Question

7. Correcting for negative externalities - Taxes versus tradablepermits

Paper factories emit chemicals as a waste product. This generates a cost to society that is not paid for by the firm; therefore, pollution is a negative externality of paper production. Suppose the U.S. government wants to correct this market failure by getting firms to internalize the cost of pollution. To do this, the government can charge firms for pollution rights (the right to emit a given quantity of chemicals). The following graph shows the daily demand for pollution rights.

Use the graph input tool to help you answer the following questions. You will not be graded on any changes you make to this graph.

Note: Once you enter a value in a white field, the graph and any corresponding amounts in each grey field will change accordingly.

Graph Input Tool Daily Demand for Pollution Rights | Price (Dollars per ton) Quantity Demanded (Millions of tons) 270 PRICE (Dollars per ton) Demand + 0 30 60 90 120 150 180 210 240 270 300 QUANTITY (Millions of tons)

One way governments can charge firms for pollution rights is by imposing a per-unit tax on emissions. A tax (or price in this case) of_____per ton of chemicals emitted will achieve the desired level of pollution.

Now suppose the U.S. government does not know the demand curve for pollution and, therefore, cannot determine the optimal tax to achieve the desired level of pollution. Instead, it auctions off tradable pollution permits. Each permit entitles its owner to emit one ton of chemicals per day. To achieve the socially optimal quantity of pollution, the government auctions off 150 million pollution permits. Given this quantity of permits, the price for each permit in the market for pollution rights will be ____

The previous analysis hinges on the government having good information regarding either the demand for pollution permits or the optimal level of pollution (or both). Given that the appropriate policy (tradable permits or corrective taxes) can depend on the available information and the policy goal, consider the following scenario.

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An environmental study conducted in a particular city suggests that if a chemical plant emits more than 30 million tons of chemicals each year, the water supply will become contaminated beyond the point where filtration techniques can make it safe for drinking.

If this is all the information the government has, which solution to reduce pollution is appropriate? Check all that apply.

___Corrective taxes

___Tradable permits

Answer 1

A tax of $35 per ton of chemicals emitted would produce desired levels of pollution.

Reason- -When Q=150, Price=$35.

Given this quantity of permits, the price for each permit in the market for pollution rights will be $35.

Reason- Quantity of permits is given to be 150, The corresponding price will be $35..

■ Tradable permits

When Quantity is known we can use Tradable permits, when cost is known we can use Corrective taxes Since we are told 30 million tons of chemicals, only Tradable permits can be used.

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