Question

7. Correcting for negative externalities - Taxes versus tradable permits Power stations emit sulfur dioxide as a waste product. This generates a cost to society that is not paid for by the firm; therefore, pollution is a negative externality of power production. Suppose the U.S. government wants to correct this market failure by getting firms to internalize the cost of pollution. To do this, the government can charge firms for pollution rights (the right to emit a given quantity of sulfur dioxide). The following graph shows the daily demand for pollution rights. Use the graph input tool to help you answer the following questions. You will not be graded on any changes you make to this graph. Note: Once you enter a value in a white field, the graph and any corresponding amounts in each grey field will change accordingly. Graph Input Tool Daily Demand for Pollution Rights 5 Price (Dollars per ton) Quantity Demanded (Millions of tons) 180 PRICE (Dollars per ton) Demand 0 20 40 60 80 100 120 140 160 180 200 QUANTITY (Millions of tons)

Answer 1

$20 per unit of tax will yield a demand of desired level of pollution (120 million tons per day).

Since the auction is expected to reveal the demand curve for polluting rights, auction of 120 million tons per day of pollution rights is expected to yield a price of $20 for each permit.

For the third question the correct solution to reduce pollution is sale of tradable permits for upto 50 million tons of chemicals each year so that the pollutant is contained to this level. By taxing at a rate which may result in a demand for polluting rights for more than 50 million tons will be detrimental to people's health.