Question

Suppose there are two plants that are emitting sulphur dioxide into the air and polluting the environment. One plant has a higher marginal benefit curve than the other. Draw and label a graph illustrating the impact of imposing a uniform environmental standard on the two plants. In a separate graph, show the effects of imposing an emission tax on the two plants. Which policy is more economically efficient and why? Explain how a cap and trade program can lead to a socially optimal outcome.

Answer 1

Solution:-

1.Suppose there are two plants that are emitting sulphur dioxide into the air and polluting the environment. One plant has a higher marginal benefit curve than the other. A graph illustrating the impact of imposing a uniform environmental standard on the two plants is drawn below,

The uniform environmental standard would be to impose a minimum level of production of quantities, at level q. Thus the level of emission would be restricted to a certain quantity , since SO2 emission must be a function of the quantity of output produced. Thus the quantity should be set according to the socially efficent allocation of output , thus restricting the level of quantity output to q.

b) The effects of imposing an emission tax on the two plants are shown below in the following graph,

If , say, an emission tax-1 = emission tax 2 = external costs is imposed on both the firms then the prices of the products will rise in both the firms. In firm-1 from price P to Po and in firm-2 from price P' to Pi. Thus there socially efficient allocation would come down for firm -1 from Q to Qo and for firm-2 from Q' to Qi. The box marked in red identifies the emission tax, new price after tax and new socially efficient allocation of firm-1 and green identifies the emission tax, new price after tax and new socially efficient allocation of firm-2.

c) The emission tax is more economically efficient one. Since, it taxes the external cost to society., according to their respective marginal benefit curve, thus the firm with higher marginal benefit produces more compared to the lower one.

d) Cap and trade program, that is restricting on quantity of output produced and thus the level of SO2 emission becomes fixed, provides a socially optimal outcome, since it restricts the production based on the socially efficient allocation of production, at q , based on the SMB =SMC of first firm, thus, the second firm even having a higher social marginal benefit, is restricted according to the minimum social marginal cost of firm 1. Hence, the emission of S02 could be controlled along with efficient allocation of resources.