5. Correcting for negative externalities - Regulation versus tradable permitsImagine the government wants to reduce the total pollution emitted by three local firms. Currently, each firm is creating 4 units of pollution in thearea, 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 twomethods: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 toeliminate each unit of pollution. For each firm, assume that the cost of reducing pollution to zero (that is, eliminating all 4 units of pollution) isprohibitively expensive.FirmFirm XFirm YFirm ZMethod 1: RegulationNow, imagine that two government employees proposed alternative plans for reducing pollution by 6 units.FirmFirm XFirm YFirm ZThe first government employee suggests limiting pollution through regulation. To meet the pollution goal, the government requires each firm to reduceits pollution by 2 units.Method 2: Tradable PermitsFirst Unit of Pollution(Dollars)8075550Complete the following table with the total cost to each firm of reducing its pollution by 2 units.Total Cost of Eliminating Two Units of Pollution(Dollars)$128Meanwhile, the other employee proposes using a different strategy to achieve the government's goal of reducing pollution in the area from 12 units to6 units. This employee suggests that the government issue two pollution permits to each firm. For each permit a firm has in its possession, it can emit1 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 reduceits 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 negotiationand exchange of permits are costless.$165FirmFirm XFirm YFirm ZBecause 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 that itdoesn't have to reduce its own pollution emissions. At which of the following prices are both firm Y and firm X willing to sell one of their permits to firmZ? Check all that apply.$179$285$342Cost of Eliminating the...Second Unit of Pollution(Dollars)13090700Imagine the the government has set the trading price of a permit at $199 per permit.Third Unit of Pollution(Dollars)2101301,075Complete the following table with the action each firm will take at this permit price, the amount of pollution each firm will eliminate, and the amount itcosts each firm to reduce pollution to the necessary level. If a firm is willing to buy two permits, assume that it buys one permit from each of theother firms. (Hint: Do not include the prices paid for permits in the cost of reducing pollution.)Initial Pollution PermitAllocation(Units of pollution)222Regulation Versus Tradable PermitsProposed MethodRegulationTradable PermitsActionDetermine the total cost of eliminating six units of pollution using both methods, and enter the amounts in the following table. (Hint: You might needto get information from previous tasks to complete this table.)Final Amount of PollutionEliminated(Units of pollution)Total Cost of Eliminating Six Units of Pollution(Dollars)Cost of PollutionReduction(Dollars)In this case, you can conclude that eliminating pollution iscostly to society when the government regulates each firm to eliminate acertain amount of pollution than when it allocates pollution permits that can be bought and sold.

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Government-issued permits known as "tradable pollution permits" allow businesses to produce up to a…