Question

6. Correcting for negative externalities - Taxes versus tradablepermits Paper factories emit chemicals 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 paper 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 chemicals). The following graph shows the daily demand for pollution rights.

Answer 1

Economic activity causes pollution. Pollution is a spillover cost of production that causes inequality and distorts the allocation of resources. Government therefore regulates private business by the standard approach and incentive based environmental policies. With the standard approach, a maximum acceptable level of pollutant is established and firms that exceed this level are punished by the means of fine. On the other hand, the incentive-based regulation schemes are pollution fees and pollution permits that utilize efficiencies of the marketplace.

Two incentive based regulation scheme for regulation of pollution are: (a) Pollution fees; and (b) Marketable Pollution Permits.

1. Pollution fees: The pollution fees reduces the spillover cost of pollution by giving the firm an incentive to change their behavior, either by forcing them to pay a fee or by finding a new less harmful process of production. The pollution fees can either be an effluent fee that is taxes on production that causes water pollution; or emission fee that is taxes on production that causes air pollution.
2. Marketable Pollution permits: Under marketable pollution permits approach, the maximum level of pollution that is acceptable to the society is divided in to units. Government then issue permits that allow the business firms to produce these units.

The following graph shows the daily demand for pollution rights.

90 81 72 O 63 g 54 O 45 36 27 18 Demand 0 0 35 70 105 140 175 210 245 280 315 350 QUANTITY (Millions of tons)

Suppose the government has determined that the socially optimal quantity of chemical pollution is 175 million tons per day. One way governments can charge firms for pollution rights is by imposing a per-unit tax on emissions. A tax (or price in this case) of $45 ton of chemicals emitted will achieve the desired level of pollution. per Now suppose the U.S. 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 pollution permits. Each permit entitles its owner to emit one ton of chemicals per day. To achieve the socially optimal quantity of pollution, the government auctions off 175 million pollution permits. Given this quantity of permits, the price for each permit in the market for pollution rights will be $45. The previous analysis hinges on the government having good information regarding either the demand for pollution permits or the optimal level of pollution (or both). Given that the appropriate policy (tradable permits or corrective taxes) can depend on the available information and the policy goal, consider the following scenario. An environmental study conducted in a particular city suggests that if a chemical plant emits more than 90 million tons of chemicals each year, the water supply will become contaminated beyond the point where filtration techniques can make it safe for drinking. If this is all the information the government has, which solution to reduce pollution is appropriate? Check all that apply. Tradable permits Corrective taxes