Assume 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 ...
Firm First Unit of Pollution (dollars) Second Unit of Pollution (dollars) Third Unit of Pollution (dollars)
Firm X 95 120 200
Firm Y 450 800 1050
Firm Z 80 100 150
Now, imagine that two government employees proposed alternative plans for reducing pollution by 6 units.

Method 1: Regulation

The first government employee suggests limiting 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 in reducing its pollution by 2 units.

Firm Total Cost of Eliminating two units of pollution (dollars)
Firm X
Firm Y
Firm Z
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. He suggests that the government issue two pollution permits for 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 X agrees to sell a permit to firm Y at an agreed-upon price, then firm Y would end up with three permits and would need to reduce its pollution by only 1 unit, while firm X 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 Y has high pollution-reduction costs, it thinks it might be better off buying a permit from firm Z and a permit from firm X, so that it doesn't have to reduce its own pollution emissions. At which of the following prices is firm Z willing to sell one of its permits to firm Y, but firm X is not? Check all that apply.

O $90

O $178

O $186

O $451

O $529

Suppose the owners of the three firms get together and agree on a trading price of $326 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 purchases two permits assume that it buys one permit from each of the other firms.

Firm Initial Pollution Permit Allocation (units of pollution) Action Final Amount of Pollution Eliminated (unis of pollution) Cost of pollution reduction
Firm X 2
Firm Y 2
Firm Z 2
For the ACTION column, choose from:

a. buy one permit

b. buy two permits

c. don't buy/sell

d. sell one permit

e. sell two permits

Determine the total cost of eliminating six units of pollution using both methods, and enter the amounts in the following table.

Proposed method Total cost of Eliminating 6 units of pollution (dollars)
Regulation
Tradable permits
In this case, it can be concluded that eliminating pollution is (More/ Less) 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.