I study ﬁrm behavior in new markets by examining coal-dependent private electric utili-ties’ beliefs about the sulfur dioxide allowance price following the implementation of the U.S. Acid Rain Program. The program is the ﬁrst large-scale cap-and-trade program, exposing the electric utility industry to a wholly novel market for pollution allowances. I estimate ﬁrms’ beliefs about the allowance price from 1995 to 2003 using a ﬁrm-level dynamic model of allowance trades, coal quality, and emission reduction investment. I ﬁnd that ﬁrms ini-tially underestimate the role of market fundamentals as a driver of allowance prices, but over time their beliefs appear to converge toward the stochastic process of allowance prices. Such beliefs in the ﬁrst ﬁve years of the program cost ﬁrms around 10% of their proﬁts. Beliefs also change the relative eﬃciency of cap-and-trade programs and emission taxes.
A central authority possessing tax and expenditure responsibilities can readily provide an efficient level of a public good. Absent a central authority, the case with climate change mitigation, voluntary arrangements must replace coercive arrangements; significant under-provision must be expected. Potential contributors have strong incentives to free ride, or to ride cheaply. International public goods are particularly challenging. The players - the nations of the world - are many and they start in quite different circumstances. Voluntary arrangements that might emerge from negotiations fall short for two reasons: First, players frame negotiations from their own standpoint, making stalemate likely. Second, the focal-point solution where contributions are proportional to benefits clashes with the disproportionate incentives little players have to ride cheaply. We identify a solution, the Cheap- Riding Efficient Equilibrium, which defines the relative contributions of players of differing size (or preference intensity) to reflect cheap riding incentives, yet still achieves Pareto optimality. Players start by establishing the Alliance/Nash Equilibrium as a base point. From that point they apply either the principles of the Lindahl Equilibrium or the Nash Bargaining Solution to proceed to the Pareto frontier. The former benefits from its focal-point properties; the latter is a standard analytic tool addressing bargaining. We apply our theory to climate change by first examining the Nordhaus Climate Club proposal. We then test the Alliance Equilibrium model using individual nations' Intended Nationally Determined Contributions pledged at the Paris Climate Change Conference. As hypothesized, larger nations made much larger pledges in proportion to their Gross National Incomes.