For want of a chair: teaching price formation using a cap and trade game
The tradable or transferable permit system, ‘cap and trade’, is one of the most innovative policy options developed by environmental economists. The authors of this paper have created a ‘cap and trade’ game, an active learning method which can be a superior way to teach current and future decision-makers about price formation, gains from trade, voluntary response to incentives, and an important environmental economics policy.
Cap and trade programmes have been used around the globe over the last 40 years by some of the world’s biggest economies. By placing a cap on a negative externality, whether a pollutant or excess fish mortality, and then allowing firms to buy and sell the right to generate it, policymakers combine government intervention with market-based incentives in order to improve welfare and internalise the externality.
Such programs, the authors argue, represent a great opportunity for economics instructors to show students how economic theory can be used in the real world by policymakers. The authors’ in-class game utilises a mobile app or paper-based interaction to create a market for a pollutant. This teaches students how prices are formed and how price-based incentives lead to voluntary – in effect cooperative – behaviour by agents. The game contributes to addressing some of the public resistance to cap and trade, as students get to recognise the benefits of not only setting a cap, but also of letting economic actors trade allowances.
Key points for decision-makers
- Cap and trade has become a global standard in environmental governance, for example in the form of emissions trading schemes and rights-based transferable permits for managing pollutants and limiting over-fishing.
- Programmes begin with a cap on the amount of a pollutant or another unpriced ‘good’. Firms must have a permit for each unit of capped pollutant. After the initial permit allocation, firms can buy and sell permits in a market. The corresponding negotiating process leads to the formation of a price for the scarce resource.
- Transferable permits programmes integrate many critical economics concepts that are difficult for students, especially undergraduates, to understand without relatable personal experience.
- Price formation is one such topic students have little experience with, so to improve learning the authors developed an in-class game as a superior way to teach compared with lecturing.
- The authors developed a ‘cap and trade’ game playable either with a mobile app or paper cards supported by an Excel spreadsheet to teach price formation.
- This enables an instructor to teach students first, how transferable permits work, and how economic theory is put to work to make society better; second, how prices are formed, based on supply and demand; and third, to compare a market price to a corrective tax, or quantity-based and price-based market mechanisms.
- Through the face-to-face buying and selling of permits, students can see how prices are formed first-hand, and how externalities are addressed at the lowest cost for the economy.
- While setting a cap on emissions may be very intuitive, the benefits of allowing emissions trading are not obvious to many, but they become more obvious through playing this game, and the exercise shows how market-based regulation can in fact result in a better societal outcome.
- The initial allocation is done randomly through a game of musical chairs, which engages students and makes lectures a bit more fun.
- The authors have used the game for around 10 years in settings from freshmen seminars to graduate courses in environmental economics, with positive student evaluations.