Question

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.

Firm	Cost of Eliminating the...
	First Unit of Pollution	Second Unit of Pollution	Third Unit of Pollution
	(Dollars)	(Dollars)	(Dollars)
Firm X	130	165	220
Firm Y	600	750	1,200
Firm Z	90	115	140

Now, imagine that two government employees proposed alternative plans for reducing pollution by 6 units.

Method 1: Regulation

The first government employee suggests limiting pollution through regulation. To meet the pollution goal, the government requires each firm to reduce its pollution by 2 units.

Complete the following table with the total cost to each firm of reducing its pollution by 2 units.

Firm	Total Cost of Eliminating Two Units of Pollution
	(Dollars)
Firm X
Firm Y
Firm Z

Method 2: Tradable Permits

Meanwhile, the other employee proposes using a different strategy to achieve the government's goal of reducing pollution in the area from 12 units to 6 units. This employee suggests that the government issue two pollution permits to each firm. For each permit a firm has in its possession, it can emit 1 unit of pollution. Firms are free to trade pollution permits with one another (that is, buy and sell them) as long as both firms can agree on a price. For example, if firm X agrees to sell a permit to firm Y at an agreed-upon price, then firm Y would end up with three permits and would need to reduce its pollution by only 1 unit while firm X would end up with only one permit and would have to reduce its pollution by 3 units. Assume the negotiation and exchange of permits are costless.

Because firm Y has high pollution-reduction costs, it thinks it might be better off buying a permit from firm Z and a permit from firm X so that it doesn't have to reduce its own pollution emissions. At which of the following prices are both firm Z and firm X willing to sell one of their permits to firm Y? Check all that apply.

$117

$171

$192

$310

$548

Suppose the the government has set the trading price of a permit at $531 per permit.

Complete the following table with the action each firm will take at this permit price, the amount of pollution each firm will eliminate, and the amount it costs each firm to reduce pollution to the necessary level. If a firm is willing to buy two permits, assume that it buys one permit from each of the other firms. (Hint: Do not include the prices paid for permits in the cost of reducing pollution.)

Firm	Initial Pollution Permit Allocation	Action	Final Amount of Pollution Eliminated	Cost of Pollution Reduction
	(Units of pollution)		(Units of pollution)	(Dollars)
Firm X	2
Firm Y	2
Firm Z	2

Regulation Versus Tradable Permits

Determine the total cost of eliminating six units of pollution using both methods, and enter the amounts in the following table. (Hint: You might need to get information from previous tasks to complete this table.)

Proposed Method	Total Cost of Eliminating Six Units of Pollution
	(Dollars)
Regulation
Tradable Permits

In this case, you can conclude that eliminating pollution is   costly to society when the government regulates each firm to eliminate a certain amount of pollution than when it allocates pollution permits that can be bought and sold.

Answer 1

Method 1- Regulation

Firm	Total Cost of Eliminating 2 Units
Firm X	130+165= $295
Firm Y	600+750= $1350
Firm Z	90+115= $205
Total	295+205+1350= $1850

Method 2- Tradable Permits

Every firm initially has 2 permits and is allowed to emit to units of pollution. Firm Z has lowest cost for reducing 2 units of pollution. Therefore, it will not wish to buy any permits and reduce 2 units for a cost of $205.

Firm X also has low cost compared to firm Y for decreasing 2 units and will reduce 2 units for $295

Firm Y has a very high cost of reducing pollution by even 1 unit at $600. Therefore, firm Y will try to buy permits from X or Z instead of reducing its own pollution. Since it costs $600 to reduce pollution on its own, any price below $600 for a permit will be acceptable to Y.

No firm can reduce pollution to 0. Therefore, every firm needs atleast 1 permit and will only be willing to sell 1 permit irrespective of price.

It costs firm Z $140 to reduce pollution by the 3rd unit. Thus, to sell its permit, it will want more than $140.

It costs firm X $220 to reduce pollution by the 3rd unit. Thus, X will want atleast $220 for its permit.

At prices greater than $220, both X and Z will be willing to sell their permits.

Of the given options, $310, $548 are acceptable for the trade with both X and Z. Other options ($117, $171, $192) are too low.

If the permit price is set at $531 per permit, it would still be better for Firm Y to buy the permits from X and Z rather than reduce its own pollution, since every unit reduction costs $600.

Firm	Initial Pollution Permit	Action	Final Amount Of Pollution Eliminated	Cost of Pollution Reduction
X	2	Sell 1 permit for $531	3	130+165+220= $515
Y	2	Buy 2 permits for $1062	0	$0
Z	2	Sell 1 permit for $531	3	90+115+140= $345

Regulation vs Tradable Permits-

Method	Total Cost of Reducing 6 Units of Pollution
Regulation	295+205+1350= $1850
Tradable Permits	515+345= $860

Therefore, it can be concluded that tradable permits are cheaper than regulations in reducing pollutions.