Correcting for negative externalities - Regulation versus tradablepermits
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 expensive.
Firm
Cost of Eliminating the...
First Unit of Pollution
Second Unit of Pollution
Third Unit of Pollution
(Dollars)
(Dollars)
(Dollars)
Firm X 130 165 220
Firm Y 600 750 1,200
Firm Z 90 115 140
Now, imagine that two government employees proposed 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
(Dollars)
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 issues 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 costless.
Because firm Y has high pollution-reduction costs, it thinks it might be better off buying a permit from firm Z and a permit from firm X so that it doesn't have to reduce its own pollution emissions. At which of the following prices is firm Z willing to sell one of its permits to firm Y, but firm X is not? Check all that apply.
$93
$155
$190
$297
$464
Suppose the owners of the three firms get together and agree on a trading price of $650 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. (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 pollution)
(Units of pollution)
(Dollars)
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
(Dollars)
Regulation
Tradable Permits
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.
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To determine the total cost of eliminating six units of pollution using both methods, we need to calculate the cost for each firm under each method and then sum them up.
Method 1: Regulation
Under regulation, each firm is required to reduce its pollution by 2 units. To find the total cost for each firm, we add up the costs of eliminating 2 units of pollution according to the given table:
Firm X:
Cost of eliminating 2 units = Cost of eliminating the first unit + Cost of eliminating the second unit
= $130 + $165 = $295
Firm Y:
Cost of eliminating 2 units = Cost of eliminating the first unit + Cost of eliminating the second unit
= $600 + $750 = $1350
Firm Z:
Cost of eliminating 2 units = Cost of eliminating the first unit + Cost of eliminating the second unit
= $90 + $115 = $205
Total cost under regulation = Cost for Firm X + Cost for Firm Y + Cost for Firm Z
= $295 + $1350 + $205 = $1850
Method 2: Tradable Permits
Under tradable permits, each firm is initially allocated 2 permits, which allows them to emit 2 units of pollution. Since the total pollution needs to be reduced by 6 units, each firm would need to eliminate an additional 4 units of pollution.
Firm X:
Action: Firm X will eliminate all 4 units of pollution itself because it has the lowest cost.
Cost of eliminating 4 units = Cost of eliminating the first unit + Cost of eliminating the second unit + Cost of eliminating the third unit
= $130 + $165 + $220 = $515
Firm Y:
Action: Firm Y will buy 2 permits from Firm X, so it only needs to eliminate 2 units of pollution.
Cost of eliminating 2 units = Cost of eliminating the first unit + Cost of eliminating the second unit
= $600 + $750 = $1350
Firm Z:
Action: Firm Z will sell 2 permits to Firm Y and eliminate 2 units of pollution itself.
Cost of eliminating 2 units = Cost of eliminating the first unit + Cost of eliminating the second unit
= $90 + $115 = $205
Total cost under tradable permits = Cost for Firm X + Cost for Firm Y + Cost for Firm Z
= $515 + $1350 + $205 = $2070
In this case, the total cost of eliminating six units of pollution using regulation is $1850, and the total cost using tradable permits is $2070. Therefore, we can conclude that eliminating pollution is more 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.