ECON 423: Environmental and Natural Resources Economics

Old Midterm Exams

Economics 423 Exam 1

Spring 1999 Ð Professor Hackett

 

There are eight questions, each worth 12.5 points. Please write clearly and legibly.

 

  1. Building on the definition of economics, briefly but succinctly explain why the economic problem extends beyond commercial market activity.

    2.  

    The definition of economics builds on the foundation that scarcity, a commonplace phenomenon not limited to goods and services exchanged in commercial markets, requires a choice, and moreover that there is an opportunity cost associated with that choice. Thus economic principles operate beyond commercial market activity and include the uses to which public lands are managed, the allocation of water in rivers and aquifers, the allocation of marine fisheries, the allocation of clean air resources, and the search behavior of a predator with scarce time and energy.

     

  2. Briefly but succinctly explain the extent to which the popular wisdom of "economy vs. the environment" reflects a conflict over ethics and values in our diverse society rather than a tradeoff between economic and environmental benefits.

    3.  

    Research ranging from Jaffee et al. (1995) and The Calif. Senate office of Research to the EPA suggests that IN AGGREGATE one cannot detect a large and significant decline in employment or loss of international manufacturing competitiveness due to current levels of US environmental and resource protection regulation. Nevertheless, LOCAL IMPACTS can be significant, such as those caused by abrupt reductions in timber harvest levels and mill closures due to heightened resource protections. What is commonly referred to as "economy v. environment" is really a values-based debate over whether existing levels of commercial activity, supported by existing environmental and resource regulations, is more or less important than the resulting environmental and resource degradation. Economic principles are not restricted to one side of this debate, because clearly environmental and resource degradation has an opportunity cost, indicated by measures such as ecosystem service values.

     

  3. Briefly but succinctly explain why a voluntary market transaction between a buyer and a seller in a well-functioning competitive market is Pareto-efficient. In answering this question, be sure to demonstrate your understanding of "the gains from trade" and "Pareto efficiency."

    4.  

    In comparing the status-quo with a change in circumstances affecting two or more people, the Pareto efficiency criterion requires that the change not only increase the overall net gains (Kaldor-Hicks), but in addition make one or more better off, and none worse off.

     

    In a well-functioning competitive market buyers have a valuation equal to (maximum willingness-to-pay), and sellers have a valuation equal to (opportunity cost). Under voluntary exchange the overall net gains (relative to the status quo) to all market participants are (maximum willingness-to-pay Ð opportunity cost), and price divides the overall net gains between the buyers and the sellers. Thus buyers receive a gain from trade equal to (maximum willingness-to-pay Ð price), and sellers receive a gain from trade equal to (price Ð opportunity cost), making both better off, thus satisfying the Pareto efficiency criterion.

     

  4. (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.

    5.  

    A: An unpaid-for benefit received by members of society as a consequence of an exchange, such as between a buyer and a seller in a market.

    B: Literacy training for citizens, which is necessary for the functioning of a democratic system.

    C: Since others benefit without paying market participants for generating positive externalities, market demand is understated, leading to too little being produced.

    D: Government subsidy of producers or consumers would help markets internalize the positive externality, and could increase quantity to the socially optimal level.

     

  5. (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.

    6.  

    A: An uncompensated cost imposed on members of society as a consequence of an exchange, such as between a buyer and a seller in a market.

    B: Pollution costs that occur when a profit-maximizing firm reduces its private costs of production by shirking on cleanup.

    C: Since others bear a cost without being compensated by the market participants, the supply curve is overstated, leading to too much being produced.

    D: A tax on the production of goods and services that generate negative externalities would help internalize the negative externality and could reduce quantity to the socially optimal level.

     

  6. If someone damages private, common, or government property, traditional systems of common law provide civil and criminal remedies to those whose property is harmed, and impose penalties on those who did the harm. Briefly explain why this system of common law was deficient in protecting certain valuable aspects of the natural environment from negative externalities or over-exploitation, and how that deficiency has been addressed in the US through legislation in the last 30 years.

    7.  

    The common law evolved to protect peoplesÕ life and property. That property could be private, government (local, county, state, federal), or common (a private road shared by neighbors, a village irrigation system, a forest owned by a neighborhood association). Yet the common law was deficient in protecting UNOWNED resources and aspects of the environment, usually "fugitive" or transboundary resources such as the atmosphere, mobile wildlife, biodiversity, pelagic fisheries, the stratospheric ozone layer, the sea floor, etc. Consequently legislation in the US and elsewhere has evolved over the last 30 or so years that in essence creates a property right held by society as a whole to a certain level of environmental, ecological, and resource integrity.

     

  7. Suppose that in a well-functioning competitive market, demand is given by the equation P = 600 Ð Q, and (private-cost) supply is given by the equation P = 100 + 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.

 

Solve for equilibrium output level Q, which according to the "law of one price" occurs at the price where QS = QD. Thus we can set the supply price equal to the demand price (the "one price"), and solve for the common Q value: 100 + Q = 600 Ð Q è 2Q = 500, or Q = 250. Plug in 250 for Q in either the supply or the demand equation to get P = $ 350. Total gains from trade is the triangular-shaped area bounded by the demand and the supply curves up to Q = 250. The consumerÕs gain from trade is [$(600-350)x250]/2 = $31,250, and the producerÕs gain from trade is [(350-100)x250]/2 = $31,250. Total gains from trade are thus the sum of the consumer and producer gains, equal to $62,500.

 

8. Suppose that production of each unit of output Q above leads to a marginal external cost of $100. If we integrate this marginal external cost into the market information in question 7 above, (a) what is the equation for the social-cost supply curve? (b) By how much is output in question 7 in excess of the socially efficient quantity, and by how much is price in question 7 below the socially efficient price? (c) Compute the $ amount of deadweight social loss from the market failure that occurs if society allows firms to continue to produce negative externalities as described above. Show your work.

 

A: The social-cost supply curve equals the private-cost supply curve plus marginal external cost (i.e., social-cost supply: P = 100 + Q + 100 = 200 + Q). Since marginal external cost is a constant $100, we can get the social-cost supply curve by simply adding marginal external cost to the private-cost supply curve.

B: The socially optimal output occurs where the social-cost supply curve crosses the demand curve: 200 + Q = 600 Ð Q è 2Q = 400, Q = 200. Since output in question 7 (the free market equilibrium w/o regulation) is 50 units more than the socially optimal output, then output is 50 units too large in question 7 above.

C: The area of deadweight loss is a triangle that has a base equal to the amount of excess production (50 units), and a height equal to marginal external cost ($100). The area of deadweight loss is $2500.

 

EXTRA CREDIT (3 points): Compute the $ value of total external cost if society allows firms to continue to produce negative externalities as described in question 8 above.

 

Since marginal external cost is a constant $100 per unit of output Q in this simplified problem, total external cost is marginal external cost multiplied by Q. If we use the "Q" from the free-market solution w/o regulation, we get total external cost = $100 x 250 = $25,000.