Question

5. Environmental standards versus tradable permits Aa Aa Suppose the government wants to reduce the total pollution emitted by three firms in its area. Currently, each firm is creating 4 units of pollution in the area, for a total of 12 pollution units. The government wants to reduce total pollution in the area to 6 units. In order to do so, the government can choose between the following two methods. Method 1: The government sets pollution standards. Method 2: The government allocates tradable pollution permits. Compare the two methods to determine the least-cost way of achieving the desired pollution quantity. Eliminating pollution can be more difficult (and thus more costly) for some kinds of firms than for others. The following table shows the cost of eliminating each unit of pollution for each of the three firms Firm X Firm Y Firm Z Cost of eliminating the first unit of pollution $95 $80 $450 Cost of eliminating the second nit of pollution $120 $100 $800 Cost of eliminating the third unit of pollution $200 $150 $1,050 Cost of eliminating the fourth unit of pollution $1,400 $750 $6,300 Under method 1, the government sets pollution standards so that each firm must reduce its pollution by 2 units. Fill in the following table with the total cost to each firm of reducing its pollution by this amount. Firm X Firm Y Firm Z Total cost of eliminating 2 units of pollution Adding up the costs to the three firms, you can see that the total cost of eliminating 6 units of pollution through regulatory standards is Now suppose the government uses method 2 to reduce pollution in the area from 12 units to 6 units by issuing two pollution permits to each firm. For each permit a firm has in its possession, it can emit 1 unit of pollution, but firms are also free to trade pollution permits with one another. For example, if firm Z were to buy a permit from firm Y, firm Z would end up with three permits and would need to reduce its pollution by only 1 unit, whereas firm Y would end up with only one permit and would have to reduce its pollution by 3 units. Assume the negotiation and exchange of permits are costless. Because of its high pollution-reduction costs, firm Z might be better off buying permits from firm Y and firm X so that it doesn't have to reduce its own pollution emissions. At which of the following prices is firm Y willing to sell one of its permits to firm Z, whereas firm X will decline to do so? Check all that apply. $310 $90 $180 $190 Again, suppose that you are considering the method of pollution reduction involving tradable permits. Suppose the owners of the three firms get together and agree on a trading price of $195 per permit. Fill in the following table with the action taken by each firm, the amount each firm will pollute, and the amount it costs each firm to reduce pollution to the necessary level. (Hint: Do not include the prices of permits in the cost of reducing pollution.) Firm X Firm Y Firm Z Initial pollution permit allocation 2 units 2 units 2 units Action Final pollution amount Cost of pollution reduction Given this scenario, the total cost of eliminating 6 units of pollution using a tradable permit system is On the basis of this example, you can conclude that eliminating pollution is costly to society when the government directs each firm to eliminate a certain amount of pollution than when it allocates pollution permits that can be bought and sold.

Answer 1

The cost of each firm or abating two units of pollution is:

Units of pollution	Firm X	Firm Y	Firm Z
First	95	80	450
Second	120	100	800
Third	200	150	1050
Fourth	1400	750	6300
Total Cost of eliminating 2 units of pollution	215	180	1250

Therefore, the total cost of pollution is: $1645

To abate the required pollution, if X has to sell 1 unit it will need $200 because the abatement cost of the 3rd unit is $200 for firm X and $150 for Firm Y. Then, for a price less than $200 and greater than $150 firm Y will sell one unit permit and X will not sell any permit.

Therefore, the correct options are:

• $180
• $190

For the same reason at a market price of $195 firm X will not sell any permit and firm Y will sell 1 permit to firm Z.

Therefore, the final result will be

	Firm X	Firm Y	Firm Z
Initial Pollution Permit	2	2	2
Action	Does Nothing	Sell 1 unit to Firm Z	Buy 1 unit from firm Y
Final Pollution Amount	2	1	3
Cost of Pollution Reduction	215	330	450

The total cost of a reduction in the above case is $995

Hence, the cost of reduction of pollution is more in case of the standard than in case of permit.

Therefore, the correct option is:

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