Which of the following best describes the difference between tradable allowances and a Pigovian tax in addressing negative externalities?

• A. Tradable allowances increase government revenue, while a Pigovian tax does not affect government finances.
• B. Tradable allowances set a fixed quantity of allowable pollution and let firms trade permits, while a Pigovian tax imposes a per-unit tax on pollution to internalize the external cost.
• C. Tradable allowances require firms to pay a fixed fee for each permit, while a Pigovian tax allows unlimited pollution without any cost.
• D. Tradable allowances are only used for positive externalities, while Pigovian taxes are used for negative externalities.

Answer: (B)

Verified step by step guidance

1. Step 1: Understand the concept of negative externalities, which occur when a firm's production or consumption imposes costs on third parties not reflected in market prices.
2. Step 2: Define tradable allowances (also known as cap-and-trade systems) as a policy tool that sets a fixed total quantity (cap) of allowable pollution and distributes permits to firms, which can then be bought and sold (traded) among firms.
3. Step 3: Define a Pigovian tax as a per-unit tax imposed on the quantity of pollution emitted, designed to internalize the external cost by making polluters pay a price equal to the marginal external damage.
4. Step 4: Compare the two approaches: tradable allowances fix the quantity of pollution and let the market determine the price of permits, while a Pigovian tax fixes the price of pollution and lets the market determine the quantity emitted.
5. Step 5: Recognize that tradable allowances create a market for pollution permits and can generate government revenue if permits are initially auctioned, whereas Pigovian taxes directly generate government revenue through the tax collected on each unit of pollution.