What information does a government need if it wants to attempt to reduce a widespread negative externality like air pollution? Who, typically, is actually in possession of that information? How do markets in tradable emissions permits solve the asymmetric information problem affecting pollution abatement efforts?

The government needs information about the marginal cost and marginal benefit of pollution reduction to decide the optimal level of air pollution abatement. The marginal cost of reducing air pollution is the opportunity cost of the resources used to reduce pollution. The marginal benefit is the utility derived due to reduced pollution like cleaner air.

The diagram given below shows the market for pollution reduction:

Q0 is the optimal level of pollution reduction given by the intersection of the MB and MC curves. Any point above or below this level results in economic inefficiency.

It is difficult for the government to decide the optimal level of pollution reduction as information about the marginal cost of pollution reduction is known only to the firms engaging in polluting activities.

For example, a small factory might have a higher cost of pollution reduction compared to an old factory. It may be difficult for the government to identify the costs of pollution abatement.

The market for emission permits provides monetary incentives to polluters to reduce their emissions or share their emission reduction costs. In this market, an optimal amount of pollution is decided based on the level a society should tolerate, given the benefits associated with the economic activities that result in such pollution. High-cost firms will be the buyers revealing their costs indirectly.

For example, the government caps the CO2 emissions to $3 billion tons a year and then produces $3 billion worth of emission permits that can be traded in the market freely. The high-cost firms will enthusiastically purchase these permits as reducing pollution is more costly than buying these permits. The low-cost firms can easily reduce their pollution, and hence, can sell such permits to high-cost firms.

In this way, the problem of asymmetric information is resolved as firms with high costs of reducing pollution will indirectly share their costs by buying such permits.