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Solution to question 8 of the exam of the 7 September 2016 The economy is composed by two polluting firms, A and B, with the following marginal abatement cost (MAC) functions, where Ab is the level of abated emissions: MACA(Ab) = 4 Ab MACB(Ab) = Ab The government wants to attain a level of overall emissions of M*=20 by means of a pollution permit scheme. Total business as usual emissions (i.e. in absence of the policy) were MMax=MA Max+ MB Max =40 which means that total abatement should be AbTot= MMax- M*=40-20=20. For simplicity, we assume that MA Max+ MB Max =20. (8a) Compute the aggregate marginal abatement cost function of the economy (hint: it is not simply the sum of MACs) (8b) Suppose the government decides to allocate emission permits for free to the two firms. Each firm receives the same amount of permits (i.e. 10). Which firm will be the net buyer of permits? Why? How many permits will it buy from the other firm and at which price? (8c) Suppose now that the government decides to assign pollution permits through auctioning. How many permits will each firm purchase? At which price? (8d) Compare the outcome of the two allocation schemes. Show the differences in terms of monetary net benefits (i.e. bank accounts) for firms A and B and for the government's budget. Briefly discuss the differences between the two allocation schemes. 8a) Aggregate marginal abatement costs is given by the horizontal sum of marginal abatement costs of all firms. To compute it, one possibility is to invert the MAC function (i.e. Ab as a function of MAC), sum them up and obtain MACAggr(Ab)=Ab*4/5 8b) Firms will buy permits as long as the price is lower than their marginal abatement costs. The market clears when no firm has incentive to further buy or sell permits, that is when their…