Consider a situation where the true aggregate marginal abatement cost curve is given by -C'(E)= a-bE, and the marginal damage function by D'(E)= d.E. The regulator believes the true marginal abatement cost curve is -C'(E)= ã -bE with ã < a (alternatively -C'(E)= a - B̃ E with B̃ < B)

(a) Which total emission level will a benevolent but ill-informed regulator choose?

(b) Calculate the resulting welfare loss for a tax and for a permit instrument. Under what conditions is the tax instrument better than the permit instrument? What is the resulting emission level under the regulator’s choice?