Pollution in strategic multilateral exchange: Taxing emissions or trading on permit markets?

We introduce polluting emissions in a sequential noncooperative oligopoly model of bilateral exchange. In one sector, a leader and a follower use polluting technologies which create negative externalities on the payoffs of strategic traders who belong to the other sector. By modeling emissions as a negative externality, we show that the leader pollutes more (less) than the follower when strategies are substitutes (complements). Then, we consider the implementation of public policies to control the levels of emissions, namely, two taxation mechanisms and a permit market. We study the effects of these public policies. Moreover, we determine the conditions under which these public policies can implement a Pareto-improving allocation.