Solution 2: Tradeable Permits Suppose we gave each company 30 pounds in tradeable permits, so Firm 1 must reduce by 20 and Firm 2 by 40. Firm 1 would be willing to sell 20 pounds of permits for $30, and those permits would be worth $60 to Firm 2. So Firm 1 would sell them.

Tradeable Permits: More Detailed Explanation If Firm 1 reduces by 20 pounds, its MC of reducing a little more is only $1/pound. If Firm 2 reduces by 40 pounds, its MC of reducing a little less is $4/pound. So Firm 1 could sell Firm 2 a pound of pollution permits for $2 and both would end up better off. Firm 1 would have to pay $1 extra for pollution control, and Firm 2 would get to pay $4 less. They would keep trading more and more permits until the MCs were equalized for the two firms. If Firm 1 sells 20 pounds of pollution permits to Firm 2, Firm 1s pollution control costs go up $30, Firm 2s fall by $60, and both firms would have MC=$2. They wouldnt trade any more because after 20, Firm 1 need them as much as Firm 2.

The Benefit of Smart Policy If Firm 1 reduces pollution by 40 pounds and Firm 2 reduces by 20 pounds, there is a gain of $30 in pollution control costs compared to when Firm 1 reduces by 20 and Firm 2 by 40. The same environmental goal of a 60-pound reduction is reached, but at lower cost.