Question 10.4

1. Why an emissions tax smaller than or greater than the marginal social cost at Q_OPT leads to a smaller total surplus compared to the total surplus generated if the emissions tax had been set optimally

   If the emissions tax is smaller than the marginal social cost at Q_OPT, a polluter will face a marginal cost of polluting (equal to the amount of the tax) that is less than the marginal social cost at the socially optimal quantity of pollution. Since a polluter will produce emissions up to the point where the marginal social benefit is equal to its marginal cost, the resulting amount of pollution will be larger than the socially optimal quantity. As a result, there is inefficiency: if the amount of pollution is larger than the socially optimal quantity, the marginal social cost exceeds the marginal social benefit, and society could gain from a reduction in emissions levels.

   If the emissions tax is greater than the marginal social cost at Q_OPT, a polluter will face a marginal cost of polluting (equal to the amount of the tax) that is greater than the marginal social cost at the socially optimal quantity of pollution. This will lead the polluter to reduce emissions below the socially optimal quantity. This also is inefficient: whenever the marginal social benefit is greater than the marginal social cost, society could benefit from an increase in emissions levels.

2. Why a system of tradable emissions permits that sets the total quantity of allowable pollution higher or lower than Q_OPT leads to a smaller total surplus compared to the total surplus generated if the number of permits had been set optimally.

   If the total amount of allowable pollution is set too high, the supply of emissions permits will be high and so the equilibrium price at which permits trade will be low. That is, polluters will face a marginal cost of polluting (the price of a permit) that is “too low”—lower than the marginal social cost at the socially optimal quantity of pollution. As a result, pollution will be greater than the socially optimal quantity. This is inefficient and lowers total surplus.

   If the total level of allowable pollution is set too low, the supply of emissions permits will be low and so the equilibrium price at which permits trade will be high. That is, polluters will face a marginal cost of polluting (the price of a permit) that is “too high”—higher than the marginal social cost at the socially optimal quantity of pollution. As a result, pollution will be lower than the socially optimal quantity. This also is inefficient and lowers total surplus.