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Phuong Ho, Postdoctoral Researcher at the Centre for Applied Research at the Norwegian School of Economics
Why Is Trading So Important in Cap and Trade? The Role of Economies of Scale and Productivity
Abstract: Economists have long established the cost effectiveness of cap and trade (CAT) owing to cost heterogeneity between firms. I offer a new value of CAT: cost reduction within firms owing to productivity improvement and economies of scale. Overcoming the unobserved-cost challenge, I extend the literature on production functions and introduce a method to estimate economies of scale using data on output and input quantity. I combine this method with a difference-in-difference strategy that exploits the policy transition from non-tradable caps to cap and trade in the Norwegian cod fishery to identify the causal impacts of trading fishing quotas. I find trading increased vessels' productivity and facilitated the realization of existing economies of scale. Vessels acquired quotas, realized economies of scale, and moved toward the minimum average cost levels by increasing their sizes and going fishing more often. In decomposition of the output-based value of traded quotas, I find economies of scale played a main role in the first few years after a big vessel acquired quotas. These results highlight that (i) flexibility through tradability in environmental regulations can reduce production costs of a firm, (ii) cost reduction is gained by both boosting existing production factors and advancements beyond scale economies, and (iii) consolidation can be a sign of cost efficiency owing to economies of scale rather than market power abuse.