Chapter

Derivative Markets for Pollution Permits and Incentives to Innovate

Linda R. Cohen and Amihai Glazer

in Climate Change and Common Sense

Published in print February 2012 | ISBN: 9780199692873
Published online May 2012 | e-ISBN: 9780191738371 | DOI: http://dx.doi.org/10.1093/acprof:oso/9780199692873.003.0012
Derivative Markets for Pollution Permits and Incentives to Innovate

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Innovation can be encouraged by grants of a patent monopoly, subsidies to innovative activities, and prizes to innovators. This chapter examines a fourth mechanism—a firm engaged in R&D has private information about whether it succeeded or failed to innovate. It can profit from this private information by buying or selling an asset whose price will depend on whether the innovation is introduced or not. In particular, we look at an innovation which reduces the cost of abating pollution, reduces the prices of pollution permits, and allows the firm engaged in R&D to profit by buying and selling futures for such permits. We determine the government policy which can generate an equilibrium with sufficient profits to induce a firm to invest in R&D, and to induce the firm which made the innovation to charge a zero price for use of its innovation.

Keywords: innovation; pollution permits; R&D; futures markets; climate change

Chapter.  8878 words.  Illustrated.

Subjects: Economic Development and Growth

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