Question

Correcting for negative externalities - Taxes versus tradable permits

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.

Graph Input Tool Daily Demand for Pollution Rights Price (Dollars per ton) 9 315 Quantity Demanded (Millions of tons) PRICE (Dollars per ton) Demand 0 FH 0 35 70 105 140 175 210 245 280 315 350 QUANTITY (Millions of tons)

1. 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.

2. 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 ____________

3. 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? Select all that apply.

Tradable permits

Corrective taxes

Answer 1

Blanks-

PRICE (Dollars per ton) Demand 0 35 70 105 140 175 210 245 280 315 350 QUANTITY (Millions of tons)

1) 27

2) 27

3) Tradable permit is correct