5. Correcting for negative externalities - Regulation versus tradablepermits Sup

Question

5. Correcting for negative externalities - Regulation versus tradablepermits

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:

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.

Firm

Cost of Eliminating the...

First Unit of Pollution

Second Unit of Pollution

Third Unit of Pollution

(Dollars)

(Dollars)

(Dollars)

Now, imagine that two government employees proposed alternative plans for reducing pollution by 6 units.

Method 1: Regulation

The first government employee suggests to limit pollution through regulation. To meet the pollution goal, the government requires each firm to reduce its pollution by 2 units.

Complete the following table with the total cost to each firm of reducing its pollution by 2 units.

Firm

Total Cost of Eliminating Two Units of Pollution

(Dollars)

Method 2: Tradable Permits

Meanwhile, the other employee proposes using a different strategy to achieve the government’s goal of reducing pollution in the area from 12 units to 6 units. He suggests that the government issue two pollution permits to each firm. For each permit a firm has in its possession, it can emit 1 unit of pollution. Firms are free to trade pollution permits with one another (that is, buy and sell them) as long as both firms can agree on a price. For example, if firm X agrees to sell a permit to firm Y at an agreed-upon price, then firm Y would end up with three permits and would need to reduce its pollution by only 1 unit, while firm X 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 firm Y has high pollution-reduction costs, it thinks it might be better off buying a permit from firm Z and a permit from firm X, so that it doesn't have to reduce its own pollution emissions. At which of the following prices is firm Z willing to sell one of its permits to firm Y, but firm X is not? Check all that apply.

$90

$178

$186

$451

$529

Suppose the the government has set the trading price of a permit at $326 per permit.

Complete the following table with the action each firm will take at this permit price, the amount of pollution each firm will eliminate, and the amount it costs each firm to reduce pollution to the necessary level. If a firm is willing to buy two permits, assume that it buys one permit from each of the other firms. (Hint: Do not include the prices paid for permits in the cost of reducing pollution.)

Firm

Initial Pollution Permit Allocation

Action(Buy one premit/ Buy two permit/ Do nothing/ Sell one premit/ sell two permit)

Final Amount of Pollution Eliminated

Cost of Pollution Reduction

(Units of pollution)

(Units of pollution)

(Dollars)

Regulation Versus Tradable Permits

Determine the total cost of eliminating six units of pollution using both methods, and enter the amounts in the following table. (Hint: You might need to get information from previous tasks to complete this table.)

Proposed Method

Total Cost of Eliminating Six Units of Pollution

(Dollars)

In this case, you can conclude that eliminating pollution is LESS/MORE? costly to society when the government regulates each firm to eliminate a certain amount of pollution than when it allocates pollution permits that can be bought and sold.

Available Methods to Reduce Pollution 1. The government sets pollution standards using regulation. 2. The government allocates tradable pollution permits.

Explanation / Answer

Ans:

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

X =95 + 120

   = 215

Y = 450 + 800

= 1250

Z = 80 +100

= 180

2) At price $178 , $186 firm Z will sell a permit to Y but firm X is not sell at that price.

Since the cost of elimination of 3rd unit of pollution to firm X is $200, at price less than $200 firm X will not sell its permit to Y.

3) when trading price of a permit is at $326 per permit. firm X and firm Z will sell a permit to Y.

Table

3) Total cost of eliminating six units of pollution

Regulation = $215 + $1250 + $180

= $1645

Tradable permits = $415 + $330

= $745

4) More

Eliminating pollution through regulation is more costly to society than tradable permits.

Firm Initial allocation of pollution permit Action Final amount of pollution eliminated Cost of pollution reduction X 2 sell one permit 3 units $95+$120+$200 = $415 Y 2 buy two permits 0 0 Z 2 sell one permit 3 units $80+$100+$150 = $330

Related Questions

Navigate

• Browse (All)
• Browse 5
• Subjects

---

---

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.