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Why Is Trading So Important in Cap and Trade? The Role of Economies of Scale and Productivity

: Economists have long established the cost effectiveness of cap and trade (CAT) owing to the cost heterogeneity between firms. I offer a new value of CAT: cost reduction within firms owing to productivity improvement and economies of scale. Overcoming the unobserved-cost challenge, I extend the literature on production function and introduce a method to estimate economies of scale using data on output and input quantity. I combine this method with the difference-in-difference strategy to exploit the policy transition from non-tradable cap to cap and trade in Norwegian cod fishery to identify the causal impacts of trading fishing quotas. I find trading increased vessels’ productivity and facilitated the realiza-tion of existing economies of scale: vessels acquired quotas, expanded their operation, and moved toward the minimum average cost levels. Vessels realized economies of scale by upgrading their sizes and going fishing more often. I decompose the output-based value of traded quotas and find economies of scale played a main role in the first few years after a big vessel acquired quotas. These results highlight (i) tradability in environmental regulations can reduce production costs of a firm, (ii) firms reduce costs by boosting existing production factors and advancements beyond scale economies, and (iii) consolidation can be a sign of cost efficiency owing to economies of scale rather than market power abuse.