5. Correcting for negative externalities - Regulation versus tradablepermits

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.

Firm	Cost of Eliminating the...
	First Unit of Pollution	Second Unit of Pollution	Third Unit of Pollution
	(Dollars)	(Dollars)	(Dollars)
Firm A	55	70	110
Firm B	650	800	1,500
Firm C	90	125	180

Next, suppose that two government officials proposed alternative plans that would reduce pollution by 6 units.

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 firm of reducing its pollution by 2 units.

Firm	Total Cost of Eliminating Two Units of Pollution
	(Dollars)
Firm A	125
Firm B	1450
Firm C	215

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 firms can agree on a price. For example, if firm A agrees to sell a permit to firm B at an agreed-upon 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 B has high pollution-reduction costs, it thinks it might be better off buying a permit from firm A and a permit from firm C so that it doesn't have to reduce its own pollution emissions. At which of the following prices are both firm A and firm C willing to sell one of their permits to firm B? Check all that apply.

$95

$145

$172

$385

$651

Suppose the the government has set the trading price of a permit at $338 per permit.

Complete the following table with the action each firm will take at this permit price, the amount of pollution each firm will eliminate, and the amount it costs each firm to reduce pollution to the necessary level. If a firm is willing to buy two permits, assume that it buys one permit from each of the other firms. (Hint: Do not include the prices paid for permits in the cost of reducing pollution.)

Firm	Initial Pollution Permit Allocation	Action	Final Amount of Pollution Eliminated	Cost of Pollution Reduction
	(Units of pollution)		(Units of pollution)	(Dollars)
Firm A	2
Firm B	2
Firm C	2

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.)

Proposed Method	Total Cost of Eliminating Six Units of Pollution
	(Dollars)
Regulation
Tradable Permits

In this case, you can conclude that eliminating pollution is ...............costly to society when the government distributes tradable permits than when it regulates each firm to eliminate a certain amount of pollution.