Question 1: cap-and-trade (30 points) There are three NOx emitting power plants in New York State. One is located in New York City while the other two are located in Upstate New York and Western New York, respectively. Because of NYCs large and relatively wealthy population, the plant in the city has a higher marginal benefit of emissions curve than the two other plants: MBNYC = 10 ENYC, MBUP = 5 0.5EUP and MBWEST = 5 EWEST, where E stands for emissions. a. [2] What are the emissions for each of the three plants in absence of any environmental regulation? How large is the profit for each plant? Epidemiologists in Columbias medical school discover that NOx is bad for infant health. They estimate that the marginal damage of emissions is equal to 4. Greenpeace picks up on this and shows pictures of crying babies in front of dirty power plants. The state government of New York responds by setting an ambitious target that requires each plant to cut emissions by 50%. b. [2] What is the individual profit for each firm after regulation? What are total profits? A consultant to the state government recalls from her BGM551 course that cap-and-trade might be a better idea. She suggests setting the cap at 50% of the total emissions without regulation, and governor Cuomo follows her advice. Each firm receives allowances equal to 50% of its emissions before regulation. c. [5] What allowance price will prevail in the market? How much will each firm emit? 2 d. [4] What is the profit for each firm under the cap-and-trade program? What is the total profit and how does it compare to the total profit from part b? What is the gain from trading for each firm? e. [2] Has the consultant chosen an efficient cap? If so, explain why. If not, explain what the efficient cap would be. The NYU School of Medicine releases a new study that shows that their esteemed colleagues from Columbia were wrong. Marginal environmental damage is larger for NYC, because an additional ton of emissions affects more people in a crowded city. Each plant is analyzed and found to have the following marginal damages: MEDNYC = 6, and MEDUP = MEDWEST = 2.5. f. [3] Calculate the total surplus under (1) no regulation, (2) a 50% reduction target imposed on each firm (no trading), and (3) cap-and-trade. [Hint: surplus takes into account both profits and environmental damages.] g. [3] Explain why the cap-and-trade program performs poorly relative to regulation from part b. Which of the design issues with cap-and-trade is causing problems here? Realizing that the cap-and-trade program is not performing as intended, the consultant recruits you, as your knowledge of BGM551 is still fresh in your mind (hopefully!). Vaguely remembering the RECLAIM program, she decides to put the upstate and the western facilities into one group and let them trade only among themselves. You, the newly recruited star, suggest 8.5 allowances for the group and 4 allowances for the NYC plant. h. [3] Is this two trading zones approach more efficient than the previous regulations? Your supervisor thinks one can do better (in terms of social surplus) by allocating the allowances in a different way. i. [3] Is that true? If no, why not? If so, give an example of a more efficient allocation. A cap-and-trade with trading ratios is sometimes proposed as the most efficient way to deal with environmental damages that vary across locations. j. [3] Briefly but carefully explain how trading ratios work.