Two firms, A and B, each currently dump 50 tons of chemicals into the local river. The government has decided to reduce the pollution and from now on will require a pollution permit for each ton of pollution dumped into the river. It costs Firm A $100 for each ton of pollution that it eliminates before it reaches the river, and it costs Firm B $50 for each ton of pollution that it eliminates before it reaches the river. The government gives each firm 20 pollution permits. Government officials are not sure whether to allow the firms to buy or sell the pollution permits to each other. What is the total cost of reducing pollution if firms are not allowed to buy and sell pollution permits from each other? What is the total cost of reducing pollution if the firms are allowed to buy and sell permits from each other?
A)$3,000; $1,500
B)$4,500; $3,500
C)$4,500; $4,000
D)$4,500; $2,500

Question

Quizplus · Accepted Answer

Without permits, both firms will reduce their pollution by 20 tons each, costing Firm A $2,000 (20 x $100) and Firm B $1,000 (20 x $50). Therefore, the total cost of reducing pollution is $3,000.

With permits, there are three possibilities – Firm A buys permits from Firm B, Firm B buys permits from Firm A, or they do not trade permits.

If Firm A buys 10 permits from Firm B for $500 each, then Firm A can keep polluting 30 tons while Firm B only pollutes 10 tons. The total cost will be $4,500.

If Firm B buys 10 permits from Firm A for $500 each, then Firm B can keep polluting 30 tons while Firm A only pollutes 10 tons. The total cost will be $3,500.

If they do not trade permits, then both firms will reduce their pollution by 20 tons each, costing Firm A $2,000 (20 x $100) and Firm B $1,000 (20 x $50) as before. The total cost will be $3,000.

Therefore, the best choice is to allow the firms to buy and sell permits from each other, as it leads to the lowest total cost of $3,500.

Two Firms, a and B, Each Currently Dump 50 Tons