5. Correcting for negative externalities- Regulation versus tradablepermits Supp
ID: 1125149 • Letter: 5
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: 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) 125 70 800 First Unit of Pollution (Dollars) 90 Third Unit of Pollution (Dollars) Firm Firm X Firm Y Firm Z 180 110 1,500 650 Now, imagine that two government employees proposed alternative 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 unitsExplanation / Answer
Regulation:
Firm X: 90 + 125 = 215
Firm Y: 55 + 70 = 125
Firm Z: 650 + 800 = 1450
Tradable Permits:
Cost of eliminating 3rd unit of pollution by X and Y is $ 180 and $ 110, so if Firm Z offers price greater than $ 180 then both firm will agree to eliminate their 3rd unit of pollution. So, prices at which X and Y will sell their permits is:
1) $ 579
2) $ 787
At price of $ 498, both firm X and Y will sell their permits 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
2
Sell one permit
3 units
90 + 125 + 180 = 395
Firm Y
2
Sell one permit
3 unit
55 + 70 + 110 = 235
Firm Z
2
Buy 2 permits
0 unit
0
Regulation Versus Tradable Permits:
Proposed Method
Total cost of eliminating six units of pollution
Regulation
215 + 125 + 1450 = 1790
Tradable Permits
395 + 235 + 0 = 630
Less costly when government distribute Tradable permits.
Firm
Initial Pollution Permits Allocation
Action
Final Amout of pollution eliminated
Cost of pollution reduction
Firm X
2
Sell one permit
3 units
90 + 125 + 180 = 395
Firm Y
2
Sell one permit
3 unit
55 + 70 + 110 = 235
Firm Z
2
Buy 2 permits
0 unit
0
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