For want of a chair: Teaching price formation using a cap and trade game

Abstract

“Cap and trade” is one of the most innovative policy options developed by environmental economists. By placing a cap on a social bad and allowing firms to buy and sell the right to generate it, policymakers combine government intervention with market-based incentives to improve welfare and internalize the externality. Such programs represent a great opportunity for instructors to show students how economic theory is used in the real world. Students can learn several important tenets of economics by playing an in-class game based on musical chairs, which creates a market for pollution using a mobile app or paper-based interaction. This active learning method engages students and improves comprehension of price formation, gains from trade, voluntary response to incentives, and an important environmental policy.

Keywords:

• Cap and trade
• carbon tax
• classroom game
• emissions trading scheme
• price formation

JEL CODES:

• A20
• Q31
• Q38

Correction Statement

This article has been republished with minor changes. These changes do not impact the academic content of the article.

Acknowledgments

The authors thank Marion Dumas, Roger Fouquet, Sharon Hall, Humberto Llavador, James Rising, and Mary-Louise Timmermans for very useful comments on an earlier version of this paper. Carattini acknowledges support from the Grantham Foundation for the Protection of the Environment and the Centre for Climate Change Economics and Policy, which is funded by the UK Economic and Social Research Council as well as from the Swiss National Science Foundation, grant number PZ00P1_180006/1.

Notes

1 While this is true according to economic theory, in practice, regulatory interventions or transaction costs may prevent the equality from holding.

2 Differences may emerge, however, in terms of surplus, especially if, in the emissions trading scheme, permits are allocated for free (grandfathered) to firms, for instance, based on past emissions (see Martin et al. 2014). This is an aspect that may be discussed in class. Please refer to Phaneuf and Requate (2017), and other textbooks, for a formal analysis.

3 We have found that using musical chairs keeps students interested. In the event that musical chairs cannot be played due to space or other constraints, another randomization process could also be used to determine who is provided an initial allocation of permits.

4 The value of the profits with a chair is drawn from a uniform distribution with a fixed interval. The profits without a chair are drawn from a uniform normal distribution between zero and the profits with a chair. Through the central limit theorem, the difference between the two values is then normally distributed.

5 While we have played the game with classes over 25 students, we find that physical space does not usually support an effective realization of the game, recording costs in class with the paper-based interaction becomes burdensome, and students may become less engaged.

6 Depending on the level of class, instructors can go into detail about the concave-up nature of the cost function and the concave-down nature of the benefit function.

7 Again, a video demo of the app can be found at https://youtu.be/K0RwenBSL3g.