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 90 Daily Demand for Pollution Rights 81 9 72 Price (Dollars per ton) Quantity Demanded (Milions of conte) 65 450 54 PRICE Dollars perton) 45 36 27 Demand 16 9 D 50 100 150 200 250 300 350 400 450 500 QUANTITY (Milions of tons)

Answer 1

Suppose the government has determined that the socially optimal quantity of sulfur dioxide emissions is 350 million tons per day.

One way governments can charge firms for pollution rights is by imposing a per-unit tax on emissions. A tax of $27 per ton of sulfur dioxide emitted will achieve the desired level of pollution. Because when the price of emitting a ton of sulfur dioxide is $27 , then power stations will demand a quantity of 350 million tons of sulfur dioxide. If the government imposed a tax less than $27 , then power stations would choose to emit more than 350 million tons of sulfur dioxide per day. Similarly, if government imposed a tax more than $27 , then sulfur dioxide emissions is less than socially optimal level.

Now suppose the government does not know the demand curve for pollution and therefore, cannot determine the optimal tax to achieve the desired level of pollution. Instead, it auctions off tradable permits . Each permit entitles its owner to emit one ton of sulfur dioxide per day. To achieve the socially optimal quantity of pollution, the government auctions off 350 million pollution permits. Given this quantity of permits,the price for each permit in the market for polution rights will be $27. Because selling 350 milllion pollution permits that each allow a firm to emit one ton of sulfur dioxide means that the supply of pollution will be 350 million tons per day. At a quantity of 350 million tons ,the market for pollution rights will clear at a price of $27. So, each pollution permit will have a value of $27 because at this price ,all 350 million pollution permits will be demanded.

Imagine that new research suggests that if manufacturers in a particular city reduced their emissions to 40 million tons of water per year,the air quality would improve dramatically.

If this all information the government has, then tradable permits solution to reduce pollution is appropriate. Because if the government knows how much it costs a particular polluting firm to reduce pollution at each quantity, this means they also know firm's demand for pollution rights. Therefore, the government can achieve the socially optimal quantity of pollution by setting a corrective tax equal to the price is willing to pay to pollute at the optimal quantity. Because the government also knows the optimal quantity of pollution, they can also use tradable permits , which are a direct means of controlling the total quantity of pollution emitted.