question archive There are three industrial firms in Happy Valley: Initial Pollution Level Cost of Reducing Pollution by 1 unit Firm (Units) (Dollars) A 70 20 B 80 25 C 50 10 The government wants to reduce pollution to 120 units, so it gives each firm 40 tradable pollution permits
There are three industrial firms in Happy Valley: Initial Pollution Level Cost of Reducing Pollution by 1 unit Firm (Units) (Dollars) A 70 20 B 80 25 C 50 10 The government wants to reduce pollution to 120 units, so it gives each firm 40 tradable pollution permits
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There are three industrial firms in Happy Valley:
| Initial Pollution Level | Cost of Reducing Pollution by 1 unit | |
|---|---|---|
| Firm | (Units) | (Dollars) |
| A | 70 | 20 |
| B | 80 | 25 |
| C | 50 | 10 |
The government wants to reduce pollution to 120 units, so it gives each firm 40 tradable pollution permits.
1) Without the permission of trading the pollution permits, what are the costs of cleaning up the pollution for each of the firms? What is the total cost of cleaning up?
2) With the permission of trading the pollution permits, which firms would buy or sell the permits and why?
3) After the firms have traded their permits, what are the costs of cleaning up the pollution for each of the firms?
4) How much cost of cleaning up is saved after trading the pollution permits?
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In part (1), each firm has 40 permits and is not allowed to trade. Therefore, Firm A must cut pollution by 70 - 40 = 30 units. This will cost Firm A $20 * 30 = $600. Firm B must cut its pollution by 80 - 40 = 40 units, so its cost will be $25 * 40 = $1,000. Firm C must cut its pollution by 50 - 40 = 10 units. Its cost is $10 * 10 = $100. The total cost of the policy is $600 + $1,000 + $100 = $1,700.
If firms are allowed to trade permits, Firm B would likely be the most interested in buying because it has the highest cost of cleaning up. Both firms A and C would sell to firm B as long as B offers them a price that's greater than their own cost of pollution reduction.
For simplicity let's assume that Firm C will sell all of its permits to Firm B for $15 per permit. This is in both firms' benefit. Firm C must now cut 50 units of pollution, and its cost will be $10 * 50 = $500, but it has gained $15 * 40 = $600 from the sale of its permits to Firm B. The net benefit to Firm C is $600 - $500 = $100. Now, Firm B does not have to reduce any of its pollution since it has 80 permits, but it paid Firm C $600 for its permits. Firm B did not trade, so it still has to pay $600 to cut its pollution as it did in part (1).
The total cost of the policy if the trade occurs is $600 + $600 - $100 = $1,100. Therefore, the firms save $1700 - $1,100 = $600 by trading.
