5. Correcting for negative externalities Regulation versus tradable permits Supp
ID: 1107027 • 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 following twio 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. First Unit of Pollution (Dollars) 130 600 90 Second Unit of Pollution (Dollars) 165 750 115 Third Unit of Pollution (Dollars) Firm Firm X Firm Y Firm Z 220 1,200 140 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.Explanation / Answer
Regulation:
Firm X: 130 + 165 = 295
Firm Y: 600 + 750 = 1350
Firm Z: 90 + 115 = 205
Tradable Permits:
Cost of eliminating 3rd unit of pollution by X and Z is $ 220 and $ 140, so if Firm Y offers price greater than $ 140 then firm Z will sell but X will not. So, prices at which Z will sell their permits is:
1) $ 141
2) $ 183
At price of $ 454, both firms will sell the permit because their 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
130 + 165 + 220 = 515
Firm Y
2
Buy two permits
0 unit
0
Firm Z
2
Sell one permit
3 unit
90+115+140 = 345
Regulation Versus Tradable Permits:
Proposed Method
Total cost of eliminating six units of pollution
Regulation
295 + 1350 + 205 = 1850
Tradable Permits
515 + 0 + 345 = 860
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
130 + 165 + 220 = 515
Firm Y
2
Buy two permits
0 unit
0
Firm Z
2
Sell one permit
3 unit
90+115+140 = 345
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