The town I live in is facing a zoning controversy.  An old family-run restaurant on a downtown corner has gone out of business and put the property up for sale.  The high bidder is Dairy Queen.  But the town’s zoning board is set to reject the sale.

At first there doesn’t seem to be any economic rationale for elected representatives of the town stopping what the citizens of the town are evidently voting for with their dollars.  The argument would be that the reason Dairy Queen is the high bidder is that Dairy Queen expects to earn the most in that location.  Since their earnings come from providing a valuable product and service, this must mean that giving the space to Dairy Queen will generate the most value for the citizens of my town.  Why doesn’t the zoning board see this?

Well, they just might be smart enough to see that the simple argument I have given is flawed.  The flaw is that it assumes that Dairy Queen faces the same market conditions as any other bidder for the space.

Bidding for the right to enter a market is determined not by the amount of value the business will create, but the amount of that value that the business gets to keep.  The share of value that the business gets to keep is determined by market conditions.  Generally, businesses that face competition get a smaller share of the value they create than businesses with less competition.

Because of this, unregulated markets for scare commercial real estate will not necessarily lead to an efficient allocation.  A bank may be more valuable to the community and yet lose the bidding to Dairy Queen.  Zoning boards can, in principle, correct this by intervening.

A similar logic is at work in pollution-permit trading markets, although with a twist.  The naive argument is that the social cost of a unit of carbon emissions is the same regardless of who is the emitter, but the benefits vary.  And the benefits will be reflected in the polluters’ willingness to pay for permits.  If we attach a high value the output of producer A, then producer A should be more willing to pay for the right to produce (and therefore pollute) than producer B whose output we value less.

But again this depends on the market conditions.  Producer B might be in a competitive market where, at the margin, it internalizes all of the gains from increased output and Producer A might be a monopolist whose marginal revenue is less than price and therefore internalizes only a fraction of the gains.

(The twist is that pollution rights are divisible and so the appropriate calculation is at the margin which flips the comparison between competitive and monopolistic producers.  Real estate is indivisible (or at least much less divisible) and so average calculations take over.)

This points to an advantage of a carbon tax over a market-based permit system.  A carbon tax can be customized by industry and market conditions.  A permit market treats all polluters equally.