Guest post from Jim Roumasset:
James Hansen's op-ed attacking cap-and-trade is not quite as stupid as Krugman makes it out to be (Unhelpful Hansen). Krugman's graph is fine, but doesn't drive the point home. Non-economists who have heard about the polluter-pays-principle can be excused for not understanding that it's the price not the punishment which internalizes the externality.
In Krugman's world of perfect certainty, Hansen's fee and dividend proposal is a form of cap and trade! The government simply sells the permits at the known price, then distributes the revenue lump sum to "the public," which is the same as if the public were given the permits in the first place. Thus fee and dividend has some efficiency advantages over Waxman-Markey, for example, which would return substantial revenue to electric utility customers, but not in a lump-sum fashion.
The equivalency graph does provide a useful starting point. As Coase has explained, first-best equivalency directs our attention to the appropriate institutional comparisons, including uncertainty and administrative costs. As far as I know, the relevant uncertainty case, with uncertainty about both marginal abatement and damage costs, has not been analyzed in the literature. Finally, since the second-best world has distortionary capital and labor taxes, revenue recycling is superior to lump-sum rebates.
