Question

Suppose the industry is currently unregulated and there are only 2 firms in the industry. Both firms are emitting 1,100 tons of pollution, thus total pollution in the industry is 2,200 tons.

The marginal cost of pollution reduction for the 2 firms are:

MCR1=1.35Q1andMCR2=0.85Q2

Now, suppose the government issued 700 permits to each firm (total pollution allowed in industry is 1,400 tons)

after trading what is the amount of pollution firm 1 will reduce?

Answer 1

The marginal cost of reduction of pollution of any identity is nothing but its demand for pollution. If we have marginal costs of pollution reduction for 2 firms, then we will find the aggregate costs of both by adding them up.

Similarly,

Adding both the quantites up, we get:

Government releases 700 permits for each firm. This does not mean that both will pollute 700 units and reduce the remaining. Rather, they will trade those permits with each other until efficient outcome is reached. A firm will buy a permit only if the price of that permit is lower than its marginal cost of reducing pollution. To find this, we equate the aggregate demand for pollution with the supply of pollution permits.

We get:

(rounded off)

At MCR = 729, Q1 will be:

540 units of pollution will be reduced by firm 1. This is the required answer.

Thanks!