6 ❖ Chapter 10/Externalities Figure 7 10. a.In terms of economic efficiency in the market for pollution, it does not matter if the government distributes the permits or auctions them off, as long as firms can sell the permits to each other. The only difference would be that the government could make money if it auctioned the permits off, thus allowing it to reduce taxes, which would help reduce the deadweight loss from taxation. There could also be some deadweight loss occurring if firms use resources to lobby for additional permits.b.If the government allocated the permits to firms who did not value them as highly as other firms, the firms could sell the permits to each other so they would end up in the hands of the firms who value them most highly. Thus, the allocation of permits among firms would not matter for efficiency. But it would affect the distribution of wealth, because those who got the permits and sold them would be better off.11. a.A permit is worth $25 to firm B, $20 to firm A, and $10 to firm C, because that is the cost of reducing pollution by one unit. Because firm B faces the highest costs of reducing pollution, it will keep its own 40 permits and buy 40 permits from the other firms, so that it can still pollute 80 units. That leaves 40 permits for firms A and C. Because firm A values them most highly, it will keep its own 40 permits. So it must be that firm C sells its 40 permits to firm B. Thus firm B does not reduce its pollution at all, firm A reduces its pollution by 30 units at a cost of $20 × 30 = $600, and firm C reduces its pollution by 50 units at a cost of $10 × 50 = $500. The total cost of pollution reduction is $1,100.b.If the permits could not be traded, then firm A would have to reduce its pollution by 30 units at a cost of $20 × 30 = $600, firm B would reduce its pollution by 40 units at a cost of $25 × 40 = $1,000, and firm C would reduce its pollution by 10 units at a cost of $10 × 10 = $100. The total cost of pollution reduction would be $1,700, $600 higher than in the case in which the permits could be traded.
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