Cap & Trade Exercise

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Cleaning Up the Environment: The Cap & Trade Method

The bottling plants of Coke, Pepsi, and 7-Up are among the main producers of cans. Assume the production of these cans pollutes the atmosphere. Your job is to reduce the total amount of pollution in this industry BY 90 units. You are given the following information about each company’s pollution level and how much it costs each company to reduce its pollution (whether by augmenting existing technology or investing in new technology). Here are the data:

Firm Initial Pollution Level Cost of Reducing Pollution By One Unit
Coke 70 tons of glop$20
Pepsi60 tons of glop$25
7-Up50 tons of glop$10
  • Your first thought is to make the pollution reduction egalitarian. You TELL each company that it must pay to reduce its pollution BY 30 tons apiece. What is the total cost to society of reducing pollution in this way?
  • Instead, you decide to issue pollution permits (one permit allows you to pollute legally 1 ton of glop). You issue permits in the following manner:
    • Coke: 30 permits or the rights to pollute 30 tons
    • Pepsi: 30 permits or the rights to pollute 30 tons
    • 7-Up: 30 permits or the rights to pollute 30 tons
  • You make the law that if you do NOT have any permits, you must pay to clean up all of your pollution. Enforcement through heavy fines for non-compliance is critical (see fines for failure to pay the London congestion charge!). But, you allow these companies to buy or sell their permits AS THEY SEE FIT. Assume the companies know or can find out each other’s costs of pollution reduction.
    • Who has an incentive to sell permits? At what price or in what price range? Why?
    • Who has an incentive to buy permits? At what price or in what price range? Why?
    • Can you think of a “market price” for these permits? Think about price pressures when either excess demand or excess supply exists in the market for permits.

Describe your market solution for permits. Explain why buyers and sellers of permits are each willing to do what they do in the market for permits. What is the total cost to society NOW of achieving the pollution reduction goal? Compare this total cost to your answer in (a) above. Does it matter whether we give 30 permits to each firm or whether 7-Up, for example, receives all 90 permits? Why or why not?