Competitive Dominance of Emission Trading Over Pigouvian Taxation in a Globalized Economy

Abstract

It is well-known that the Pigouvian taxation scheme and emission trading scheme (delegating the emission pricing authority to the market mechanism) offer equivalent incentives to reduce emissions in various autarky settings. In contrast, we demonstrate that in a globalized economy with international trade and cross border pollution, adopting the latter is the strict dominant strategy of each country, and global welfare is maximized when all countries adopt the latter. Adopting the latter incentivizes the other country to tighten its environmental regulation without concern for excessive shrink of domestic production and aggravation of cross border pollution from the adopting country.

Keywords: Emission Trading, Pigouvian Taxation, International Trade, Cross Border Pollution

JEL Classification: H23, L51, Q56, Q58