Question 3 (Cap and trade versus emissions tax) The European Union (EU) emissions trading system is a cap-and-trade system for reducing industrial greenhouse gas emissions (negative externalities) to combat climate change. The cap limits the amount of certain greenhouse gases that can be emitted and is reduced over time so that total emissions fall. Firms in the system may receive or buy emission allowances, which they surrender each year to cover their annual emissions or face heavy fines. Firms with excess allowances may use them to cover future needs or sell them to another firm that does not have enough of its own.

a) Under what circumstances would auctioning allowances be equivalent to a tax in reducing emissions? Use the framework presented in class to illustrate the conditions behind the equivalence between the two policy approaches.

b) Why might a government prefer auctioning allowances over a tax on emissions? To help support your arguments, refer to the short article by Mankiw "Smart Taxes, an open invitation to join the Pigou club", Eastern Economic Journal, 2009, 35, (page 14 - 23), posted on LEARN in the topic 3 folder