Small Pollution Markets: Tradable Permits versus Revelation Mechanisms

A simple two-period model with two polluters is analyzed. They emit a homogeneous hazardous substance, and they are given tradable permits to pollute. The social planner issues permits and tries to learn the cost of reducing pollution by observing the quantity of permits traded in the first period. It is shown that although efficient trade is prevented by strategic considerations by the polluters, the planner learns something from observing only quantities. Comparisons are made between this approach and that of mechanism design, and it is concluded that the latter is superior in theory, but sensitive to collusion by the firms.