5. Correcting for negative externalities- Regulation versus tradablepermits Supp
ID: 1153586 • 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 tha 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 fol methods: Available Methods to Reduce Pollution 1. The government sets pollution standards using regulation. 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) 120 Third Unit of Pollution Firm Firm X Firm Y Firm Z First Unit of Pollution (Dollars) 95 450 80 Dollars) 200 1,050 150 100 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
Explanation / Answer
Regulation:
Firm X: 95 + 120 = 215
Firm Y: 450 + 800 = 1250
Firm Z: 80 + 100 = 180
Tradable Permits:
Cost of eliminating 3rd unit of pollution by X and Z is $ 200 and $ 150, so if Firm Y offers price greater than $ 150 then firm Z will sell but X will not. So, prices at which Z will sell their permits is:
1) $ 178
2) $ 186
At price of $ 326, both firms will sell the permit because their cost of eliminating 3rd unit of pollution is less than the set price.
Firm
Initial Pollution Permits Allocation
Action
Final Amount of pollution eliminated
Cost of pollution reduction
Firm X
2
Sell one permit
3 units
95 + 120 + 200 = 415
Firm Y
2
Buy two permits
0 unit
0
Firm Z
2
Sell one permit
3 unit
80+100+150 = 330
Regulation Versus Tradable Permits:
Proposed Method
Total cost of eliminating six units of pollution
Regulation
215 + 1250 + 180 = 1645
Tradable Permits
415 + 0 + 330 = 745
More costly when government eliminate pollution by using regulation.
Firm
Initial Pollution Permits Allocation
Action
Final Amount of pollution eliminated
Cost of pollution reduction
Firm X
2
Sell one permit
3 units
95 + 120 + 200 = 415
Firm Y
2
Buy two permits
0 unit
0
Firm Z
2
Sell one permit
3 unit
80+100+150 = 330
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