Economics 423, Midterm Examination #2, Spring 2001 – Professor Hackett 

Name: ______________KEY___________________

Please provide the very best answer to each of the questions below

PART I: Short answer (3 questions, 8 points each, 24 points total). Be sure to respond to each part of each question. Clearly label your answer to parts (a), (b), (c), etc.

1. (a) What two characteristics distinguish a common-pool resource (CPR) from public goods or private goods? (b) What is the name of the externality that lies at the heart of the Tragedy of the Commons, and very briefly describe how it works. (c) What happens to Hotelling rents under Tragedy of the Commons? (d) If an open access CPR is suffering from Tragedy of the Commons, what three property rights regimes have been proposed as possible solutions?

(a) CPRs feature rivalry in consumption (subtractability), unlike public goods. CPRs feature difficulty in limiting access and use by others, whereas private goods can be made exclusive.

(b) Appropriation (or rule of capture) externality.

(c) They are dissipated (reduced or eliminated).

(d) Private, common, or government (state) property.

2. (a) Carefully draw and fully label a diagram in the space below that shows the equilibrium level of effective support in the political market for regulation. (b) Carefully show how supply and/or demand changes, and how the equilibrium level of effective support changes, if the opportunity cost of a legislator's time spent supporting the regulation goes up.

(a) Draw a supply/demand diagram. The vertical axis is labeled "political currency." The horizontal axis is labeled "quantity of effective support." Show equilibrium level of effective support where supply and demand cross.

(b) The supply curve will shift inwards since the opportunity cost of supplying a given level of effective support has increased. Therefore the equilibrium level of effective support will decline.

3. (a) What type of willingness-to-pay values can be estimated using contingent valuation that cannot be estimated using travel cost? (b) Suppose that relative to a perfectly safe occupation, the labor market provides a $2000/year wage premium for jobs in which the annual risk of accidental on-the-job death is 1 in 1000. Based on this data, what is the economic value of a statistical life? (c) Based on your lecture outlines, briefly describe embedding bias and how it undermines confidence in one of the nonmarket valuation methods. (d) Suppose that environmental regulation raises firms' fixed costs in an industry. If market demand for their product remains unchanged, what will be the impact of higher fixed costs on industry structure?

(a) Non-use values (or passive use, such as existence values)

(b) VSL = (wage premium)/(increased probability of death) = $2000/0.001 = $2 million.

(c) The embedding effect occurs when willingness-to-pay responses for the particular good (ex: protecting the mountain lake) are approximately equal to the willingness-to-pay responses for the more inclusive good (ex: protecting an entire mountainous region that includes the lake as a small component of the whole).

(d) Higher fixed costs for a firm means that either (i) the firm must raise prices and sell the same quantity, or (ii) keep prices the same and sell a larger quantity. If all firms raise price and market demand remains constant, then total market sales volume will fall, meaning that some firms will have to leave the industry. If price remains the same but firms all try to increase quantity sold, and market demand remains constant, then some firms will be unable to increase sales and will have to leave the industry. Either way, industry structure becomes more concentrated--fewer firms competing against one another.

PART II: Matching (13 matches, 3 points each, 39 points total). 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. Rule of capture externality	__l__ Rule structures that determine whether the equilibrium level of effective support is sufficient for environmental legislation to become law.
b. Marginal benefit equals marginal cost	__i__ This relationship between price and marginal cost occurs for a very scarce and valuable resource with low marginal cost and traded in a competitive market.
c. Incentive not to comply with environmental regulation	__a__ The external cost imposed on other fishers when one fisherman lands a large haul of fish on his deck.
d. Indirect costs of environmental regulation	__n__ Environmental valuation technique that infers the value of environmental qualities (such as nearby parks) that are bundled together with things (such as houses) that are traded in markets.
e. Ecosystem services not traded in markets	__b__ Occurs at the level of pollution control where total net benefits are maximized.
f. Incentive to comply with environmental regulation	__j__ Refers to pollution abatement and control expenditures paid by firms, consumers, and government.
g. Total benefit equals total cost	__e__ There is no rising market price to indicate when these become increasingly scarce.
h. Demand for regulation increases	__k__ Occurs when individual fishers race to land as many fish as possible during a limited season opening.
i. Large marginal Hotelling rents	__f__ . Exists when the cost savings from being out of compliance with environmental law are smaller than the expected penalty.
j. Direct compliance costs	__h__ This will happen when an additional environmental group joins the coalition of interest groups lobbying for an environmental regulation.
k. Derby effects	__r__ This fishery management tool can reduce or eliminate the race for fish.
l. Political institutions	__s__ The condition that holds when two or more things can be measured on the same scale.
m. Demand for regulation decreases	__g__ Occurs at the level of pollution control where total net benefits are zero.
n. Hedonic regression method
o. Natural resources traded in well-functioning competitive markets
p. Brief fishing seasons
q. Small marginal Hotelling rents
r. Individual transferable quotas
s. Commensurate

PART III. Computational analysis (3 questions, 12 or 13 points each, 37 points total)

1. Suppose that there are 100 units of a nonrenewable resource available over two periods (0 and 1). Demand in each period is given by P = 100 - 0.5Q. Marginal cost is a constant 20 in both periods. The discount rate is 30 percent.

a. (3 points) Which of the following is the dynamically efficient allocation of this resource? (clearly circle one answer):

• 25.253 (today), 74.747 (next year)

• 35.65 (today), 64.35 (next year)

• 45.454 (today), 54.646 (next year)

• 48.48 (today), 51.52 (next year)

• 50 (today), 50 (next year)

• 51.52 (today), 48.48 (next year)

• 54.646 (today), 45.454 (next year)

• 64.35 (today), 35.65 (next year)

• 74.747 (today), 25.253 (next year)

b. (4 Points) Prove your answer to part "a" above is right by deriving Hotelling's rule for the answer that you circled. Show your work.

Yr 0: P = 100 - 0.5*64.35 = $67.825; PDV(P-MC) = $(67.825 - 20)/1.3⁰ = $47.825

Yr 1: P = 100 - 0.5*35.65 = $82.175; PDV(P-MC) = $(82.175 - 20)/1.3¹ = $47.825

c. (3 points) Now suppose that the discount rate becomes zero, but demand and marginal cost remain the same. Determine the dynamically efficient allocation of this resource over the two time periods.

Year 0: ___50___ Year 1: ___50___

d. (3 points) Prove your answer to part "c" above is right by deriving Hotelling's rule for the answer that you wrote down. Show your work.

Yr 0: P = 100 - 0.5*50 = $75; PDV(P-MC) = $(75 - 20)/1.0⁰ = $55

Yr 1: P = 100 - 0.5*50 = $75; PDV(P-MC) = $(75 - 20)/1.0¹ = $55

2. Suppose that a risk-neutral firm can save $10 million per year in compliance costs by not complying with environmental regulations.

a. (6 points) Suppose that the probability of the infraction being detected by field monitors is 70 percent, and that the probability of a judge imposing the statutory penalty given detection is 50 percent. If the statutory penalty calls for a fine equal to double the annual cost savings, will this monitoring and enforcement system create deterrence? Show your work.

Expected penalty: 0.7 * 0.5 * $20 million = $7 million.

Cost savings: $10 million.

Since the expected penalty is less than the cost savings, there is no deterrence.

b. (6 points) Given the information above, what is the minimum statutory penalty that would be just sufficient to create deterrence? Show your work.

0.7 * 0.5 * X = $10 million

X = $10 million/0.35 = $28.572 million is absolute minimum.

3. The data in the table below refers to pollution emissions and marginal pollution abatement cost per ton in an industry. Total industry-wide emissions are to be reduced by 50 percent (2400 tons/year):

Firms	Historical Emissions (Tons/Yr)	Marginal Abatement Cost ($/Ton)	Allowances Bought	Allowances Sold	Total Abatement Cost (No Tradable Allowances)	Total Abatement Cost (Tradable Allowances)
Alkyone	600	10		300	$3000	$6000
Merope	600	20		300	$6000	$12000
Kelaino	600	30		300	$9000	$18000
Elektra	600	40		300	$12000	$24000
Sterope	800	50	400		$20000
Taygete	800	60	400		$24000
Maia	800	70	400		$28000

a. (6 points) Suppose that the regulatory target of cutting total emissions by 50 percent is accomplished with a command-and-control regulatory system that requires each firm to cut its emissions by 50 percent. Correctly fill in the "total abatement cost" column for "no tradable allowances" in the table above.

b. (6 points) Now suppose that the regulatory target of cutting total emissions by 50 percent is accomplished by allowing each firm to emit only 50 percent of its historical emissions. These allowances are fully tradable. Correctly fill in the "allowances bought", "allowances sold", and "total abatement cost, tradable allowances" columns in the table above.