Question

1. Suppose that two firms emit a certain pollutant in Shreveport, Louisiana. The marginal cost (MC) of reducing pollution for each firm is as follows: MC₁ = 3e₁ and MC₂ = 45e₂, where e₁ and e₂ are the amounts (in tons) of emissions reduced by the first and second firms, respectively. Assume that in the absence of government intervention, Firm 1 generates 500 units of emissions and Firm 2 generates 500 units of emissions.

1. Suppose Shreveport regulators decide to reduce total pollution by 400 units. If they decide to set a performance standard of 200 units of reduction per firm, what is the total cost to each of the firms?
2. In order to be cost effective, how much should each firm cut its pollution (to reach the 400 unit goal together)?
3. What emissions fee should be imposed to achieve the cost-effective outcome?
4. Suppose that instead of an emissions fee, the regulatory agency introduces a tradable permit system and issues 600 permits, each of which allows the emission of one unit of pollution. Firm 2 uses its political influence to convince the regulatory agency to issue 500 permits to itself and only 100 permits to Firm 1. How many, if any, permits are traded between the firms?
5. Under this cap-and-trade system, what is the minimum amount of money that must be paid (total) for these permits?
6. If the Shreveport regulators expect that Firm 2’s MC of pollution reduction might increase to MC₂’ = 57e₂ should they implement the emissions fee or cap-and-trade system. Support your answer fully.
7. Assume the government sets the pollution reduction goal by comparing the Marginal Social Benefit (MSB) of pollution reduction to the societal Marginal Cost (MC) of pollution reduction. Suppose that MC = 40e before firm 2’s MC goes up, and it equals MC’ = 50e after. What must be true about MSB if the emissions fee’s use results in an amount of pollution reduction closer to the optimal (post increase) than a cap-and-trade system. Explain fully and feel free to make up an appropriate equation for MSB to justify your answer.

Answer 1