The Players

To keep groups small, I will divide the class in half and each half will perform the same role-playing exercise. For the exercise, I will divide the students into three groups:

1. One group will play The Environmental Protections Agency (EPA) and will decide how much to reduce pollution, how many permits to issue, or how much to charge as a pollution tax. The EPA’s motivation is to produce the best net benefit for society by balancing the costs of reducing greenhouse gas emissions against the benefits of limiting global warming.
2. A second group will play Alpha Electricity: a large power company with a varied portfolio of generating plants including coal, natural gas, and nuclear. Alpha’s motives are purely to produce the greatest profit for its shareholders regardless of the cost to society of greenhouse gas emissions.
3. A third group will play Beta Industries: a large heavy-industrial conglomerate with many large factories producing steel, aluminum, and petrochemicals such as plastics, paints, and pharmaceuticals. Beta’s motives are purely to produce the greatest profit for its shareholders regardless of the cost to society of greenhouse gas emissions.

For the purposes of this exercise, we will assume that the EPA can accurately estimate the damage that would be caused by global warming, and thus, that it can also accurately estimate the social benefit of reducing greenhouse gas emissions. However, the EPA cannot accurately assess the costs individual companies will incur when they reduce their emissions. This means that the EPA’s estimates of net benefits (benefits minus costs) is limited by its uncertainty about the cost of reducing emissions.

Only the EPA will know the social cost of greenhouse gas emissions, only Alpha will know Alpha’s cost for reducing emissions, and only Beta will know Beta’s cost for reducing emissions.

Without regulation, Alpha and Beta would each emit 150 million tons of CO₂ per year. The goal of the exercise is for the EPA to reduce pollution to achieve the socially optimal balance between the benefits of economic activity (jobs, wealth, etc.) and the harms of pollution. The goal of each firm is to maximize their profit regardless of the costs or benefits to society or to its competitor.

To keep things simple, emissions cuts will be figured in blocks of 1 million tons, so a firm can cut emissions by zero, 1 million tons, 2 million tons, …, up to a maximum of 15 million tons (cutting emissions by 15 million tons means the firm reduces its emissions to zero).

The Game

The game will have six stages:

1. First, the EPA will gather information on the cost of abating pollution. A representative of the EPA can ask four questions about each company’s marginal costs and benefits (I recommend asking questions about the marginal profit for the \(n^{\text{th}}\) million tons of pollution: “what is your marginal profit for the 6th million tons you emit?”).

   A representative of each company will answer the question. The representatives may answer strategically, meaning they may exaggerate the costs. The EPA may take this into account in deciding how to use the answers to estimate the true cost of reducing emissions.

2. Second, the EPA will determine three possible courses of action:

   1. A command and control regulation, which mandates a specific emissions by each firm. Because the Constitution guarantees equality before the law, this regulation must impose the same emissions limit on each firm.¹ Based on what it knows about the costs (to the firms) and benefits (to society) of emissions, the EPA will determine how many million tons of emissions to allow (to keep things simple, the EPA should make the amount an even number: 2 million tons, 4 million tons, 6 million tons, etc.) and then divide those emissions allowances equally between the two firms.
   2. A cap-and-trade. Under this program, the total emissions cuts would be the same and the EPA will issue permits to emit CO₂. Each permit will allow the owner to emit 1 million tons of CO₂. Total CO₂ emissions are 30 million tons minus the emissions cuts the EPA wants to impose. Again, to keep things simple, issue an even number of permits. The EPA will give each company an equal number of permits (if the EPA issues 10 permits, it gives 5 to each company).
   3. An emissions-tax program. Under this program, the EPA determines the tax a firm must pay for every million tons of CO₂ it emits. The firms will then decide on their own how much CO₂ they want to emit.

3. Third, the firms determine how much CO₂ they will emit under the command-and-control program (this is easy, because it’s the amount the EPA allows).

4. Fourth, permits will be distributed. The EPA will distribute equal numbers of permits to each firm and allow the firms to trade permits with each other.

5. Fifth, we will impose an carbon tax, at the price set by the EPA in stage 2. The two firms will be free to cut emissions by as much or as little as they want (between 0 and 15 million tons each).

6. Sixth and finally, we will reveal the details from each step, including the private information each firm has about its costs, and calculate the deadweight loss under each of the three types of regulation. This will let us discuss and analyze the strengths and limitations of each regulatory program.

Acknowledgements

This exercise was adapted from The Pollution Game, an interactive exercise developed by Jay R. Corrigan, Associate Professor of Economics, Kenyon College.
See J.R. Corrigan, ``The Pollution Game: A Classroom Exercise Demonstrating the Relative Effectiveness of Emissions Taxes and Tradable Permits,’’ The Journal of Economic Education 42, 70–78 (2011) doi: 10.1080/00220485.2011.536491

Optional Preparation Exercises:

To prepare for the lab, please do the following exercises, which refer to tables 1 & 2, below. These are only for practice and you do not need to turn them in:

1. Table 1 lists the marginal profit a company earns by emitting CO₂. Fill in the blanks in the table to show the total profits it earns at each amount of CO₂ emissions.

2. What level of CO₂ emissions would produce the maximum total profit? How much profit would this be?

3. If the company is emitting the amount of CO₂ that would maximize its profits, and then the Environmental Protection Agency requires the company to reduce its emissions by 5 million tons, what is the total cost for the company to comply with the regulation?

4. What is the marginal cost to comply with the regulation? (Be careful and consider, if the company cuts 1 million tons, then a second million tons, and so forth, what did it cost the company to make the fifth million-ton cut?)

5. If the EPA imposed a tax of $30 per ton on CO₂ emissions, complete the table to indicate the new marginal profit and total profit at each level of emission.

6. Under a $30 per ton tax, what level of CO₂ emissions would produce the maximum total profit? What would its total profit be? How much less is this than the total profit you reported in question 2?

7. Table 2 shows the economic value of the marginal environmental harm caused by each additional million tons of CO₂ emissions. Fill in the blanks to indicate the total environmental harm.

8. The marginal net economic impact is the marginal profit generated by emitting each million tons of CO₂ minus the marginal environmental harm. This number is the net benefit to society from emitting an additional million tons of CO₂. If the number is positive, society benefits. If it is negative, society suffers.

   Fill in the marginal and total economic impacts, using the information on environmental harm from Table 2 and the information on marginal profits from Table 1.

9. What is the optimum amount of CO₂ to emit if we consider the net benefit to society (i.e., the net economic impact).

10. If you were going to set a cap on emissions, how many tons would you set the cap at?

11. If you were going to set a tax on emissions, how many dollars per ton would you set the tax at?