Question

 Power stations emit sulfur dioxide 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 power 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 sulfur dioxide). 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.

 Suppose the government has determined that the socially optimal quantity of sulfur dioxide emissions is 245 million tons per day.

 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 sulfur dioxide 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 sulfur dioxide per day. To achieve the socially optimal quantity of pollution, the government auctions off 245 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.

 Imagine that new research suggests that if manufacturers in a particular city reduced their emissions to 80 million tons of waste per year, the air quality would improve dramatically.

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

•  Tradable permits

•  Corrective taxes

Answer 1

One way government can charge firms for pollution rights is by imposing per-unit tax on emissions. The tax (or price) = $27 per ton sulfur dioxide emitted will achieve the desired level of pollution. (Because quantity = 245 millions tons when price = $27 per ton.) If the government impose tax less than $27 per ton then , power stations would choose to emit more than 245 million tons of sulfur dioxide  . Similarly , if the government impose a tax more than $27 per ton then, sulfur dioxide emitted would be reduced more than the socially optimal level.

Suppose to achieve the socially optimal quantity of pollution , the government auctions off 245 million pollution permits. Given, this quantity of permits ,the price for each permit ,the price for each permit in the market for pollution rights will be $27 per ton. Because selling 245 million pollution permits that allow firm to emit one ton of sulfur dioxide means that the supply of pollution will be 245  million tons per day. At a quantity of 245 million tons , the market for pollution rights will clear at a price of $27 per ton. This implies that each pollution permit will have a value of $27 because at this price all 245 million pollution permits will be demanded.

TRADABLE PERMITS: The government would want to use the tradeable permits as the preferred mode of pollution control as it helps fix the rate of pollution rights without knowing the demand for the same.

If the government knows how much it costs a particular polluting firm to reduce pollution at each quantity , this means they also knows the firm's demand for pollution rights. Therefore, the government can achieve the socially optimal quantity of pollution by setting a corrective tax equal to the price the firm is willing to pay to pollute at the optimal quantity ,This causes producers to internalize the cost, so they will generate pollution only up to the point where marginal benefit equals to the marginal social cost . This quantity will be lower than that in the absence of the tax , since without the tax they would continue to produce units that generated private benefits equal to private marginal cost but lower than the total marginal cost.Because the government also knows the optimal quantity of pollution , they can also use Tradable permits, which are a direct means of controlling the pollution emitted. So, both are equally effective , depends on which information is available.