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Question 1: Carbon tax vs cap & trade Suppose we know that marginal damages fro...

Apr 15, 2024

Question 1: Carbon tax vs cap & trade Suppose we know that marginal damages from CO2 emissions are given by M D(e) = 10e, where e is total emissions. The marginal savings are M S(e) = 90 − 5e. The regulator wishes to use either a carbon tax or an emissions trading scheme to reduce emissions to their efficient level. A Assuming that the regulator knows the true marginal savings and marginal damage curves, which policy instrument should they choose? B Suggest a reason that the regulator may overestimate the marginal savings function. C Suppose that the regulator overestimates the marginal savings from CO2 emissions, believing it to be ̃M S(e) = 120 − 5e. Given these beliefs, which policy instrument should they choose based on economic efficiency reasons? Explain your answer using a diagram (no need for calculations)

Key Concept

Economic Efficiency

Explanation

Both a carbon tax and an emissions trading scheme can achieve the efficient level of emissions if the regulator knows the true marginal costs and benefits. The choice between the two depends on whether we prioritize price certainty (carbon tax) or quantity certainty (cap and trade). However, since the marginal damage and marginal savings functions are linear and known, either instrument can be set to achieve the efficient outcome.

Key Concept

Information Asymmetry

Explanation

The regulator may overestimate the marginal savings function due to information asymmetry, where firms have better information about their own cost structures than the regulator. Firms may also have an incentive to overstate their costs of reducing emissions to influence the regulator's decision.

Key Concept

Economic Efficiency with Incorrect Information

Explanation

If the regulator overestimates the marginal savings, a cap and trade system might be more efficient because it fixes the quantity of emissions and lets the market determine the price, which could lead to a more accurate discovery of the true marginal savings through trading. With a tax, the regulator risks setting it too low or too high based on the incorrect marginal savings estimate.

Question 2: Cap \& Trade 按 Esc 即可退出全屏模式 An economy has two types of firms that contribute GHG emissions to the atmosphere: coal power plants emit

10 \mathrm{Mt} \mathrm{CO2}

/year per firm and cement factories emit

1 \mathrm{MtCO} 2 /

year per firm (where

1 \mathrm{MtCO} 2 /

year

=1,000,000

tons of carbon dioxide per year). There are 100 coal power plants and 300 cement factories. The two types of firms are different, but within each sector firms are the same. Total abatement costs for each coal power plant are

C_{1}\left(a_{1}\right)=5 a_{1}^{2}

, where

a_{1}

is abatement for a coal power plant, measured in MtCO2/year. Total abatement costs for each firm in the cement industry are

C_{2}\left(a_{2}\right)=6 a_{2}+7.5 a_{2}^{2}

. A Calculate the overall baseline emissions of the economy. If annual emissions should be reduced to

940 \mathrm{Mt} \mathrm{CO} 2 /

year, how many Mt CO2 have to be abated? The government decides to implement a cap-and-trade system. It sets an economy-wide cap at 940 MtC02/year and auctions off permits. Assume that there is perfect competition on the permit market.

1

B At what price do permits trade? How many MtCO2 of permits do firms in each of the two sectors purchase? C Assume that the total abatement costs in the coal industry are

C_{1}\left(a_{1}\right)=2 a_{1}

rather than the above costs. How many MtCO2 of permits does the coal sector purchase? How many MtCO2 of permits does the cement sector purchase?

Answer

The overall baseline emissions of the economy are 1300 MtCO2/year, and the amount of CO2 that needs to be abated is 360 MtCO2/year. The price at which permits trade cannot be determined without additional information. The number of permits purchased by each sector depends on the marginal abatement costs and the equilibrium price in the permit market, which requires further calculation.

Solution

Calculation of baseline emissions: The baseline emissions are calculated by summing the emissions of all firms before any abatement

$$ \text{Baseline emissions} = (100 \text{ coal power plants} \times 10 \text{ MtCO2/year per plant}) + (300 \text{ cement factories} \times 1 \text{ MtCO2/year per factory}) = 1000 + 300 = 1300 \text{ MtCO2/year} $$

Calculation of required abatement: The required abatement is the difference between the baseline emissions and the cap set by the government

$$ \text{Required abatement} = \text{Baseline emissions} - \text{Cap} = 1300 \text{ MtCO2/year} - 940 \text{ MtCO2/year} = 360 \text{ MtCO2/year} $$

Determination of permit price and quantity: The price of permits and the quantity purchased by each sector depend on the marginal abatement cost curves for each sector, which intersect with the demand curve for permits at the equilibrium price. Without the demand curve or additional information, we cannot determine the exact price or quantity

Key Concept

Baseline emissions and required abatement

Explanation

Baseline emissions are the total emissions from all sources without any abatement measures. Required abatement is the total emissions reduction needed to meet a regulatory cap. The cap-and-trade system aims to reduce emissions to the cap level by allowing firms to trade permits in a market, where the price of permits is determined by supply and demand for the right to emit CO2.