Question

In this situation you have two firms that face separate marginal abatement cost functions of MAC1 = 6.5 and MAC1 = 4.5, where A is units of abatement that occur by a firm. Both companies can sell up to two units of output and each unit of output generates one unit of pollution. The price for each unit of output is $15.00 that yields a revenue of $30 dollars per period. Each company is required to hold a permit for each unit of pollution generated. The government issues 2 permits and each company hold 1 permit.

a. Using each marginal abatement cost functions, explain the strategy for Firm 1. Would they buy and additional permit or sell a permit when the price for permits is $3.00? Explain. Using each marginal abatement cost functions, explain the strategy for Firm 2. Would they buy and additional permit or sell a permit when the price for permits is $3.00? Explain.

c. If the price for permits increases to $5.00, what is the strategy for Firm 1? Will there be a tradable permit market system if the price for permits is $5?

Answer 1

Given that,

MAC1 = 6.5A

MAC2 = 4.5A

Marginal abatement cost of 1 unit for Firm 1 = 6.5 * 1

= $6.5

Marginal abatement cost of 1 unit for Firm 2 = 4.5 * 1

= $4.5

Above calculations indicates that the marginal abatement cost of 1 unit for Firm 1 is $6.5 that is higher than the Marginal abatement cost of 1 unit for Firm 2, i.e. $4.5.

(a) Firm 1 will buy the permit,

This is because the price of permit is $3 and the Marginal abatement cost of 1 unit for Firm 1 is $6.5.

Hence, by the purchase of permit it can save $3.5($6.5 - $3).

(b) Firm 2 will also buy the permit,

This is because the price of permit is $3 and the Marginal abatement cost of 1 unit for Firm 2 is $4.5. So by the purchase of permit it can save $1.5($4.5 - $3).

(c) If the price of Permit increases to $5, then

firm 1 will still purchase it because its own marginal cost of abatement of 1 unit is $6.5 which is greater than $5.

As there will be trade at $5, so there will be a tradeable permits market.