Consider two firms that produce energy drinks and have factories located next to
ID: 1163909 • Letter: C
Question
Consider two firms that produce energy drinks and have factories located next to the Hudson river. Each firm pollutes 50 tons of chemicals into the river per day. The government decides to reduce the pollution by allocating each firm 40 tradeable permits. Each permit allows a firm to pollute 1 ton of chemical into the river per day. Note that Firm A can abate its pollution for $50 per ton and Firm B can abate its pollution for $100 per ton.
1 which of the following statements is correct:
a. The price of the tradeable permit will be greater than $100.
b. The price of the tradeable permit will be less than $50.
c. Firm A will be better off if it sells permits to Firm B.
d. Firm B will be better off if it sells its permits to Firm A.
2 suppose instead of issuing the permits the government decides to pass a regulation that only allows each firm to pollute 40 tons of chemicals into the Hudson river per day. This regulation would:
a. Result in a more efficient outcome than issuing permits.
b. Result in a less efficient outcome than issuing permits.
c. Result in the same outcome as issuing permits.
d. None of the above are necessarily true.
Explanation / Answer
Solution:
Q1: No. of tradeable permits for each firm = 40 (each permit for each ton of pollution in river)
Marginal cost of abatement, MCA for firm A = $50 per ton, MCAB = $100 per ton.
Now, a firm will buy permits only if the price of each permimt is lower than it's marginal abatement cost. Why? Because, if the price of permit is higher, they'll prefer to reduce the pollution by abating it, which is cheaper for them to do and thus will buy 0 permits. Only if price is lower than MCA, will they buy the permits, since then abating is relatively expensive.
So, given the MCAs of two firms, case cannot be that price of permit > max{MCAA,MCAB} = 100 (since, none will buy permits. So, price has to lower than $100 (eliminates option a).)
Also, price of permit < min{MCAA,MCAB} = 50, since, then both firms will prefer to buy permits, but total no. of available permits = 80 (40 each) permitting for 80 tons of pollution, while both produce pollution level of 100 tons (50 tons each) (eliminates option b).)
Now, consider a scenario when this price, P is between these two extremes, min{MCAA,MCAB} < P < max{MCAA, MCAB}, or 50 < P <100, say P = 60 for examle. Then, firm B will buy all the permits (since 60<100 = MCAB), since price of permits is less than it's MCA of $100, but firm A will prefer to abate pollution at cost of $50 rather than buying permits (since MCAA = 50 < 60). Firm B, on purchasing all 80 permits, permitting to produce 80 tons of pollution, can sell 30 of these permits to firm A at $50 each, since, B requires only 50 permits of them to produce 50 tons of pollution, and firm A will buy these 30 permits since it's MCA = this price of $50 offered by firm B. In this way firm B is better off by selling it's permits to firm A.
Q2: For this question, we can talk about two alternatives:
In regards with pollution, from above question we can see that even if permits are issued, total tons of pollution in Hudson river = 100 tons. But under such regulation passed, the firms will be obliged to follow/abide by the regulation, thereby resulting in 100 tons of pollution per day (40 tons each firm). So, under regulation passing policy, pollution level will be reduced, making it socially efficient.
In regards with economy income, with less than 50 tons of pollution, production of energy drinks might reduce, and thus the income spending on energy drink reduces, and GDP as well, which is socially inefficient.
I have presented two contrasting arguments regarding regulation passing policy, so may be none of above are necessarily true is the correct option.