Question

Assume that you have two firms that face marginal abatement cost functions of ???1 = 4.5? and ???1 = 2.5?, where A is units of abatement undertaken 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 $12.00 that yields a revenue of $24 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. b. 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

Answer:

Given MAC1=4.5A and MAC2=2.5A

Marginal abatement cost of 1 unit for Firm 1=4.5*1=$4.5.

Marginal abatement cost of 1 unit for Firm 2=2.5*1=$2.5.

Looking at the calculations above we can clearly say that the Marginal abatement cost of 1 unit for Firm 1 is $4.5 that is higher than the Marginal abatement cost of 1 unit for Firm 2, i.e. $2.5.

a.

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

b.

Firm 2 will sell the permit because price of permit is $3 and the Marginal abatement cost of 1 unit for Firm 2 is $2.5. So by the sale of permit it can earn $0.5($3-$2.5).

c.

If the price of Permit increases to $5 then firm 1 will not purchase it because its own marginal cost of abatement of 1 unit is $4.5 which is less than $5. As there will not be any trade at $5, so there will not be any tradeable permits market.