Question

Suppose the government wants to reduce the total pollution emitted by three firms. Currently, each firm is creating 4 tons of pollution, for a total of 12 tons. The government is considering the following two methods to reduce total pollution to 6 tons:

1.	The government sets regulation specifying that each of the three firms must cut its pollution in half.
2.	The government allocates two tradable pollution permits to each of the three firms. Each permit allows the firm to emit 1 ton of pollution. Assume the negotiation and exchange of permits are costless.

The following table shows the cost each firm faces to eliminate each unit of pollution.

	Firm X	Firm Y	Firm Z
Cost of Eliminating:
First ton of pollution	$220	$620	$900
Second ton of pollution	$320	$720	$1,000
Third ton of pollution	$430	$860	$1,200
Fourth ton of pollution	$560	$1,000	$1,600

Suppose the owners of the three firms get together and agree on a trading price of $820 per permit.

Complete the following table with the action each firm will take at this permit price and the amount of pollution each firm will eliminate.

Firm	Initial Pollution Permit Allocation	Action	Final Amount of Pollution Eliminated
	(Tons of pollution)		(Tons of pollution)
Firm X	2	(buy one permit) (buy two permits) (neither buy or sell) (sell one permit) (sell two permits)
Firm Y	2	(buy one permit) (buy two permits) (neither buy or sell) (sell one permit) (sell two permits)
Firm Z	2	(buy one permit) (buy two permits) (neither buy or sell) (sell one permit) (sell two permits)

Determine the total cost of eliminating 6 tons of pollution under each method, and enter the amounts in the following table.

Method	Total Cost of Eliminating 6 Tons of Pollution
	(Dollars)
Regulation
Tradable pollution permits

In this case, using tradable pollution permits reduces 6 tons of pollution at (a higher cost than) using regulation.

(a lower cost than)

(the same cost as)

Answer 1

Ans:

1) Total cost of eliminating two units of pollution

Firm X = $220 + $320

= $540

Firm Y = $620 + $720

= $1340

Firm Z = $900 + $1000

= $1900

2) when the permit price is $820 per permit, only firm X will sell a permit to firm Z

Firm	Initial pollution permit allocation	Action	Final amount of pollution eliminated	Cost of pollution reduction
X	2	sell two permits	4 units	$220 + $320 + $430 + $560 = $1530
Y	2	neither buy nor sell	2 units	$620 + $720 = $1340
Z	2	buy two permits	0

3) Total Cost of Eliminating 6 Tons of Pollution

Regulation = $540 + $1340 + $1900

= $3,780

Tradable permits = $1530 + $1340

= $2,870

4) a lower cost than

Using tradable pollution permits reduces 6 tons of pollution at a lower cost than using regulation.