Principles of Microeconomics / Unit 11 MIC 1013 review, 2 to 3 minutes
One Polluting Market, Three Remedies
The idea
One polluting market run under three remedies shows what each does and costs. The market first. Demand meets private supply at too large a quantity, because the seller's marginal private cost leaves out the damage; social cost sits above it by the external cost per unit, and the optimum is where demand meets social cost. Remedy one, a rule: order every polluter to cut by the amount that reaches the optimum. The quantity is right, but each firm cuts the same amount whatever its abatement cost, so the industry spends more than necessary, and no firm gains by cutting further. Remedy two, a charge equal to the external cost per unit: the tax shifts private supply up onto social supply, the market itself moves to the optimum, and each firm abates until its marginal abatement cost equals the charge, so the cheap abatement happens and the dear abatement is paid for instead. Remedy three, a cap with permits set at the optimal quantity: the total is fixed by law, and trading moves the abating to the firms that can do it cheapest, until every firm's marginal abatement cost equals the permit price. The charge and the cap reach the same outcome from opposite sides, price first or quantity first. All three can hit the quantity; the two market tools hit it at the lowest cost and keep rewarding firms for finding cheaper abatement. The rule is what a government reaches for when it cannot measure abatement costs; the price tools, when it can measure emissions.
In practice
Worked example: the paint market makes four thousand cans at forty-five dollars and should make three thousand at fifty. A rule caps output at three thousand and orders each of ten plants to cut a hundred, whether cutting costs it five dollars a can or fifty. A charge of ten dollars a can lifts every plant's cost by ten, supply shifts up, and the market clears at three thousand cans and fifty dollars, with the plants whose abatement costs less than ten abating and the rest paying. A cap of three thousand with tradable permits fixes the quantity and lets the five-dollar plants sell permits to the fifty-dollar plants, so the same thousand cans are cut where cutting is cheapest. Same quantity three times; the cheapest total cost twice.
Where people slip
Three cautions. The optimum is three thousand cans, not zero; a remedy that eliminated the pollution would destroy surplus worth more than the damage it prevented. The charge must equal the external cost per unit to land on the optimum; a charge chosen for revenue lands elsewhere. And the cap's permit price is revealed by trading, not set by the regulator, so a cap and a charge differ in who bears the uncertainty when abatement costs turn out different from expected.
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