Question

5. Correcting for negative externalities - Regulation versus tradable permits Suppose the government wants to reduce the total pollution emitted by three local firms. Currently, each firm is creating 4 units of pollution in the area, for a total of 12 pollution units. If the government wants to reduce total pollution in the area to 6 units, it can choose between the following two methods: Available Methods to Reduce Pollution 1. The government sets pollution standards using regulation. 2. The government allocates tradable pollution permits. Each firm faces different costs, so reducing pollution is more difficult for some firms than others. The following table shows the cost each firm faces to eliminate each unit of pollution. For each firm, assume that the cost of reducing pollution to zero (that is, eliminating all 4 units of pollution) is prohibitively expensive. Cost of Eliminating the... Firm Firm First Unit of Pollution (Dollars) 130 Second Unit of Pollution (Dollars) 165 Third Unit of Pollution (Dollars) 220 Firm 90 115 140 Firm z 600 750 1,200 Now, imagine that two government employees proposed alternative plans for reducing pollution by 6 units. Now, Imagine that two government employees

Answer 1

Total cost of eliminating two units of pollution-

Firm X=130+165= 295

Firm Y= 90+115= 205

Firm Z=600+750= 1350

Price at which firm Y is willing to sell but firm X is not. This is the price between $140 to $220.

●$219

●$212

Firm	initial allocation	Action	Final amount	Cost
X	2	don't buy/sell	2	130+165=295
Y	2	sell one permit	3	90+115+140=345
Z	2	buy one permit	1	600

$218>$140 firm Y will sell one unit.

$218<$750, firm Z will buy one unit.

$218<$220, firm X will neither buy nor sell.

Total cost of elimination

Regulation-295+205+1350= $1850

Tradable permits-295+345+600=$1240

Eliminating pollution is MORE costly when the government regulates each firm than when it allocates pollution permits.

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