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... Second Unit Pollution (Dollars) 100 First Unit Pollution (Dollars) 80 Third Unit of Pollution (Dollars) Firm Firm X 150 Firm Y 450 800 1,050 Firm z 95 120 200 Now, imagine that two government employees proposed alternative plans for reducing pollution by 6 units. Method 1: Regulation The first government employee suggests limiting pollution through regulation. To meet the pollution goal, the government requires each firm to reduce its pollution by 2 units.

Answer 1

Total cost of eliminating two units of pollution-

Firm X= 80+100=180

Firm Y= 450+800=1250

Firm Z= 95+120=215

Both Firm X and Firm Z is willing to sell the permit So the price must be higher than $150 & $200.

●$410

●$708

Permit price= $182 is greater than $150 & smaller than $200 (the cost of eliminating third unit of pollution for firm X and Z.)

Firm	Initial permit	action	Final amount	cost of pollution reduction
X	2	sell one permit	3	80+100+150=330
Y	2	buy one permit	1	450
Z	2	Dont buy/sell	2	95+120= 215

Total cost of elimination

Regulation= 180+1250+215=$1645

Tradable permits= 330+450+215= $995

Answer- more

Reason- Regulating pollution is more costly with regulation than with permits. $1645>$995.

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