For Want of a Chair: Teaching Price Formation Using a Cap and Trade Game

Abstract

The tradable or transferable permit system, "cap and trade", is one of the most innovative policy options developed by environmental economists. Over the last 40 years, cap and trade programs have been used around the globe by some of the world's biggest economies. By placing a cap on a bad, whether a pollutant or excess fish mortality, and then allowing firms to buy and sell the right to generate it, policy makers combine government intervention with market-based incentives in order to improve welfare and internalize the externality. Such programs represent a great opportunity for economics instructors to show students how economic theory can be used in the real world by policy makers while teaching foundational economic concepts. By using an in-class game that utilizes a mobile app or paper-based interaction to create a market for a pollutant (or another rival but non-excludable resource), students can learn several important tenants of economics. These include how prices are formed and how price-based incentives lead to voluntary, as if cooperative, behavior by agents. This active learning method engages students while improving their comprehension of price formation, gains from trade, voluntary response to incentives, and an important environmental economics policy.