Economics 423, Midterm Examination #1, Spring 2001 – Professor Hackett 

Name: _________________________________ (1 point)

PART I: Short answer (8 points each). Be sure to respond to each part of each question. Clearly label your answer to parts (a), (b), (c), etc.

1. Drawing upon your own interests, (a) make up a very brief, simple example of a situation involving ecosystems, natural resources, or the environment clearly illustrating that scarcity, and thus economics, applies beyond commercial market activity. (b) Briefly explain the concept of opportunity cost, and use your example to illustrate.

a. Water in the Eel river is scarce because there are more uses for it than is available at a zero price, such as the current issue of diversion of river water for irrigation, urban drinking water, and recreation in Sonoma County, which reduces in-stream flows needed for salmonids.

b. Opportunity cost is the net value of the best alternative to the current allocation. Thus the opportunity cost of diverting water for Sonoma county is the forfeited value of in-stream flows on the Eel needed for restoring salmonids.

2. (a) Define a negative externality. (b) Provide one clear example of a negative externality. (c) Briefly explain how negative externalities distort otherwise well-functioning competitive markets and lead to market failure. (d) Briefly describe one type of government policy intervention that might resolve the market failure due to negative externalities.

a. Negative externalities are external costs generated from production and exchange and borne without compensation by members of society.

b. For example, when firms can avoid costly cleanup by polluting, they create an external cost—the harms created by their pollution—that is shared by many in society.

c. In the absence of regulation, firms produce from the private-cost supply, which is to the right of the social-cost supply, leading to quantity of the good or service being too large.

d. Pigouvian taxes imposed on sellers.

3. (a) Define a positive externality. (b) Provide one clear example of a positive externality. (c) Briefly explain how positive externalities distort otherwise well-functioning competitive markets and lead to market failure. (d) Briefly describe one type of government policy intervention that might resolve the market failure due to positive externalities.

a. Positive externalities are external benefits generated from production and exchange and enjoyed without payment by members of society.

b. For example, when parents pay to vaccinate their children against infectious disease, they create an external benefit—the reduced likelihood of epidemic—that is shared by many in society.

c. A usual case is that market demand is based on private benefits, and since this is less than demand based on social benefits, the result is too little being produced.

d. Subsidies to buyers.

PART II: Matching (3 points each). There is one uniquely correct match that connects a word or phrase on the left with a description on the right. Only clear and unambiguous answers can be marked as correct.

Word or Phrase	Description
a. Consequentialism	__H__ A policy intervention that requires firms to pay marginal external cost, and thereby causes market supply to be based on marginal social cost rather than marginal private cost.
b. Categorical imperative	__A__ The core concept that underlies teleological ethical systems such as utilitarianism.
c. Pareto efficient	__C__ When comparing a policy alternative to the status quo, this is an efficiency criterion that is satisfied when the policy alternative makes some better off and nobody worse off than the status quo.
d. Kaldor-Hicks efficient	__K__ The property rights regime in which ownership is held in common by a group.
e. Market failure	__I__ A policy intervention in which government provides financial assistance to buyers equal to marginal external benefit, and thereby causes market demand to be based on social benefits rather than private benefits.
f. Positive externality	__N__ Occurs when price is below equilibrium in a competitive market, and quantity demanded exceeds quantity supplied.
g. Negative externality	__F__ An external benefit generated from production and exchange and enjoyed without payment by members of society.
h. Pigouvian tax	__O__ The gains from trade that flow to consumers and producers, which together imply that voluntary exchange among well-informed buyers and sellers satisfies the Pareto efficiency criterion.
i. Subsidy	__G__ An external cost generated from production and exchange and borne without compensation by members of society.
j. Usufructuary rights	__B__ The core concept that underlies deontological ethical systems, developed by Immanuel Kant.
k. Common property	__E__ Occurs when one or more of the requirements for a well-functioning competitive market is not met in a substantial way.
l. Private property	__D__ When comparing a policy alternative to the status quo, this is an efficiency cirterion that is satisfied when the policy alternative generates aggregate benefits to society that exceed aggregate costs to society, regardless of how those benefits and costs are distributed.
m. Open access	__J__ Certain use and withdrawal rights to property that is owned by others.
n. Shortage	__M__ A state of affairs that exists when there are no property rights systems recognized that constrain access to a resource or withdrawals of resource units, typically for a natural resource.
o. Consumer & producer surplus	__L__ The property rights of access, withdrawal, management, exclusion, and alienation are held by a private company, partnership, or individual owner.

PART III. Computational analysis (15 points each)

1. Suppose that in a well-functioning competitive market, demand is given by the equation P = 1050 – Q, and (private-cost) supply is given by the equation P = 50 + Q, where "P" is price and "Q" is market quantity of some good or service. (a) Compute the market equilibrium P and Q. (b) Compute the total gains from trade (consumer and producer surplus). Show your work.

a. 50+Q = 1050-Q ==> Q = 500; P = 50+500 = $550.

b. Consumer surplus: 0.5*$(1050-550)*500 = $125,000; Producer surplus = 0.5*$(550-50)*500 = $125,000; Total surplus = CS + PS = $250,000.

2. Suppose that production of each unit of output Q above leads to a marginal external cost of $200. If we integrate this marginal external cost into the market information in question 1 above, the equation for the social-cost supply curve is given by P = 250 + Q. By how much is output in question 1 above in excess of the socially efficient quantity, and by how much is price in question 1 above the socially efficient price? Show your work.

First compute socially optimal P and Q based on demand and the social-cost supply: 250+Q = 1050-Q ==> Q = 400; P = 250+400 = $650.

The solution in question 1 yields a quantity that is 100 units too large, and a price that is $100 too small, relative to the socially optimal solution when all external costs are internalized in the social-cost supply curve.

EXTRA CREDIT (3 points): Determine the gain in total surplus (consumer + producer) that would occur if a Pigouvian tax of $200 per unit of output were imposed on firms in this market. Show your work AND illustrate your answer with a fully-labeled diagram.

Using the P and Q solutions from question 2 above for the socially optimal outcome, we get the following:

Consumer surplus: 0.5*$(1050-650)*400 = $80,000.

Producer surplus: 0.5*$(650-250)*400 = $80,000.

Total surplus = CS + PS = $160,000.

*** NOTE: This problem did not ask (but perhaps should have asked) the amount by which a Pigouvian tax would enhance the true social gains from trade to society, once external costs are included. Let's do it anyways:

1. From problem 1 the private gains from trade is $250,000. Subtract from that total external cost of $200*500 = $100,000. Thus the true social gains from trade without any regulation, and with firms freely polluting, is $250,000 - $100,000 = $150,000.

2. The extra credit exercise indicates that with a Pigouvian tax the true social gains from trade (assuming that society uses the tax revenues to help those harmed by pollution) is $160,000.

3. Therefore a Pigouvian tax enhances efficiency of the competitive market process by increasing true social gains from trade by $10,000.