5. Correcting for negative externalities - Regulation versus tradablepermits Sup

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 aréa, for a total of 12 polilution 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 difficuilt for some firms than others. The following table shows the cost each firm faces to eliminate each unit of poilution. For each firm, assume that the cost of reducing pollution to zero (that is, eliminating all 4 units of pollution) Is prohibitively expensive Firm Firm X Firm Y Firm Z First Unit of Pollution (Dollars) 130 600 90 Cost of Eliminating the... Second Unit of Pollution (Dollars) 165 750 115 Third Unit of Pollution (Dollars) 220 1,200 140 Now, imagine that two government employees proposed alternative plans for reducing pollution by 6 units Method 1: Regulation

Explanation / Answer

Ans:

1) The total cost of eliminating two units of pollution.

Firm X = $130 + $165

           = $295

Firm Y = $600 + $750

           = $1350  

Firm Z = $90 + $115

           = $205

2) $142, $188

The cost of eliminating third unit of pollution to firm X is $220 and firm Z is $140.when the permit price is above $140, firm Z will sell a permit to firm Y.when the permit price is below $220, firm X will not sell a permit to firm Y.

3) when the permit price is $355, both firm X and firm Z will sell a permit to firm Y.

4) Total cost of eliminating six units of pollution

Regulation = $295 + $1350 + $205

                  = $1850

Tradable permits = $515 + $345

                            = $860

5) Less

we can conclude that eliminating pollution is less costly to society with tradable permits.

Firm Initial pollution permit allocation Action Final amount of pollution eliminated Cost of reducing pollution X 2 sell one permit 3 units $130 + $165 + $220 = $515 Y 2 buy two permits 0 0 Z 2 sell one permit 3 units $90 + $115 +$140 = $345

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