7. Correcting for negative externalities -Regulation versus tradable permits Sup

ID: 2733424 • 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 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) 70 800 125 First Unit of Pollution Third Unit of Pollution (Dollars) Firm Firm X Firm Y Firm Z (Dollars) 110 1,500 180 650 90 Now, imagine that two government 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

Cost of eliminating two units of pollution

Firm X = $55 + $650 = $705

Firm Y = $70 + $800 = $870

Firm Z = $110 + $1500 = $1610

Cost of eliminating 6 units of pollution through regulatory standards is $705 + $870 + $1610 = $3185

If both the firms sell one of their permits then they both will have to reduce their pollution by 3 units.

Cost for firm X to reduce the third unit of pollution = $90

Cost for firm Z to reduce the third unit of pollution = $180

Total cost = $270 And 270/2 per firm

So the firm X & Z will sell their permit with a price of $135

Firm X

Firm Z

Firm Y

Initial pollution permit allocation

Action

Sells one permit to Firm Y

Buys one permit each from Firm X and Firm Z

Final pollution amount

Cost of pollution reduction

264

393

786

The total cost of eliminating 6 units of pollution using a tradable permit system is $264 + $393 + $786 = $1443.

Eliminating pollution is more costly to society when the government directs each firm to eliminate a certain amount of pollution than when it allocates pollution permits that can be bought and sold.