Question

11. Correcting for negative externalities - Regulation versus tradablepermits 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. Third Unit of Pollution (Dollars) Firm Cost of Eliminating the... Second Unit of Pollution (Dollars) 165 750 115 First Unit of Pollution (Dollars) 130 600 90 Firm X 220 Firm Y 1,200 140 Firm z

Answer 1

Method 1 Regulation

Firm X = 130+165=295

Firm Y= 600+750=1350

Firm Z=90+115=205

Method 2 Tradable permits

Should be above Z $ X's cost of third unit of pollution(>140 and 220)

select $310 and 548

Firm	Initial permit	Action	Final Amount	Cost of reduction
X	2	Sell 1 permit	3	130+165+220=515
Y	2	Buy 2 permit	0	0
Z	2	Sell 1 permit	3	90+115+140=345

Regulation vs Tradable permits

Regulation=295+1350+205=1850

Tradable permits = 515+345=860

In this case you can conclude that eliminating pollution is less costly to society when the government distributes tradable permits