Question

5. Correcting for negative externalities - Regulation versus tradablepermits

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	90	125	180
Firm Y	55	70	110
Firm Z	650	800	1,500

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.

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

$99

$160

$163

$692

$707

Suppose the the government has set the trading price of a permit at $630 per permit.

Regulation Versus Tradable Permits

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

Answer 1

Ans:

1) Total cost of eliminating two units of pollution.

Firm X = $90 + $125

= $215

Firm Y = $55 + $70

= $125

Firm Z = $650 + $800

= $1450

2) $160, $163

The cost of eliminating third unit of pollution for firm X is $180 and the cost of eliminating third unit of pollution for firm Y is $110. when the permit price is above $110 and below $180, only firm Y will sell a permit to firm Z.

3) when the permit price is $630, both firm X and firm Y will sell a permit to firm Z.

Firm	Initial pollution permit allocation	Action	Final amount of pollution eliminated	Cost of pollution reduction
X	2	sell one permit	3 units	$90 + $125 + $180 =$395
Y	2	sell one permit	3 units	$55 + $70 + $110 = $235
Z	2	buy two permits	0	0

4) Total cost of eliminating six units of pollution

Regulation = $215 + $125 + $1450

= $1790

Tradable permits = $395 + $235

= $630

5) Less

Eliminating pollution is less costly to society when the government distributes tradable permits than when it regulates each firm to eliminate a certain amount of pollution.