Question

Soot is considered the second largest cause of global warming. It is emitted from a variety of sources, but most notably from vehicles. Damian owns a logistics company that has a very large fleet of diesel trucks. The Australian Government recently introduced legislation that charges companies based on the amount of emissions of their fleets that are above 5% soot. They can either opt to meet the 5% target and pay no permit cost (Process D), or purchase permits entitling them to pollute in excess of 5% (but this will also incur a cost to modify their fleet using Processes A, B, and C).

Process	A	B	C	D
Soot emissions (%)	10	8	6	5
Costs to modify Damian’ fleet with Process ($ thousand)	0	100	700	900
Permit cost ($ thousand)	500	300	100	0

1. Given the government’s policy, the government believes that currently emissions of soot are too high. An economist would say that the current level of soot emissions results in less surplus than the optimal level. In other words, the market is currently: Blank 1. Type E for Efficient, NE for Not Efficient, O for exceeding the Opportunity cost or M for Maximising social benefits.
2. Imagine the government altered its goal and instead decided that only 60% of Damian’s fleet had to be compliant with the 5% target. What would be the total cost to society be to ensure Damian’s company complied with the Government’s requirements?   Answer in millions of dollars (rounded to two decimal places). $Blank 2 million.
3. Given the cost of permits and costs to modify his fleet, what process will Damian prefer out of the four options? Blank 3. Type A, B, C, or D.

Answer 1

Ans (a) Since the current emissions of soot are too high, and the current emission results in less surplus than the optimal level, the market is currently under Type O i.e. the Opportunity Costs are increasing.

Opportunity cost refers to the cost of the next best alternative foregone. The Law of Increasing Costs states that once all factors of production ( Land, Labour, and capital ) are at maximum output and efficiency, producing more will cost more than average. So as pollution increases, the opportunity cost will also increase. The Law of Increasing costs is an important law of Microeconomics. It is an important consideration for business owners who strive to keep their operations running at full capacity so as to achieve the highest level of profit possible.

An increase in output will create a higher cost for each additional unit of output. According to this law, if an increasing amount of a variable factor is applied to a fixed quantity of other factors per unit of time, the resulting increase in output will start becoming smaller and even smaller with time.

Thus, the law of diminishing returns (or law of increasing costs can be studied from two points of view:-

(i) As it applies to Agriculture, and

(ii) As it applies to industry.

However, there are certain assumptions of the law of increasing costs:-

(a) Time is too short for the firm to change the number of fixed factors.

(b) All units of variable factors are efficient

(c) There is no change in the techniques of production.

Ans (b) Now, if the government alters its goal and instead decided that only 60% of Damian 's fleet had to be compliant with the 5% target, the total cost to the society can be calculated as follows:-

Process	A	B	C	D
Soot Emissions (%)	10	8	6	5
Costs to modify Damian Fleet with Process ($ thousand )	0	100	700	540
Permit cost ($ thousand )	500	300	100	0
Total Cost	500	400	800	540

Since only 60% of Damian's fleet had to be compliant with the 5% target, only 60% the fleet cost of process D will be incurred because 5% target is being met just there and Process A, B, and C are having greater soot emissions i.e more than 5%.

Ans(c) If we consider the original case i.e when 100% cost of the fleet is to be considered in the case of Process D, the Total Cost can be calculated as follows:-

PROCESS	A	B	C	D
Soot emissions (%)	10	8	6	5
The cost to modify Damian Fleet with the process ($ thousand)	0	100	700	900
Permit cost ($ thousand )	500	300	100	0
Total Cost	500	400	800	900

Since the total cost is least in case of Process B.i.e 400. Hence, Damian should prefer Process B.

Even, if part (b) is looked at Damian should prefer Process B.