Suppose we know that marginal damages from CO2 emissions are given by MD(e) = 10e, where e is total emissions. The marginal savings are MS(e) = 90 5e. The regulator wishes to use either a carbon tax or an emissions trading scheme to reduce emissions to their efficient level.

1. Assuming that the regulator knows the true marginal savings and marginal damage curves, which policy instrument should they choose?

2. Suggest a reason that the regulator may overestimate the marginal savings function.

3. Suppose that the regulator overestimates the marginal savings from CO2 emissions, believing it to be MS (e) = 120 5e. Given these beliefs, which policy instrument should they choose? Explain your answer using a diagram (no need for calculations)