Suppose the government wants to reduce the total pollution emitted by three firms in its area. Currently, each firm is creating 4 units of pollution in the area, for a total of 12 pollution units. The government wants to reduce total pollution in the area to 6 units. In order to do so the government can choose between two methods: Under method 1, the governments sets pollution standards, whereas under method 2, the government allocated tradable pollution permits, Let’s compare the two methods to determine the least-cost way of achieving the desired pollution quantity. Eliminating pollution can be more difficult, and thus more costly, for some kinds of firms than it is for others. The table below shows the cost of eliminating each unit of pollution for each of the three firms.

Cost of eliminating the first unit of pollution $130 (firm x), $90 (firm y), $600 (firm z)
Cost of eliminating the second unit of pollution $165 (firm x), $115 (firm y), $750 (firm z)
Cost of eliminating the third unit of pollution $220 (firm x), $140 (firm y), $1,200 (firm z)

Assume that the cost of reducing pollution to zero (that is, eliminating all 4 units of pollution) is prohibitively expensive.

In order to regulate pollution, suppose the government sets pollution standards so that each firm must reduce its pollution by 2 units. Fill in the table below with the total cost to each firm of reducing its pollution by this amount.

Total cost of eliminating 2 units of pollution
Firm X
a) $165
b) $385
c) $295
d) $350

Firm Y
a) $255
b) $115
c) $230
d) $205

Firm Z
a) $1,350
b) $1,800
c) $750
d) $1,950

Adding up the costs to the three firms, you can see that the total cost of eliminating 6 units of pollution through standards of regulation is
a) $1,850
b) $1,645
c) $1,490
d) $2,590

Now suppose the government decides to use a different strategy to achieve its goal of reducing the pollution in the area from 12 units to 6 units – namely, it issues two pollution permits to 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 and firm Y were able to agree on a suitable price for a permit, firm Y would end up with three permits and would only need to reduce its pollution by 1 unit, whereas 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 is costless.

Because of its high pollution – reduction costs, firm X thinks it might be better off buying permits from firm Y and firm Z so that it doesn’t have to reduce its own pollution emissions. At which of the following prices is only firm Y willing to sell one of its permits to firm X, while firm Z will decline to do so? Check all that apply.
a) $100
b) $410
c) $5180
d) $195

Again, suppose that you are considering the method of pollution reduction involving tradable permits. Suppose the owners of the three firms get together and agree on a trading price of $415 per permit. Fill in the following table with the amount each firm will pollute and the amount it costs each firm to reduce pollution to the necessary level (Hint: Do not include the prices of permits in the cost of reducing pollution)

Initial pollution permit allocation = 2 units (firm X), 2 units (firm Y), 2 units (firm Z)
Trades firm X trades firm Y trades firm Z
Final pollution amount firm X firm Y firm Z
Cost of reducing pollution to final amount firm X firm Y firm Z

Given this scenario, the total cost of eliminating 6 units of pollution using a tradable permit system is
a) $0
b) $860
c) $1,690
d) $1,240

Based on this example, you can conclude that eliminating pollution is
a) more
b) less
costly to society when the government directs each firm to eliminate a certain amount of pollution than when it allocates pollution permits that can be bought and sold.