Attempts: Keep the Highest: 4. Correcting for negative externalities Regulation

ID: 1144306 • Letter: A

Question

Attempts: Keep the Highest: 4. 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) Cost of Eliminating the First Unit of Pollution Dollars 130 Second Unit of Pollution Dollars Third Unit of Pollution Dollars Firm 165 115 750 220 Firm 90 140 Firm 600 1,200 Now, imagine that two government employees propose alternative plans for reducing pollution by 6 units. Method 1: Regulation

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 and less than 220 then only firm Y will agree to eliminate their 3rd unit of pollution. So, prices at which Y will sell their permits is:

1) $ 212

2) $ 219

At price of $ 218, only firm Y will sell the permit because its cost of eliminating 3rd unit of pollution is 140 which 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 1 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

Less costly when government distribute Tradable permits.