Two firms, A and B, each currently emit 100 tons of pollution into the air. To r

Question

Two firms, A and B, each currently emit 100 tons of pollution into the air. To reduce the pollution from now on EPA will require a pollution permit for each ton of pollution emitted into the air. EPA limits pollution to 60 tons, giving each firm 30 pollution permits. It costs Firm A $100 for each ton of pollution that it eliminates before it is emitted into the air, and it costs Firm B $50 for each ton of pollution that it eliminates before it is emitted into the air. What is the total cost of current production if EPA orders the firms to reduce pollution to 60 tons? If the two firms can buy or sell pollution permits from each other, assume a price of $75 per permit is negotiated, what is the potential cost to each firm if the existing production is maintained?

Explanation / Answer

1. If Firm A reduces its tons of pollution from 100 to 60, then cost to Firm A = 40 tons X $ 100 per ton = $ 4,000

If Firm B reduces its tons of pollution from 100 to 60, then cost to Firm A = 40 tons X $ 50 per ton = $ 2,000

2. Since negotiated price of pollution permit is less than the cost to Firm A, so firm A will purchase all the 30 permits from Firm B at price of $ 75. So, cost of Firm A to purchase the permits = $ 75 X 30 = $ 2,250

It means that now Firm A does not need to reduce its tons of pollution as it possess the permits.

On the other hand, total cost of reducing pollution to 60 tons creates cost of $ 2,000 for Firm B as it sell the permits to Firm A so it has to reduce its full tons of pollution rather it receives $ 2,250 from Firm A in sale of permits. So, Firm B earns a profit of $ 250 i.e. ($ 2,250 - $ 2,000).

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