Suppose the government wants to reduce the total pollution emitted by three firm

Question

Suppose the government wants to reduce the total pollution emitted by three firms in its area. Currently, each firm is creating 4 units of pollution in the area, for a total of 12 pollution units. The government wants to reduce total pollution in the area to 6 units. In order to do so, the government can choose between the following two methods. Method 1: The government sets pollution standards. Method 2: The government allocates tradable pollution permits. Compare the two methods to determine the least-cost way of achieving the desired pollution quantity Eliminating pollution can be more difficult (and thus more costly) for some kinds of firms than for others. The following table shows the cost of eliminating each unit of pollution for each of the three firms. Cost of eliminating the first unit of pollution Cost of eliminating the second unit of pollution Cost of eliminating the third unit of pollution Cost of eliminating the fourth unit of pollution Firm X $600 $750 $1,200 $8,400 Firm Y $130 $165 $220 $1,100 Firm Z $90 $115 $140 840 Under method 1, the government sets pollution standards so that each firm must reduce its pollution by 2 units. Fill in the following table with the total cost to each firm of reducing its pollution by this amount. Firm X Firm Y Firm Z Total cost of eliminating 2 units of pollution Adding up the costs to the three firms, you can see that the total cost of eliminating 6 units of pollution through regulatory standards is Now suppose the government uses method 2 to reduce pollution in the area from 12 units to 6 units by issuing two pollution permits to each firm. For each permit a firm has in its possession, it can emit 1 unit of pollution, but firms are also free to trade pollution permits with one another. For example, if firm × were to buy a permit from firm z, firm X would end up with three permits and would need to reduce its pollution by only 1 unit, whereas firm Z 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.

Explanation / Answer

Ans:

1) Computation of total cost of elimination 2 units of pollution by each firm(in dollars)

X = $600 + $750

= $1350

Y = $130 + $165

= $295

Z = $90 + $115

= $205

Hence, the total cost of eliminating 6 units of pollution using regulation = $1850

2) At a price of $360 and $395 both will sell a permit to firm X.

The cost of elimination of 3rd unit of pollution for  firm Y and firm Z is $220 and $140, hence a price above $220 both firms will sell a permit.

3) When the permit price is $415  

Table

Hence the total cost of eliminating 6 units of pollution using tradable permits = $515 + $340 = $855

5) More

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

Particulars X Y Z Initial pollution permit allocation 2 2 2 Action Buy two permits sell one permit sell one permit Final pollution amount 0 3 3 Cost of pollution reduction 0 $515 $340

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