Problem Set 2

Summary:
Auctioning Permits
Abated Permits Control Cost Permit Cost Net Cost Govt. Rev.
Firm 1 9 11 $162 $396 $558 $396
Firm 2 15 5 $270 $180 $450 $180
TOTAL 24 16 $432 $576 $1008 $576
Taking the net industry costs minus the generated revenue:
$1008 – 576 = $432
d) What is the efficiency loss between the grandfathering and auctioning scenarios? (Hint: it
may be useful to construct a table illustrating the net costs in parts a – c). How could the
government make the auctioning system more politically favorable within the industry?
In reality, why might the auctioning system not be as efficient as this theoretical
example?
Note that for both the grandfathering and auctioning scenarios, we arrive at the same
outcome (in terms of units abated by each firm and net societal costs). In this case, the net
societal costs of abatement for both scenarios is $432. However, the grandfathering
scenario had net societal costs of $460.8. Thus, there is an efficiency loss of $28.8
associated with choosing grandfathering over the auction. The auction has the additional
benefit of being revenue-generating for the government.
To make the auctioning system more politically feasible, the government could expend
some of its revenue from the sale of permits to aid the industry in its abatement costs (i.e.,
offer a subsidy).
However, the industry can expend resources lobbying for the grandfathering scenario. If
the transaction costs from lobbying exceed the benefits gained from auctioning the
permits, it may make more sense to avoid the costly political battle and grandfather the
permits. Additionally, there may be higher transaction costs associated with
administering an auction (as opposed to just distributing them).
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