This question asks you to analyze the e ?ects of the introduction of a carbon scheme that was recently approved by the Australian parliament. In the ?rst phase of the scheme, a tax on carbon of AU$25 per ton of carbon emitted is imposed on the 500 largest polluting ?rms emitting 500 million tons of carbon per year (before the tax is introduced). In the second phase of the scheme, a cap and trade system is introduced instead of the carbon tax.

(a) The Australian government predicts that the carbon tax will reduce the quantity of emission by 100 million tons per year. How much will be the government revenue for this tax?

(b) In order to minimize the negative impact of this tax on the Australian ?rms, the government has designed some compensation packages. Assume that the government uses all the revenue from the carbon tax to compensate the 500 ?rms. Explain why the 500 ?rms are still worse off.

(c) Does the carbon tax that the Australian parliament approved, generate a deadweight loss? Explain.

(d) Now consider the following three ?rms. After the introduction of the tax, ?rm 1 reduces emissions of carbon by 2 million tons (that is, it abates 2 million tons or A ∗ 1 = 2); ?rm 2 reduces emissions of carbon by 500,000 tons (that is, it abates 500,000 tons or A ∗ 2 = 0.5); ?rm 3 does not reduce emissions at all (that is it abates zero or A∗ 3 = 0).

i. What is the marginal cost of abatement of ?rm 1 of abating 2 million tons that is MC1 (A ∗ 1)? Explain.

ii. What is the marginal cost of abatement of ?rm 2 of abating 500,000 tons that is MC2 (A ∗ 2)? Explain.

iii. What is the marginal cost of abatement of ?rm 3 of abating zero tons that is MC3 (A ∗ 3)? Explain.

(e) Now assume that the prediction of the government is correct and that after the introduction of the carbon tax, the emissions of carbon de- crease to 400 million tons per year. In the second phase of the carbon scheme, the carbon tax is eliminated and the government allocates 400 million carbon permits which allow emissions of 400 million tons of carbon to the ?rms. Those permits can be bought and sold in a national market (cap and trade). If nothing else changes between the ?rst and the second phase of the carbon scheme, what is the price that you expect to observe in the market for carbon? Explain.

(f) Keep assuming that the government allocates 400 million carbon permits. Can you determine the quantity of emissions each ?rm in part d) will abate? Explain.