Cap-and-Trade

Governments have similarly tried to address the negative externalities from the burning of fossil fuels (e.g., climate change) through cap-and-trade systems, which are modern-day applications of the Coase theorem. The way these systems work is that the government requires emitters to hold permits for the amount of pollutants they emit. The government also sets a fixed number of total permits, which serves as the emission cap in the market, similar to the imposed limit on the number of cows that could graze on Boston Common. Then companies can trade permits on an open exchange. Such a system satisfies the conditions of the Coase theorem because property rights are well defined through the permitting process, companies act rationally to maximize their profits, and the open market provides low transaction costs.