7. Correcting for negative eternalitles- Regulation versus tradable permits Supp

ID: 2439807 • Letter: 7

Question

7. Correcting for negative eternalitles- 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 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 First Unit of Pollution (Dollars) 130 90 600 Cost of Eliminating the... Second Unit of Pollution (Dollars) 165 115 750 Third Unit of Pollution (Dollars) 220 140 1,200 Firm Firm X Firm Y Firm Z Now, imagine that two government employees propose alternative plans for reducing pollution by 6 units. Method 1: Regulation The first govenment employee suggests to limit pollution through regulation. To meet the poilution goal, the government requires each firm to reduce its pollution by 2 units

Explanation / Answer

Regulation:

Firm X: 130 + 165 = 295

Firm Y: 90 + 115 = 205

Firm Z: 600 + 750 = 1350

Tradable Permits:

Cost of eliminating 3rd unit of pollution by X and Y is $ 220 and $ 140, so if Firm Z offers price greater than $ 140 but less than $ 220 then Y would sell the permit but X will not. So, prices at which Y will sell its permit but X will not is:

1) $ 212

2) $ 219

At price of $ 218, only firm Y 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 Amout of pollution eliminated

Cost of pollution reduction

Firm X

Don't buy/Sell permit

2 units

130 + 165 = 295

Firm Y

Sell one permit

3 unit

90 + 115 + 140 = 345

Firm Z

Buy one permit

1 unit

600

Regulation Versus Tradable Permits:

Proposed Method

Total cost of eliminating six units of pollution

Regulation

295 + 205 + 1350 = 1850

Tradable Permits

295 + 345 + 600 = 1240

Eliminating pollution is more costly when government regulates each firm to reduce pollution by certain amount.