To address the problem of negative externalities, governments may use a quota system to try and limit them. In a quota system, the negative externality is capped at a certain amount. In the example of pollution, the government may put a quota on the amount of pollution a factory can produce by issuing tradable permits.
Tradable permits are one of the market-based approaches the government can use to address externalities. In the past tradable permits have been primarily used to control pollution .
Emissions Trading
Emissions trading or "cap and trade" is a market-based approach used to control pollution by providing economic incentives for reducing the emissions of pollutants.
When pursuing this approach the government sets a limit or cap on the amount of a pollutant that may be emitted. It then allocates emissions permits up to the specified limit among firms. The permits represent the right to emit or discharge a specific volume of a specified pollutant. Firms are required to hold a number of permits equivalent to their emissions. Firms that need to increase their volume of emissions must buy permits from firms that require fewer of them. This transfer is referred to as a trade. In effect, the buyer is paying a charge for polluting, while the seller is being rewarded for having reduced emissions. The outcome achieved by the market for permits is more efficient, regardless of the initial allocation of permits.
The market for tradable permits creates incentives for firms to produce less pollution. Firms that have a high cost of reducing emissions are willing to pay for the permits, while those that can reduce emissions in the most cost-efficient manner will do so and sell their permits. Tradable permits thus achieve a desired level of the externality by allowing the market to determine which market actors can create the externality.
There are several active trading programs for air pollutants. For greenhouse gases the largest is the European Union Emission Trading Scheme. In the United States there is a national market for sulfur dioxide emissions to reduce acid rain. Markets for other pollutants tend to be smaller and more localized.