5. Correcting for negative externalities Regulation versus tradable permits Supp
ID: 1102973 • Letter: 5
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 folloving 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 of Pollution (Dollars) First Unit of Pollution (Dollars) 60 500 75 Third Unit of Pollution (Dollars) Firm Firm X Firm Y Firm Z 120 1,100 160 675 100 Now, imagine that two government employees proposed alternative plans for reducing pollution by 6 units. Method 1: RegulationExplanation / Answer
Regulation:
Firm X: 60 + 80 = 140
Firm Y: 500 + 675 = 1175
Firm Z: 75 + 100 = 175
Tradable Permits:
Cost of eliminating 3rd unit of pollution by X and Z is $ 120 and $ 160, so if Firm Y offers price greater than $ 120 but less than 160 then only Firm X will agree to eliminate their 3rd unit of pollution. So, prices at which X will sell its permits is:
1) $ 127
2) $ 158
At price of $ 474, both firms will sell their permit because its cost of eliminating 3rd unit of pollution is less than the set price.
Firm
Initial Pollution Permits Allocation
Action
Final Amout of pollution eliminated
Cost of pollution reduction
Firm X
2
Sell one permit
3 units
60 + 80+ 120 = 260
Firm Y
2
Buy two permits
0 unit
0
Firm Z
2
Sell one permit
3 unit
75 + 100 + 160 = 335
Regulation Versus Tradable Permits:
Proposed Method
Total cost of eliminating six units of pollution
Regulation
140 + 1175 + 175 = 1490
Tradable Permits
260 + 335 = 595
Less costly when government distribute Tradable permits.
Firm
Initial Pollution Permits Allocation
Action
Final Amout of pollution eliminated
Cost of pollution reduction
Firm X
2
Sell one permit
3 units
60 + 80+ 120 = 260
Firm Y
2
Buy two permits
0 unit
0
Firm Z
2
Sell one permit
3 unit
75 + 100 + 160 = 335
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