Question

Consider two cities, each of which initially experiences 100 tons of pollution per day (50 tons from each polluting firm). City T imposes a pollution tax, resulting in an overall pollution reduction of 20 percent and a decrease in equilibrium employment. City U implements a uniform-reduction policy under which each firm cuts its pollution by 20 percent. Which city will experience a larger reduction in equilibrium employment? Illustrate.

Answer 1

City U will experience a larger reduction in equilibrium employment.

Explanation- The 2 cities have different approaches to reduction of pollution. Pollution is what is called a negative externality.
City T uses pollution tax- this is a market based instrument approach. City U uses uniform reduction policy, which is a command and control based approach. City T's tax will allow market forces to adjust accordingly and hence get the most efficient new equilibrium. Since the tax is on a total pollution basis, it will allow the firms to follow lowest cost path to reduce pollution. The total reduction would still be 20%, but it will be in such a way that the firm where it costs higher to reduce pollution by one tonne, will reduce lesser pollution while the firm where its cheaper to reduce, will reduce higher.

In economic terms, if the firms have different marginal abatement costs (MAC), the tax will let the market stabilize at a quantity of pollution reduction by both firms where their MACs become equal. This will be most efficient with least costs and hence, lowest possible reduction in equilibrium unemployment.

In City U- a uniform reduction, on the other hand, will result in deadweight loss. It will ask both firms to reduce pollution by same amount. And if their MACs are different, than the firm with higher MACs and the firm with lower MACs both reducing the same amount will result in greater costs. An ideal market like city T would've allowed the firms to have different reductions in output and have the lowest costs. But City U's uniform approach will increase cost and result in higher reduction in equilibrium employment.