Question

Suppose pollution comes from two firms: H and L. The aggregate marginal benefit from pollution to firms is described by

        MB=16-(2/3) y, where y is total pollution.

The two firms’ marginal benefit from pollution is described by the following functions:

MB^H = 24-2y ^H

MB^L = 12-y ^L

where y ^H and y ^L represent the level of pollution for firm H and firm L; that is, y= y ^H +y ^L .     

The government study has concluded that the marginal damage of pollution is

MD = (2/3) y.

Now suppose the government does not know each firm’s marginal benefit function. The marginal benefit functions estimated by the government are:

Estimated MB^H = 20-2y ^H.

Estimated MB^L = 10-y ^L.

1. If the government decides to use pollution quantity standard (or tradable permits) to reduce emissions,

(1) How much would the pollution target be set to?

(2) How much would be the total benefit and total damage?

(3) How much would be the efficiency loss?

2. If the government decides to use pollution tax to reduce emissions,

(1) How much would the tax rate be set to?

(2) How much would be the total benefit and total damage?

(3) How much would be the efficiency loss?

3. Is pollution tax a better policy than tradable permits for this case? Explain your answer.

Answer 1

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