3. In the graph below, a regulator imposes an emissions tax or an emissions

market on the industry. The regulator knows the true marginal damage

function (MD), but only has an estimate of the industry's aggregate marginal

abatement cost function (Estimated MAC). Given its estimate of the

industry's MAC, the regulator either (1) sets an emissions tax tº expecting

the industry to respond with Eº emissions, or (ii) puts Q° emissions permits

in circulation expecting the permit price to be pº.

However, the true aggregate marginal abatement cost function (True MAC)

is higher than the regulator's estimated MAC.

Use this graph to explain why

a. emissions are inefficiently high under the regulator's emissions tax

tº, and [2 points]

b. emissions are inefficiently low under the regulator's emissions market

with Q° emissions permits. [2 points]

p²

p¹

pº = tº

Estimated MAC

True MAC

EºQ° E¹ E²

=

MD

Emissions