5. Correcting for negative externalities - Regulation versus tradable permits Suppose a municipality votes to reduce the combined pollution introduced by three local companies. Presently, each firm creates 4 units of pollution in the area, for a total of 12 pollution units. The government can reduce total pollution in the area to 6 units by choosing between the following two methods: Methods to Reduce Pollution 1. The government imposes pollution standards using regulation. 2. The government issues tradable pollution permits. The costs faced by each firm are different, so it is more difficult for some firms to reduce pollution than others. The following table shows the cost faced by each firm to eliminate each unit of pollution. Assume that the cost of eliminating all 4 units of pollution (that is, reducing pollution to zero) is prohibitively expensive for all three firms. Cost of Eliminating the... First Unit of Pollution Second Unit of Pollution Third Unit of Pollution Firm (Dollars) (Dollars) (Dollars) Firm A 130 165 220 Firm B 90 115 140 Firm C 600 750 1,200 Next, suppose that two government officials proposed alternative plans that would reduce pollution by 6 units. Method 1: Regulation Method 2: Tradable Permits Meanwhile, the other employee proposes using a different strategy to achieve the government's goal of reducing pollution in the area from 12 units to 6 units. This employee suggests that the government issue two pollution permits to each firm. For each permit a firm has in its possession, it can emit 1 unit of pollution. Firms are free to trade pollution permits with one another (that is, buy and sell them) as long as both rms can agree on a price. For example, if rm A agrees to sell a permit to firm B at an agreedupon price, then firm B would end up with three permits and would need to reduce its pollution by only 1 unit while firm A would end up with only one permit and would have to reduce its pollution by 3 units. Assume the negotiation and exchange of permits are costless. Because firm C has high pollution-reduction costs, it thinks it might be better off buying a permit from firm B and a permit from firm A so that it doesn't have to reduce its own pollution emissions. At which of the following prices are both firm B and firm A willing to sell one of their permits to firm C? Check all that apply. Cl $124 C] $154 C] $162 Cl $296 Cl $482 Suppose the the government has set the trading price of a permit at $474 per permit. Complete the following table with the action each rm will take at this permit price, the amount of pollution each firm will eliminate, and the amount it costs each rm to reduce pollution to the necessary level. If a rm is willing to buy two permits, assume that it buys one permit from each of the other rms. (Hint: Do not include the prices paid for permits in the cost of reducing pollution.) Initial Pollution Permit Final Amount of Pollution Cost of Pollution Allocation Eliminated Reduction Firm (Units of pollution) Action (Units of pollution) (Dollars) Firm A 2 V : Firm B 2 v :] Firm c 2 v :l Regulation Versus Tradable Permits Determine the total cost of eliminating six units of pollution using both methods, and enter the amounts in the following table. (Hint: You might need to get information from previous tasks to complete this table.) Total Cost of Eliminating Six Units of Pollution Proposed Method (Dollars) Regulation Tradable Permits In this case, you can conclude that eliminating pollution is V costly to society when the government regulates each firm to eliminate a certain amount of pollution than when it allocates pollution permits that can be bought and sold. Method 1: Regulation The first government employee suggests reducing pollution through regulation. To meet the pollution goal, the government requires each firm to reduce its pollution by 2 units. Complete the following table with the total cost to each rm of reducing its pollution by 2 units. Total Cost of Eliminating Two Units of Pollution Firm (Dollars) Firm A :' Firm B :] Firm C :]