Question

Correcting for negative externalities - Taxes versus tradablepermits

Paper factories emit chemicals as a waste product. This generates a cost to society that is not paid for by the firm; therefore, pollution is a negative externality of paper production. Suppose the government wants to correct this market failure by getting firms to internalize the cost of pollution. To do this, the government can charge firms for pollution rights (the right to emit a given quantity of chemicals). The following graph shows the daily demand for pollution rights.

Use the graph input tool to help you answer the following questions. You will not be graded on any changes you make to this graph.

Note: Once you enter a value in a white field, the graph and any corresponding amounts in each grey field will change accordingly.

02040608010012014016018020090817263544536271890PRICE (Dollars per tonne)QUANTITY (Millions of tonnes)Demand

Graph Input Tool

Daily Demand for Pollution Rights
	Price (Dollars per tonne)
	Quantity Demanded (Millions of tonnes)

Suppose the government has determined that the socially optimal quantity of chemical pollution is 140 million tonnes per day.

One way governments can charge firms for pollution rights is by imposing a per-unit tax on emissions. A tax (or price in this case) of

per tonne of chemicals emitted will achieve the desired level of pollution.

Now suppose the government does not know the demand curve for pollution and, therefore, cannot determine the optimal tax to achieve the desired level of pollution. Instead, it auctions off tradable pollution permits. Each permit entitles its owner to emit 1 tonne of chemicals per day. To achieve the socially optimal quantity of pollution, the government auctions off 140 million pollution permits. Given this quantity of permits, the price for each permit in the market for pollution rights will be

.

The previous analysis hinges on the government having good information regarding either the demand for pollution permits or the optimal level of pollution (or both). Given that the appropriate policy (tradable permits or corrective taxes) can depend on the available information and the policy goal, consider the following scenario:

Suppose the government knows the optimal quantity of pollution as well as how much it costs a particular polluting firm to reduce pollution at each quantity.

If this is all the information the government has, which solution to reduce pollution is appropriate? Check all that apply.

Tradable permits

Corrective taxes

Answer 1

Suppose the government has determined that the socially optimal quantity of chemical pollution is 140 million tons per day.

One way governments can charge firms for pollution rights is by imposing a per-unit tax on emissions. A tax of $27 per ton of chemical pollution emitted will achieve the desired level of pollution. Because when the price of emitting a ton of chemical is $27, then paper factories will demand a quantity of 140 million tons of sulfur dioxide. If the government imposed a tax less than $27 , then paper factories would choose to emit more than 140 million tons of chemical pollution per day. Similarly, if government imposed a tax more than $27 , then chemical pollution is less than socially optimal level.

Now suppose the government does not know the demand curve for pollution and therefore, cannot determine the optimal tax to achieve the desired level of pollution. Instead, it auctions off tradable permits . Each permit entitles its owner to emit one ton of chemical pollution per day. To achieve the socially optimal quantity of pollution, the government auctions off 140 million pollution permits. Given this quantity of permits,the price for each permit in the market for polution rights will be $27. Because selling 140 milllion pollution permits that each allow a firm to emit one ton of chemical pollution means that the supply of pollution will be 140 million tons per day. At a quantity of 140 million tons ,the market for pollution rights will clear at a price of $27. So, each pollution permit will have a value of $27 because at this price ,all 140 million pollution permits will be demanded.

Suppose the government knows the optimal quantity of pollution as well as how much it costs a particular polluting firm to reduce pollution at each quantity.

If this all information the government has, then tradable permits solution to reduce pollution is appropriate. Because if the government knows how much it costs a particular polluting firm to reduce pollution at each quantity, this means they also know firm's demand for pollution rights. Therefore, the government can achieve the socially optimal quantity of pollution by setting a corrective tax equal to the price is willing to pay to pollute at the optimal quantity. Because the government also knows the optimal quantity of pollution, they can also use tradable permits , which are a direct means of controlling the total quantity of pollution emitted.