Cap-and-trade under transactions costs and factor irreversibility

We study production capacity and emission permit utilization under joint production of a valued good and an environmental bad, pollution. Firms experience random productivity shocks after factor employment. A cap-and-trade regulation controls pollution emissions. Trade in emission permits entails transactions costs. Under proportional permit trading costs, the equilibrium depends on total per unit trading cost; its incidence between buyers and sellers does not matter. Under fixed trading costs, both buyers’ and sellers’ costs matter. Under proportional costs, permit trade always occurs when total trading costs are below net trade surplus. If these costs are sufficiently low, the production–emission outcome is as under costless trade with full utilization of production capacity and emission permits. With fixed costs, trade occurs if costs are sufficiently low, but production capacity and emissions permits are never fully utilized. Under proportional costs, trade is impeded most when the emission cap is either relatively high or low. There exists a nonmonotonic relationship between the emissions cap and a lower bound for trading costs that obstructs trade. Under fixed costs, a similar relationship holds only if the output variance is scale independent. Under proportional costs, capacity utilization decreases with output variance; the result is the opposite under fixed costs.