1. Externalities – Definition and examplesAn externality arises when a firm or person engages in an activity that affects the well-being of a third

ofper ton of bolts.4. Understanding different policy options to correct for negativeexternalitiesCarbon dioxide emissions have been linked to worsening climate conditions. The following table lists some possible public policies aimed at reducing the amount of carbon dioxide in the air.For each policy listed, identify whether it is a command-and-control policy (regulation), tradable permit system, corrective subsidy, or corrective tax.5. Correcting for negative externalities – Regulation versus tradablepermitsSuppose the government wants to reduce the total pollution emitted by three local firms. Currently, each firm is creating 4 units of pollution in the area, for a total of 12 pollution units. If the government wants to reduce total pollution in the area to 6 units, it can choose between the following two methods:Available Methods to Reduce Pollution1.The government sets pollution standards using regulation.2.The government allocates tradable pollution permits.Each firm faces different costs, so reducing pollution is more difficult for some firms than others. The following table shows the cost each firm faces to eliminate each unit of pollution. For each firm, assume that the cost of reducing pollution to zero (that is, eliminating all 4 units of pollution) is prohibitively expensive.FirmCost of Eliminating the…First Unit of PollutionSecond Unit of PollutionThird Unit of Pollution(Dollars)(Dollars)(Dollars)Firm X130165220Firm Y90115140Firm Z6007501,200Now, imagine that two government employees proposed alternative plans for reducing pollution by 6 units.Method 1: Regulation The first government employee suggests to limit pollution through regulation. To meet the pollution goal, the government requires each firm to reduce its pollution by 2 units.Complete the following table with the total cost to each firm of reducing its pollution by 2 units.FirmTotal Cost of Eliminating Two Units of Pollution(Dollars)Firm XFirm YFirm ZMethod 2: Tradable Permits Meanwhile, the other employee proposes using a different strategy to achieve the government’s goal of reducing pollution in the area from 12 units to 6 units. He suggests that the government 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 agrees to sell a permit to firm Y at an agreed-upon price, then firm Y would end up with three permits and would need to reduce its pollution by only 1 unit while 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 are costless.Because firm Z has high pollution-reduction costs, it thinks it might be better off buying a permit from firm Y and a permit from firm X so that it doesn’t have to reduce its own pollution emissions. At which of the following prices is firm Y willing to sell one of its permits to firm Z, but firm X is not? Check all that apply.$123$212$219$569$595Suppose the owners of the three firms get together and agree on a trading price of $218 per permit.

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