Describe how a cap-and-trade system works.

Tradeable emissions permits ("cap and trade")are a way to overcome the asymmetric information problem. These work by giving polluters a financial incentive to reveal their emission reduction costs and follow through on emissions reductions. Suppose the U.S. government knows that the allocatively optimal amount of CO₂ emissions is 4 billion tons per year, but that 5 billion tons are currently being emitted. The government will cap the total amount of emissions by printing up and handing out to polluters only 4 billion tons' worth of tradable emissions permits. Each permit may be for, say, 1 ton of CO₂ emissions, and emitting that amount of CO₂ is legal only if you have a permit. The government will have to hand out the permits without knowing whether they are going to the emitters that have the lowest costs of abatement. But then the government can let the invisible hand do its work. The permits are tradeable, meaning that they can be bought and sold freely. An emissions-trading market will pop up, and what you'll find is that the firms with the highest costs of emissions reduction will purchase permits away from the firms with the lowest costs of emission reduction. The high-cost firms benefit because it is less expensive for them to buy permits to keep on polluting than it is to reduce their own pollution. And the low-cost firms benefit because they can make more money selling their permits than it will cost them to reduce their emissions (which they must do after they sell away their permits). Both sides win, the externality is reduced at the lowest cost, and society achieves the allocatively efficient level of pollution. This is an economically sophisticated way of overcoming the asymmetric information problem in pollution abatement in order to reduce emissions at the lowest possible cost.