Problem

You work for the Environmental Protection Agency - the government wants to regulate emissions of a particular pollutant and following your advice is considering a market based approach rather than a command and control approach. It has not decided whether to regulate using taxes or tradeable permits.

You estimate the marginal benefit to society of abating emissions as well as the marginal cost to firms of installing pollution reducing technology as MCA = 100 + Q/2 and MBA = 1000 - 2Q where Q = the number of tons of the pollutant.

(a) Given your estimates of the marginal cost and benefit of abatement. What would be the optimal emissions tax to set?

(b) If firms would emit 600 tons absent any controls, what would be the optimal number of emissions permits to allocate?

(c) Some uncertainty exists in your calculation of the marginal cost of abatement - the cost of abatement may in fact be substantially higher. If the marginal cost of abatement is actually MCA = 200 + Q/2, what is the deadweight loss associated with using the tax from part (a) relative to the optimal tax rate.

(d) Explain whether your answer to part (c) would be different if the government used tradable permits rather than taxes? Why or why not?

(e) What are the relative political merits for using taxes or tradable permits?