Question

There are three manufacturing firms in a small town. The table below shows each firms current pollution level and what it costs each firm, per unit, to reduce pollution Firm Initial Pollution Level (Units) Cost of Reducing Pollution by 1 Unit (Dollars) 40 60 14 80 The government wants to reduce pollution to 120 units, so it decides to give each firm 40 pollution permits. It has not yet decided whether or not to make the permits tradable. Which of the following is true? a) The total pollution reduction cost will be $620 less if the government allows trading of permits b) The total pollution reduction cost will be $840 less if the government allows trading of permits. c) The total pollution reduction cost will be $840 more if the government allows trading of permits d) The allowance of permit trading will not affect total pollution reduction cost. 25. The free market equilibrium maximizes welfare, or total surplus, unless a. There are third parties affected by the transactions. b. Certain market participants have control over the equilibrium. c. There is no way to prevent consumption by non-payers. Any of the above would prevent the market from achieving the social optimum.

Answer 1

Answer:

A. Consider the scenario wherein there is no trade permit of pollution is allowed, then the total cost of maintaining the pollution level of 120 unit is as under:

1. Firm A has pollution level of 40 units, and govt has given permit of 40 units, so there will be no cost for firm A.

2. For firm B, it has pollution level of 60 units, 20 units higher than permit, so firm B has to maintain the level of 40 units pollution by incurring cost ( 20 * 14 ) = 280 $

3. For Firm C, pollution level is 40 units more than permit given govt, so again firm C will reduce pollution unit by incurring cost ( 40 * 28 ) = 1120 $

Thus, if there is not trade permit allowed and have to maintain the limit of 120 units of pollution then the total cost of maintaining this level is

= Cost of firm A + Cost of Firm B + Cost of Firm C

= 0 $ + 280 $ + 1120 $

= 1400 $ ( No trade permit )

B Now we will see, this example when these firms trade their permit, and we will find optimum allocation of permit at which cost is minimized that will also maintain the total pollution unit 120.

1. Firm A has lowest cost of reducing pollution i.e 7$. So firm A will sell its all 40 units’ permit to the firm C with highest pollution unit, So firm A is not having pollution permit then it will reduce all 40 units pollution level by incurring cost ( 40 * 7 ) = 280 $

2. Now Firm C has its own 40 units permit + 40 units by A, and it has total pollution unit level is 80. So there will be no cost for C for pollution as it has same level of permit ( 40 units bought from A )

3. For firm B, it has permit of 40 units of pollution but actual pollution unit is 60 units. And there is not permit left in market to buy. So firm B will reduce 20 units pollution by incurring cost ( 20 * 14 ) = 280 $

Thus, if there is trade permit allowed and have to maintain the limit of 120 units of pollution then the total cost of maintaining this level is

= Cost of firm A + Cost of Firm B + Cost of Firm C

= 280 $ + 280 $ + 0 $

= 560 $ ( With trade )

Final Answer

Without trade cost is 1400 $ and with trade of pollution permit it reduced to 560$

Thus, there is advantage of 1400$ – 560 $ = 840 $

Thus correct option is option B, giving permission to trade pollution permit, it will reduce total cost by 840 $