7. Correcting for negative externalities - Regulation versus tradable permits Su

Question

7. 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) is prohibitively expensive First Unit of Pollution (Dollars) 130 600 90 Cost of Eliminating the . . . Second Unit of Pollution (Dollars) 165 750 115 Third Unit of Pollution Firm Firm X Firm Y Firm Z (Dollars) 220 1,200 140 Now, imagine that two government employees propose alternative plans for reducing pollution by 6 units. Method 1: Regulation The first government employee suggests to limit pollution through regulation. To meet the pollution goal, the government requires each firm to reduce its pollution by 2 units

Explanation / Answer

Total costs of eliminating 2 units of pollution

Firm X = 130+165 = 295

Firm Y = 600+750 = 1350

Firm Z = 90+115 = 205

The firms X and Z are ready to sell there permits till they are getting more amount than the cost of eliminating pollution. So Firm X will sell at 650 and 670 while firm Z will sell at 141, 183, 650 and 670.

Eliminating pollution is more costly to society when the government regulates each firm to eliminate certain amount of pollution than tradable permits

Proposed Method Total cost of elimination Regulations 1850 Tradable permits 360

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