Suppose that two power plants each releases 200 units of toxic air into the atmosphere per year. Both firms are ordered by the federal government to reduce their pollution levels. Let Q denote the amount of pollution reduction. Firm A’s marginal costs associated with pollution reduction are M C = 2Q − 20. Firm B’s marginal costs associated with pollution reduction are MC = 3Q. The marginal benefit of pollution reduction is MB = 240. (a) What is the socially optimal level of each firm’s pollution reduction? Show your cal- culation. (b) Taking the sum of the two firm’s optimal level of pollution calculated in (a) as the target of total reduction, is the policy of splitting this target amount equally between the two firms socially optimal? Why? (c) How would a “cap and trade” scheme work? In particular, (i) How many pollution permits should be issued to the two firms in total? (ii) Assuming equal amount of initial pollution permits for each firm, who buys how much permits from whom? How much pollution reduction each firm would achieve? (iii) Is the final outcome after trade efficient? Explain.
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