5. Correcting for negative externalities- Regulation versus tradable permits Sup

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 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) 70 800 125 First Unit of Pollution Third Unit of Pollution Firm Firm X Firm Y Firm Z (Dollars) (Dollars) 110 1,500 180 650 90 Now, imagine that two government employees proposed alternative plans for reducing pollution by 6 units

Explanation / Answer

Ans:

1) Computation of total cost of eliminating two units of pollution by each firm

X = $55 + $70

= $125

Y = $650 + $800

= $1450

Z = $90+$125

= $215

2) Tradable permits - Following will apply

$367 and $384

Since cost of reducing the pollution is not same for every unit and in case of sale of a tradable permit will require the firm to reduce 3 units of pollution. The cost for reducing the 3rd unit of pollution is $110 and $180, hence a price above $180 will motivate the firms X and Z to sell one of their permits to firm Y.

3) Table showing amount of pollution eliminated and cost of pollution reduction

4) Total cost of eliminating 6 units of pollution

Regulation - $1790

Tradable permits - $1105

Hence, we can conclude that eliminating pollution is more costly to society with regulation.

Firm Initial pollution permit allocation Action Final amount of pollution eliminated Cost of pollution reduction X 2 Sell 3 units $235 Y 2 buy 1 unit $650 Z 2 No action 2 units $220

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