There are three industrial firms in Happy Valley. Firm Initial PollutionLevel Co

Question

There are three industrial firms in Happy Valley.

Firm                      Initial PollutionLevel                            Cost of Reducing Pollution by 1 Unit

A                              70Units                                            $20
B                              80Units                                            $25
C                              50Units                                            $10

The government wants to reduce pollution to 120 units, so it giveseach firm 40 tradable pollution permits.
a. Who sells permits and how many do they sell? Who buys permitsand how many do they buy? Briefly explain why the sellers andbuyers are each willing to do so. What is the total cost ofpollution reduction in this situation?
b. How much higher would the costs of pollution reduction be if thepermits could not be traded?

Any help would be much appreciated.

Explanation / Answer

A - 70 - $20 B - 80 - $25 C - 50 - $10 Firm B does not trade away the credits he receives. He valuesthe permits higher than everyone else (because his cost of reducingpollution is the highest) so the permits already reside with thehighest valued use. We can assume that the three are going to negotiate with eachother. There are two scenarios that could arise - and bothhave the same outcome: 1.) Lets say that Firms A and C realize that Firm B values thepermits more than they do. Given this, all partiesnow realize that gains from trade exists - and they'll exploitit. Firms A and C will end up undercutting each others'prices in order to get B to buy their credits. The lowesteither one can go is to the point where P=MC, in this case MC = 20for Firm A, and MC = 10 for Firm C. So, as soon as Firm Clowers its price below 20, Firm B is bumped out of the marketbecause each of them have 40 credits, and Firm B needs 80 credits -So Firm C will sell all of their credits to Firm B. Then,Firm B won't need anymore credits. Conclusion: Firm C sells all of its credits to Firm B forless than $20, and Firm A doesn't sell or buy any. 2.) Lets say that Firms A and B know that C values itscredits for less then them. Rather than bid down prices,these 2 firms will bid UP - essentially, Firm C will be auctioningoff its credits. As soon as Firm B offers more than $20 forthe credits, Firm C will end up selling Firm B all of its credits -just like before. Conclusion: The same. How much higher would the costs be? Well, because we can't know EXACTLY where the negotiations will endin the bidding or the undercutting, we can't really say. Thecosts may ultimately be the exactly same if Firm C sells all of itscredits to Firm B for $25 (b/c Firm B would be indifferent at thisprice, so they would probably buy).

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