cap-and-trade and windfall profits A city called Seoul is suffering from high concentrations of mercury in the air, caused by burning coal in power plants. There are two of these plants close to the city. The city’s mayor wants to use cap-and-trade to reduce emissions to a reportedly “safe” level of 60 tons. The two firms have the following marginal benefits of emissions: MB1 = 100 – 2e1, MB2 = 25 – 0.5e2. a. How much mercury will each firm emit? What allowance price will prevail in the market? Firm 2 hires a smart lobbyist who convinces the government that its profits are relatively low and that it therefore deserves a generous allowance allocation. The government agrees and allocates a1 = 20 allowances to firm 1 (for free) and a2 = 40 allowances to firm 2 (for free). b. What are the firms’ profits? Do any of the firms earn windfall profits? [Hint: compare profits with and without regulation.] Windfall profits have been sharply criticized by consumer advocacy groups and politicians. c. What can regulators do in practice to avoid windfall profits?
cap-and-trade and windfall profits
A city called Seoul is suffering from high concentrations of mercury in the air, caused by burning
coal in power plants. There are two of these plants close to the city. The city’s mayor wants to
use cap-and-trade to reduce emissions to a reportedly “safe” level of 60 tons. The two firms have
the following marginal benefits of emissions: MB1 = 100 – 2e1, MB2 = 25 – 0.5e2.
a. How much mercury will each firm emit? What allowance price will prevail in the
market?
Firm 2 hires a smart lobbyist who convinces the government that its profits are relatively low and
that it therefore deserves a generous allowance allocation. The government agrees and allocates
a1 = 20 allowances to firm 1 (for free) and a2 = 40 allowances to firm 2 (for free).
b. What are the firms’ profits? Do any of the firms earn windfall profits? [Hint: compare
profits with and without regulation.]
Windfall profits have been sharply criticized by consumer advocacy groups and politicians.
c. What can regulators do in practice to avoid windfall profits?
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