Two firms are ordered by the federal government to reduce their pollution levels. Firm A’s marginal costs associated with pollution reduction are MC = 20 + 4Q. Firm B’s marginal costs associated with pollution reduction are MC = 10 + 8Q. The marginal benefit of pollution reduction is MB = 400 – 4Q. Assume the marginal benefit pollution reduction applies to the overall level (for the two firms combined) and not to each firm separately.
a. What is the socially optimal level of each firm’s pollution reduction?
b. Compare the social efficiency of three possible outcomes:
(1) Require both firms to reduce pollution by the same amount. (2) Charge a common tax per unit of pollution. (3) Require both firms to reduce pollution by the same amount but allow pollution permits to be bought and sold.