ECON 423: Environmental and Natural Resources Economics

Econ 423-Environmental and Natural Resources Economics

Exam 2-Fall 1998-Prof. Hackett

Answer any 8 of the 10 questions below. Each are worth 12.5 points.


1. Consider a privately owned nonrenewable, nonrecyclable natural resource traded in a competitive market. If it is known that available stocks are declining while annual demand and marginal production costs remain constant, briefly but succinctly explain:


a. The direction (rise or fall) of price adjustment over time (price dynamics):

Prices will rise, as indicated by Hotelling's rule.


b. How the price dynamics in (a) affect the market demand for substitute resources:

The principle of substitution indicates that as the price of a good rises, the demand for substitutes will generally increase.


c. How the price dynamics in (a) affect investment in research and development to develop more resource-efficient technology:

As the price of the resource rises, so do the benefits from more resource-efficient technology (these benefits are savings of expenditures on the more costly resource). Thus there will be an increase in R&D. Example: The burst of alternative-energy R&D in the mid to late 1970s after the OPEC oil price increases.


d. Does Hotelling's rule imply (1) high levels of consumption in one year followed by an abrupt "running out" of the resource in the next, or (2) a smooth and continuous decline in available stocks? Briefly explain:

Hotelling's rule requires that the PDV of (P-MC) be equalized across time periods, which in turn implies (2) a smooth and continuous decline in available stocks. In contrast, abrupt changes in available stocks imply abrupt changes in prices, in which case the PDV of (P-MC) will not be equal.


2. Hotelling's rule implies that the market value of saving some privately owned depletable natural resources for the future will prevent excessive consumption and depletion of the resource in the present (as long as discount rates are not "too high"). Explain the key reason why this does not occur for open-access common-pool resources (CPRs).


As indicated in 1.d. above, Hotelling's rule does not generally imply high levels of consumption today followed by an abrupt "running out" in the future (except for very high discount rates). The reason is that consumption of a unit of the resource today has an opportunity cost-the PDV of its net value (P-MC) in the future. If this opportunity cost exceeds its current net value, then a private owner will save it for the future.

In contrast, in an open-access CPR a resource appropriator cannot save a unit of the resource for the future when such a saving would otherwise occur under private ownership or in an effectively managed limited-access CPR [i.e., PDV (P-MC) in the future exceeds (P-MC) today]. The reason is that under open-access conditions, leaving the resource in place for future harvest and consumption will likely result in another appropriator harvesting the resource today. Since all CPRs feature an appropriation externality (the appropriator gets the benefits from excessive harvest, while the costs are shared), and under open access conditions there is no ability to establish rules to limit use, then Hotelling rents are predicted to be dissipated in the current time period.


3. [True/False; use a fully-labeled diagram to show why]: Scott Gordon's economic model of a fishery CPR indicates that under open-access conditions, resource appropriators will harvest up to the point where Hotelling Rents are fully dissipated. In contrast, if access were limited and appropriators could work together collectively for their mutual gain, harvest targets would be set at a lower level where Hotelling Rents are maximized.


True. See the following Internet link for the appropriate diagram:

Figure 5.4 from the textbook


4. Benefit/Cost analysis is a powerful tool that can yield useful information for environmental and natural resource policy makers. Yet there are various types of shortcomings that suggest we cannot always use benefit/cost analysis as the sole factor in determining environmental or natural resource policy. List and very briefly describe as many of these different types of shortcomings as possible:

  • Using cost/benefit analysis as the single deciding factor in setting policy assumes implicitly that the value of all objects and states of affairs are commensurable, meaning that they can be ranked based on a single characteristic of value such as money. Yet issues of fairness, ethics, and spirituality may not be commensurable with monetized costs or benefits. Can we compare the value of a unique sacred place to the revenues and jobs created by logging, mining or razing the site?
  • Scientists and others do not fully understand the interdependencies in ecosystems, and so when we do benefit/cost on one element of the ecosystem (for example, on preserving a particular species or damming a segment of river), we cannot understand the benefit/cost implications for all the other elements of the ecosystem. In other words, social and ecological systems may be too complex to comprehensively quantify through cost/benefit analysis.
  • Some of the benefits of environmental improvements include the reduced loss of human life. Placing an infinite value on a human life in benefit/cost analysis would lead to the conclusion that all of the world's resources should be allocated to prevention of any one death, an unlikely choice of social policy. Yet if we measure the value of a human life based on income generation, then the analysis will tell us that a life in a rich country is worth more than in a poor country. In this case, benefit/cost analysis will yield the unethical conclusion that it is "efficient" to dispose of toxics and other life-threatening pollutants in low-income countries because lives saved in rich countries are worth more than lives lost in poor countries. The Nazis applied similar "efficiency" arguments regarding the differential value of human lives to justify the euthanasia of groups such as the disabled. Thus benefit/cost analysis can lead to environmental discrimination and racism.
  • When we use cost/benefit analysis to evaluate projects or policies that affect future generations, we must somehow decide on how to bring the benefits and costs accruing to these future generations into the present. While discounting clearly makes sense in individual behavior, if we apply discounting to benefit/cost analysis, are we robbing future generations to benefit the present? Moreover, to fully monetize the benefits or costs of current policy on future generations, we would have to know their preferences and available technology, which is not possible).
  • When we monetize benefits and costs without regard to who receives them, we are implicitly assuming that a dollar generates the same incremental gain in pleasure or marginal utility to all people. Yet this is not generally true when wealth is highly unequally distributed; in such cases a $10 gain to a mother with a hungry child likely generates substantially higher marginal utility than it would to a billionaire. Thus policies that generate the greatest net monetary benefit may in fact generate a substantially inefficient level of human happiness when we assume that the marginal utility of money is the same for all people.

5. Describe (a) the merits and (b) the shortcomings of the contingent valuation method of nonmarket environmental benefits valuation.


(a) Key merits of the CVM include the ability to measure both active and passive use values, and the ability to evaluate public policies in a referendum format and thus get an indication of citizen preferences.


(b) Key shortcomings include the fact that the $ responses are hypothetical rather than actual dollar votes, which leads to violations of fundamental economic axioms (one of the more prominent of these violations is embedding bias, which means that respondents assign the same value to a small subset of an environmental benefit or improvement as they do to the overall environmental benefit or improvement). Other shortcomings common to other surveys is the problem of bias in wording and presentation, and the problem of selecting a satisfactory subject pool.


6. Consider environmental regulations that require firms to install costly pollution-control equipment or upgrades (e.g., replacement of underground storage tanks at gas stations) and thus raise firms' fixed cost. If market demand for the goods or services produced by these firms remains constant, (a) exactly how will this regulation affect the breakeven output level of firms in the industry? (b) If this market is competitive and firms are just covering their costs, how will this regulation affect the number of firms in the industry?


(a) Breakeven Q = TFC/(P-AVC), where TFC is total fixed cost, P is price, and AVC is average variable cost. If P and AVC remain constant but TFC rises due to the need for installing pollution-control technology, then breakeven Q rises. For example, if P = 10, AVC = 8, and TFC = 100,000, then breakeven Q = 50,000. If TFC rises to 200,000, then breakeven Q rises to 100,000.

(b) If market demand remains constant, and if prior to the regulation all firms were just covering their costs (breaking even), then the requirement that all firms at least break even means with higher fixed costs means that the market cannot support as many sellers, and so the number of firms must decline.


7. It has recently been reported that the oil company BP and several others are supporting the control of greenhouse gases such as carbon dioxide that occur from burning fossil fuel. These firms are known to be investing in research and development (R&D) in alternative energy technology. (a) Relate this situation to DuPont and the Montreal Protocol case described in chapter 7 of the text. (b) How might successful alternative energy R&D by BP change the political economy of greenhouse gas controls?


(a) The case of DuPont and international halocarbon controls is one in which the original political-economic situation for regulation was Olsonian (diffuse benefits, concentrated costs), but this was changed when DuPont developed less ozone-destructive alternatives and thus had an incentive to raise its rivals' costs by joining forces with those favoring regulation. This added a more Stiglerian element to the political economy of regulation (DuPont gets concentrated benefits from the regulation, and so will invest resources to create that regulation).


(b) If BP developed a significantly cheaper or more productive new alternative-energy technology, then like DuPont above they would have a strong incentive to raise their rivals' costs by lobbying for taxes or other controls on fossil fuels, which would help increase demand for their alternative-energy technology.


8. Suppose that an environmental offender saves $10,000 each year in tipping fees by illegally burning garbage. If the probability of the offender being caught in a given year is 45 percent, and if imposition of a set fine in an out-of-court settlement is 100 percent, what is the minimum size of the set fine necessary to generate deterrence? Show your work:


$10,000 = 0.45 * 1.0 * X

X = $10,000/0.45 = $22,223. Therefore, the penalty can be no lower than $22,223.


9. List and very briefly describe the conditions under which it is most likely that a firm's reputation with its consumers will create an incentive to comply or even overcomply with environmental standards:

Market reputations are most likely to foster deterrence in an environmental context when the following conditions are met:

  • Information acquisition costs for citizens/consumers are low, and a large number care about the environment. One factor that increases the level of consumer awareness is when the market for a firm's product is the same as the location of the firm's polluting activity. Self-reporting laws such as the Toxics Release Inventory facilitate the dissemination of information.
  • Quality substitute products made by firms with a better pollution record are readily available.
  • The cost of organizing environmentally conscious consumers to coordinate boycotts is low.
  • The firm places a high value on repeat-sales business and future business income relative to current income. In this case, an impaired reputation can result in the loss of an existing image-based price premium or market share.

10. Suppose there are three firms emitting a uniformly mixed pollutant into an airshed, and new regulations allow each to emit only half of its past emissions. Firm X has a constant marginal abatement cost of $10/ton, and its past emissions were 100 tons/year. Firm Y has a constant marginal abatement cost of $50, and its past emissions were 60 tons/year. Firm Z has a constant marginal abatement cost of $90, and its past emissions were 160 tons/year. Compute the annual pollution abatement and control costs in this industry with and without fully marketable allowances. What are the cost savings from fully marketable allowances trading? Show your work.


(a) Without marketable allowances: Firm X has abatement costs of $10*50 = $500; Firm Y has abatement costs of $50*30 = $1500; Firm Z has abatement costs of $90*80 = $7200. Total industry pollution abatement and control (PAC) costs are $9,200.


(b) With marketable allowances: Firm X sells its 50 allowances to Firm Z, and Firm Y sells its 30 allowances to Firm Z. Therefore PAC for Firm X is $10*100 = $1000; PAC for Firm Y is $50*60 = $3000. Firm Z has 160 allowances (the 80 it originally had plus the 80 it bought), and so does not have to reduce emissions. Total industry PAC cost is $4000.

Cost savings from fully marketable allowances is $9200 - $4000 = $5200.


Extra Credit (3 points): The Bureau of Land Management (BLM) recently proposed closing Black Sands Beach (down by Shelter Cove) to off-road vehicles (ORV's). This area has seen a dramatic increase in use by hikers and backpackers in recent years, and conflicts with ORV's have been increasing. One can interpret the BLM's justification for this policy change to be that the overall gain to hikers and backpackers from this closure substantially outweighs the overall loss to ORV recreationalists.

 

Does the BLM's rationale for this policy change more closely meet the requirements of Kaldor-Hicks efficiency or Pareto efficiency? Briefly explain why.


Kaldor-Hicks, because net benefits from the closure are larger than under the status-quo policy, but no mechanism has been developed to compensate those made worse off. Because of the latter, it is not Pareto.