Suppose the government wants to reduce the total pollution emitted by three loca
ID: 1127182 • Letter: S
Question
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:
Now, imagine that two government employees propose 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 units.
Method 2: Tradable Permits
Meanwhile, the other employee proposes using a different strategy to achieve the government’s goal of reducing pollution in the area from 12 units to 6 units. He suggests that the government issue two pollution permits to each firm. For each permit a firm has in its possession, it can emit 1 unit of pollution. Firms are free to trade pollution permits with one another (that is, buy and sell them) as long as both firms can agree on a price. For example, if firm X agrees to sell a permit to firm Y at an agreed-upon price, then firm Y would end up with three permits and would need to reduce its pollution by only 1 unit, while firm X would end up with only one permit and would have to reduce its pollution by 3 units. Assume the negotiation and exchange of permits are costless.
Because firm Z has high pollution-reduction costs, it thinks it might be better off buying a permit from firm Y and a permit from firm X, so that it doesn't have to reduce its own pollution emissions. At which of the following prices is firm Y willing to sell one of its permits to firm Z, but firm X is not? Check all that apply.
Suppose the owners of the three firms get together and agree on a trading price of $585 per permit.
Regulation Versus Tradable Permits
Available Methods to Reduce Pollution 1. The government sets pollution standards using command-and-control 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.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 firm Y will agree to eliminate their 3rd unit of pollution but X will not. So, prices at which only Y sell their permits is:
1) $ 170
2) $ 183
At price of $ 585, both firm X and Y 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
2
Sell one permit
3 units
130+165+220 = 515
Firm Y
2
Sell one permit
3 unit
90 + 115 + 140 = 345
Firm Z
2
buy two permits
0 unit
0
Regulation Versus Tradable Permits:
Proposed Method
Total cost of eliminating six units of pollution
Regulation
295 + 205 + 1350 = 1850
Tradable Permits
515 + 345 + 0 = 860
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
130+165+220 = 515
Firm Y
2
Sell one permit
3 unit
90 + 115 + 140 = 345
Firm Z
2
buy two permits
0 unit
0
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