Question

A firm’s marginal cost of abatement is MAC = 3A. One unit of output generates one unit of emissions. Suppose that its baseline (unregulated) emissions level is 100 units. Also suppose that profits are so high that the firm will always produce at its capacity of 100 units regardless of whatever policies below are implemented.

(a) Suppose the government imposes a regulation that the firm cannot emit more than 50 units. How much will the firm abate?

(b) A team of skilled economists and epidemiologists determine that the marginal benefit of reducing emissions for this firm are $210. What is the socially optimal abatement of the firm?

(c) Suppose that there is a cap and trade system in place (marketable emission permits). The firm receives 20 pollution permits and must abate and/or purchase permits to cover the remainder of its baseline emissions. Suppose that the firm is small and takes the permit price as given. If the permit price is $210 per unit, will the firm buy or sell permits? How many will it buy or sell?

Answer 1

a)

If maximum allowable limit is 50 units of pollution,

Abatement by firm=100-50=50 units

b)

Marginal benefit of abatement=$210

Set MAC=Marginal benefit

3A=210

A=70 units

Social optimal abatement=70 units

c)

If the firm receives 20 permits, it is needed to 80 (100-20) units of emission.

Refer to part (b), we can see that if firm abates 1 more units above 70 units, marginal cost is higher than the marginal benefits. So, it is optimal for the firm to buy permits instead of abating beyond 70 units.

So, firm will buy permits .

Number of permits needed to be bought=80-70=10