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7. Correcting for negative externalities – Regulation
versus tradable permits

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


Cost of Eliminating the . . .

First Unit of
Second Unit of
Third Unit of
(Dollars) (Dollars) (Dollars)
Firm X 80 100 150
Firm Y 450 800
Firm Z 95 120 200

Now, imagine that two government employees propose alternative
plans for reducing pollution by 6 units.

Method 1: Regulation

The first government employee suggests to limit pollution
through regulation. To meet the pollution goal, the government
requires each firm to reduce its pollution by 2 units.

Complete the following table with the total cost to each firm of
reducing its pollution by 2 units.

Firm Total Cost of
Eliminating Two Units of Pollution
Firm X
Firm Y
Firm Z

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. He 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

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






Suppose the owners of the three firms get together and agree on
a trading price of $182 per permit.

Complete the following table with the action each firm will take
at this permit price, the amount of pollution each firm will
eliminate, and the amount it costs each firm to reduce pollution to
the necessary level. If a firm purchases two permits, assume that
it buys one permit from each of the other firms.
(Hint: Do not include the prices paid for permits
in the cost of reducing pollution.)

Firm Initial
Pollution Permit Allocation
Action Final Amount
of Pollution Eliminated
Cost of
Pollution Reduction
(Units of
(Units of
Firm X 2
Firm Y 2
Firm Z 2

Regulation Versus Tradable Permits

Determine the total cost of eliminating six units of pollution
using both methods, and enter the amounts in the following table.
(Hint: You might need to get information from
previous tasks to complete this table.)

Proposed Method Total Cost of
Eliminating Six Units of Pollution

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