A cap and trade system limits, or caps, the total amount of a negative externality, and producers must buy licenses to generate that externality.

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In a cap and trade system, a cap is placed on the total amount of a negative externality that can be produced. Producers must have licenses to generate that externality, and they must either buy those licenses or reduce their emissions to stay within the cap. This creates a market where the cost of emitting the externality is reflected in the price of the licenses.

A Cap and Trade System Limits, or Caps, the Total