5. Correcting for negative externalities Regulation versus tradable permits Supp

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. First Unit of Pollution (Dollars) 80 450 95 Cost of Eliminating the... Second Unit of Pollution Dollars) 100 800 120 Third Unit of Pollution Firm Firm X Firm Y Firm Z Dollars) 150 1,050 200 Now, imagine that two government employees proposed altemative 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

Ans:

1) Computation of cost of elimination of two units of pollution(In dollars)

X = 80 + 100

= 180

Y = 450 + 800

   = 1250

z = 95 + 120

   = 215

2) The cost of elimination of 3rd unit of pollution for firm X is $150 and firm Z is $200. Hence firm X and Z will trade a permit for a price which is above $200.

Following will apply - $410 , $708

3) If the government sets a price of $182 per permit only X will sell the permit to Y.

Table

4) Total cost of eliminating six units of pollution

Regulation = $180 + $1250 + $215

   = $1645

Tradable permits = $330 + $450 + $215

= $995

5) More

Eliminating pollution by regulation is more costly to society than the pollution permits.

Firm Initial pollution permit allocation Action Final amount of pollution eliminated Cost of pollution reduction X 2 sell one permit 1 unit $330 Y 2 Buy one permit 1 unit $450 Z 2 Don't buy / sell 2 units $215

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