Strategic Manipulation of Pollution Permit Markets: An Experimental Approach

Abstract

"In this paper we employ experimental economic methods to examine the effect of market structure on the use of marketable emissions permits. In particular, we ask whether firms can strategically manipulate a product market using marketable emissions permits. Subjects participate in two markets, a permit market and a product market. They use permits to reduce the cost of production of the final goods that they sell in the product market. Four treatments are used to test the effects of initial permit allocation and market structure. The first two treatments explore 'simple' manipulation. In this case firms are all price takers in the product market but must compete for permits. In the second two treatments the experiment is expanded so that firms compete both in the permit and in final product markets, thus opening the potential use of permits as a form of market predation. Results show that in a market with one dominant firm and a number of fringe firms, strategic manipulation occurs repeatedly in the laboratory as the dominant firm uses licenses in an inefficient manner in order to minimize its costs, increase its profits and exclude rivals in the product market. Further these findings indicate, that far from improving market efficiency and decreasing the cost to society of pollution control, implementation of tradable permit markets where there are firms in a position of market power may decrease efficiency."