How does a pollution tax differ from a cap-and-trade system?

• A. A pollution tax fixes the price of emissions; cap-and-trade fixes the quantity of emissions.
• B. A pollution tax sets the quantity of emissions; cap-and-trade sets the price of permits.
• C. Both instruments set an identical price and quantity outcomes in all cases.
• D. A pollution tax creates a price on emissions; cap-and-trade creates a cap but allows trading to adjust the price.

Answer: (D)

The key idea is what each policy holds constant and what it lets adjust through the market. A pollution tax charges a per-unit fee on emissions, so the cost of emitting is fixed. Firms respond by reducing emissions to avoid the tax, but the actual level of emissions isn’t guaranteed to be a specific amount. In contrast, cap-and-trade sets a hard limit on total emissions—the cap. The government distributes or auction permits for that total, and firms can trade permits among themselves. Because the cap fixes the quantity, the overall emissions are predetermined; the price of emissions, determined by the permit market, can rise or fall as firms buy and sell permits.

So the correct idea is that a pollution tax creates a price on emissions, while cap-and-trade creates a cap on emissions and uses trading to let the price adjust.