, a tougher selection effect indicates a higher average productivity of active firms as more low-productivity entrants are eliminated, allowing the mass of entrants and active firms to be endogenously determined. The selection effect does not work in Shinkuma and Sugeta (2016) as they assume all the entrants can produce and no firms exit.

Some papers, like Shinkuma and Sugeta (2016), introduce a term of environmental cost as a negative externality in the utility. Here, we temporarily suppress this term and compare policies to reach the same emission target. We will show that including such an externality term in the utility does not change our results in Sect. 3.3.

Assumptions (5) and (6) ensure that \(\varphi _t^*<{\bar{\varphi }}\) and \(T>0\) when \(f=f^*\).

Some papers assume that the government will allocate a fraction of initial allowances to firms freely and the rest are auctioned (Shinkuma and Sugeta 2016; Lai 2022). However, in this research, the equilibrium market outcome and social welfare remain unchanged regardless of the initial allowances allocation among the entrants or auctioned. The proof is given in Appendix A.

We consider that the initial allowances are allocated to the entrants rather than active firms only to capture the essence of asymmetric information. Firm productivity is private information. The government knows the productivity distribution of all firms, but not the specific productivity level of each firm. Identifying the productivity of active firms later might incur additional costs, which is not the focus of our research. On the other hand, when the productivity information is known to both firms and the government, the market outcomes will vary with different initial allowance allocations, which have been discussed in detail by Konishi and Tarui (2015).

Assumptions (5) and (6) ensure that \(\varphi _e^*<{\bar{\varphi }}\), while (7) ensures that \(\Pi >0\) when \({\bar{e}}={\bar{e}}^*\).

The authors are indebted to an anonymous referee for bringing this issue to their attention.

The gap here is a relative value. Note that \(\varphi _i\) denotes the marginal input level. The ratio of productivity levels of ETS to CT is written as \(\varphi _t^*/\varphi _{e}^*\). Figure 2 shows that \(\varphi _t^*/\varphi _{e}^*|_{k=3}>\varphi _t^*/\varphi _{e}^*|_{k=5}\), indicating a larger productivity gap between two policies when heterogeneity increases.

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Title: Carbon tax vs. emission trading in a monopolistically competitive market with heterogeneous firms
Authors: Kefu Lin
Rui Pan
Dao-Zhi Zeng
Publication date: 30-10-2023
Publisher: Springer Berlin Heidelberg
Published in: The Annals of Regional Science / Issue 2/2024
Print ISSN: 0570-1864
Electronic ISSN: 1432-0592
DOI: https://doi.org/10.1007/s00168-023-01249-8

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