7. Correcting for negative externalities Regulation versus tradable permits Supp

ID: 1119479 • Letter: 7

Question

7. 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 difTerent 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 90 Now, imagine that two govermment employees propose 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.

Explanation / Answer

Regulation:

Firm X: 55 + 70 = 125

Firm Y: 650 + 800 = 1450

Firm Z: 90 + 120 = 210

Tradable Permits:

Cost of eliminating 3rd unit of pollution by X and Z is $ 110 and $ 180, so if Firm Y offers price greater than $ 180 then both will sell. So, prices at which they will sell their permits is:

1) $ 367

2) $ 384

At price of $ 129, only X will sell the permit because its 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

Sell one permit

3 units

55 + 70 + 110 = 235

Firm Y

Buy one permit

1 unit

650

Firm Z

Don't buy/Sell permit

2 unit

90 + 125 = 215

Regulation Versus Tradable Permits:

Proposed Method

Total cost of eliminating six units of pollution

Regulation

125 + 1450 + 210 = 1785

Tradable Permits

235 + 650 + 215 = 1100

Less costly when government distribute Tradable permits.