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. First Unit of Pollution (Dollars) Cost of Eliminating the... Second Unit of Pollution (Dollars) Third Unit of Pollution (Dollars) Firm Firm X 165 220 Firm Y 130 600 90 1.200 750 115 Firm z 140

Answer 1

Firm	TC of eliminating two units of pollution
Firm X	130+165 =295
Firm Y	600+750=1350
Firm Z	90+115=205

At 141 & 183 Firm Z will sell permit

Firm	Initial poll permits	Action	Final amount	Cost
Firm X	2	Sell one permits	3	130+165+220=515
Firm Y	2	Buy two permits	0	0
Firm Z	2	Sell one permits	3	90+115+140=345

Proposed method	TC
Regulation	295+1350+205=1850
Tradeable permits	515+345=860

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