Question

5. Correcting for negative externalities - Regulation versus tradable permit Suppose the government wants to reduce the total pollution omitted 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 facem different costa, se reducing pollution is more difficult for some firms than others. The following table shows the cont cach firm faces to eliminate cach 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. First Unit of Pollution Cost of Eliminating the... Second Unit of Pollution (Dollar Third unit of Pollution GSO BOO 1,500 Now, imagine that two government employees proposed alternative plans for reducing pollution by 6 units Method 2: Tradable Permits Meanwhile, the other employee proposes using a different strategy to achieve the government's goal of reducing pollution in the area from 12 units to 6 units. This employee suggests that the government issue two pollution permits to each firm. For each permit a firm has in its possession, it can emit 1 unit of pollution. Firms are free to trade pollution permits with one another (that is, buy and sell them) as long as both firms can agree on a price. For example, if firm X agrees to sell a permit to firm Y at an agreed-upon price, then firm Y would end up with three permits and would need to reduce its pollution by only 1 unit while firm X would end up with only one permit and would have to reduce its pollution by 3 units. Assume the negotiation and exchange of permits are costless. Because firm Z has high pollution-reduction costs, it thinks it might be better off buying a permit from firm Y and a permit from firm X so that it doesn't have to reduce its own pollution emissions. At which of the following prices are both firm Y and firm X willing to sell one of their permits to firm Z? Check all that apply. $109 $149 $170 $579 $787 Suppose the the government has set the trading price of a permit at $498 per permit. Suppose the the government has set the trading price of a permit at $498 per permit. Complete the following table with the action each firm will take at this permit price, the amount of pollution each firm will eliminate, and the amount it cost each firm to reduce pollution to the necessary level. If a firm is willing to buy two permits assume that it buys one permit from each of the other firms. (Hint: Do not include the prices paid for permits in the cost of reducing pollution.) Initial Pollution Permit Final Amount of Pollution Cost of Pollution Allocation Eliminated Reduction Firm (Units of pollution) Action (Units of pollution) (Dollars) Firm Firm Firm Regulation Versus Determine the total cost of eliminating six units of pollution using both methods, and enter the amounts in the following table. (Hint: You might need to get information from previous tasks to complete this table.) Total Cost of Eliminating Six Units of Pollution Proposed Method Regulation Tradable Permits In this case, you can conclude that eliminating pollution is costly to society when the government regulates each firm to eliminate a certain amount of pollution than when it allocates pollution permits that can be bought and sold.

Answer 1

Method 1 Regulation

Firm X = 90+125 = 215

Firm Y= 55+70 = 125

Firm Z= 650+800 = 1450

Method 2 Tradable permits

Both X and Y are willing to sell

select 579 and 787

Firm	Initial permit	Action	Final Amount	Cost of reduction
X	2	Sell 1 permit	3	90+125+180=395
Y	2	Sell 1 permit	3	55+70+110=235
Z	2	Buy 2 permit	0	0

Regulation vs Tradable permits

Regulation=215+125+1450=1790

Tradable permits = 395+235=630

In this case you can conclude that eliminating pollution is more costly to society when the government regulates