In this question, we’ll use the same scenario as in Question 1. In particular, t
ID: 1156157 • Letter: I
Question
In this question, we’ll use the same scenario as in Question 1. In particular, two firms can reduce emissions of a pollutant at the following marginal costs:MC1 = 2x1 for Firm 1 and MC2 = x2 for Firm 2. Initially, there is no regulation, and each firm emits 15 tons of emissions, for aggregate emissions of 30 tons. Now suppose the regulator decides to reduce pollution by 12 tons using a system of tradable permits (cap and trade). When this regulation is in place, a firm has to hold 1 permit for each ton of pollution it emits.
How many permits will the regulator issue? If the permits are split evenly between the two firms in the industry, how many permits will be given to each firm?
After the two firms trade, what will be resulting allocation of pollution abatement responsibility, assuming that there are no transaction costs? Compute the total cost of abatement for each firm and the total cost of abatement for industry as a whole.
How many permits will each firm buy or sell? What will the market price of tradable permits be in equilibrium? Assume that the market for permits is perfectly competitive.
What is the full cost of this regulation (total abatement cost plus the cost of permits for the firm that buys permits, and total abatement cost minus the revenue from selling permits for the firm that sells them) for each of the firms, and for two firms combined?
Explanation / Answer
Cap and trade is a government policy of controlling emission by encouraging industries to reduce their volume of emissions.
Total emission by 2 firms = Emission of each firm × 2
= 100 units × 2
= 200 units
Emission must be controlled = 90 units
If allocated to firm 1:
MC1 = $1 × q1
= $1 × 90
= $90
If allocated to firm 2:
MC2 = $1/2 × q2
= $0.5 × 90
= $45
Lower MC indicates lower total cost (TC); (MC2 < MC1). Therefore, the TC of 2 is lower than the TC of 1 and 2 has better control.
Ans. True
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