Question

Number of units abated (reduced)	MC of abatement Firm 1	MC of abatement Firm 2	MC of abatement Firm 3
1	1	2	3
2	2	4	5
3	3	12	7
4	5	14	9
5	6	16	10
6	14	22	18

1. Now suppose that instead of a standard, the regulator has chosen to implement a pollution trading program. Specifically, 2 pollution permits are allocated to each firm and then the firms are allowed to trade, how many permits do you expect each firm to hold after trading? Why? [Each permit allows a firm to emit one unit of pollution. Assume that firms will reduce their cheapest pollution units first] What is the total cost of this policy relative to the standard? Why might the regulator want to use this policy instead of the standard? (3 points)

Answer 1

Solution

The regulator want to use this policy instead of the standard policy because this policy (pollution trading) is more efficient in the sense more beneficial to all the stakeholders (the industries themselves i.e., firm 1 ,2 and 3) and the government also.

This is because the marginal cost of abatement of a unit of pollution is different for different in the case of Firm 1,2 &3.So,if there is pollution trading with permits,the higher cost firms can purchase the credits/ permits from the firms that are having excess until the cost of the permit purchase is less than the cost of reducing the pollution.The firms having excess credits can sell these to the firms which require at some premium or a cost.So,it is a win-win situation for the players.

The government also benefits in this process as efficiency of the industry (collection of all firms) is more than in earlier process / regulation.,since they can get more tax revenue due to higher production and the industry also becoming / retaining higher profits.

So,if the standard policy of emitting only 2 units of pollution from each firm is introduced(trading is not allowed),then a total of only 6 units of pollution is allowed from industry.If each firm emits 6 units of pollution then they have incur cost of abatement on 4 units of pollution respectively.Assuming that firms will reduce their cheapest pollution units first]

Cost of abatement - Firm A (1+2+3+5) i.e., 11

Cost of abatement - Firm B (2+4+12+14) i.e., 32

Cost of abatement - Firm C (3+5+7+9) i.e., 24

Total cost of reducing 12 units of pollution by the industry is : 67

Given that 2 permits are allocated to each of the firms i.e., Firm 1 Firm 2 and Firm 3.So,2 permits allow each of them to emit 2 units of pollution.Suppose each firm produces 6 units of pollution(assuming trading of permits is not for profit)

Cost of reducing 1st 2 units of production is 3,6 and 8 for Firm 1,2&3 respectively.

Firm 2 purchases all the 4 permits (2 from each firm 1 & 3) since the cost of reducing its last 4 units of production is (12+14+16+22) is 64 which is the highest.

Then cost by Firm 1 is (1+2+3+5+6+14) i.e., 31

cost by Firm 2 is 0

cost by Firm 3 is (3+5+7+9+10+18) i.e., 52

So,Total cost is 83

Note Here according to the example I have assumed,the cost structure is so.There is no clarity on how many units of pollution are allowed under the standard method.Here I have assumed that each firm produces 6 units of pollution respectively.But in general cases,establishing a pollution trading improves the efficiency as discussed above as the firms having higher marginal cost of reducing a unit of pollution buy the permit from others who are having the marginal at relatively lower cost than them,hence efficiency improvement.

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So,Firm 3 purchases its 1 st permit from either Firm 1 / 2 (can be assumed as Firm 1 since it is the least provided the firms are not trading the permits at a profit) since cost of reducing it's 1 st unit of pollution is 3.