5. Correcting for negative externalities - Regulation versus tradable permits

Imagine the government wants to reduce the total pollution emitted by three local firms. Currently, each firm is creating 4 units of pollution in the area, for a total of 12 pollution units. If the government wants to reduce total pollution in the area to 6 units, it can choose between the following two methods:

Available Methods to Reduce Pollution

1.The government sets pollution standards using regulation.

2.The government allocates tradable pollution permits.

Each firm faces different costs, so reducing pollution is more difficult for some firms than others. The following table shows the cost each firm faces to eliminate each unit of pollution. For each firm, assume that the cost of reducing pollution to zero (that is, eliminating all 4 units of pollution) is prohibitively expensive.

Cost of Eliminating the... First Unit of Pollution Second Unit of Pollution Third Unit of Pollution Firm (Dollars) ( Dollars) (Dollars) Firm X 130 165 220 Firm Y 90 115 140 Firm Z 600 750 1,200Initial Pollution Permit Final Amount of Pollution Cost of Pollution Allocation Eliminated Reduction Firm (Units of pollution) Action (Units of pollution) (Dollars) Firm 2 X Firm 2 Y Firm 2 Z