Economics 423, Midterm Examination #2, Fall 2002 – Professor Hackett 

Name: Answer Key

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

PART I: Fill in the blanks (3 points each, 45 points total)

1. One of the reasons why deregulation of electric energy failed in California is that the price paid by consumers was fixed, while the price paid by utilities was set in a market that was subject to high prices due in part to manipulation by electric energy generators and brokers.

2. Marginal profit refers to the difference between price and marginal cost for scarce natural resources traded in markets. It becomes larger as resource stocks decline or as future demand grows.

3. The discount rate represents the time value of money. As it becomes larger, the dynamically efficient allocation of a scarce natural resource features a larger proportion of the overall stock being consumed in the present rather than the future. Sustainability requires that it be small or zero.

4. Individual transferable quotas give fishermen withdrawal rights to a percentage of total allowable catch and eliminate the rule of capture externality that leads to a race for fish (derby), compression of landings in a brief period of time, overcapitalization, and dangerous fishing conditions.

5. A common pool resource has the characteristics of rivalry in consumption and difficulty excluding use, while common property is an ownership regime in which a group of proprietors collectively govern a natural or constructed resource.

6. Elinor Ostrom’s design principles reveal the factors required for the ownership regime of common property to successfully overcome tragedy of the commons and sustain a local common-pool resource.

7. The term commensurability refers to the ability to measure two or more things using a common metric. It usually fails when one is trying to monetize the value of sacred places in benefit/cost analysis.

8. One important benefit of controlling pollution is that fewer premature human deaths occur. The value of a statistical life approach uses wage/risk studies and surveys to monetize the value of premature deaths averted by stricter environmental regulation. A shortcoming of this method is that it indicates that lower-wage workers have less valuable lives.

9. The travel cost method is based on the observed behavior of recreationalists, and can be used to measure the non-market recreational use value of wilderness areas and wild rivers. This method cannot measure non-use value.

10. The contingent valuation method can be used to measure non-use values for aspects of the environment or natural resources.

11. Foregone revenues from logging restrictions and higher costs from anti-pollution equipment are examples of direct compliance costs, while higher prices caused by increased market concentration caused by higher fixed costs, and reduced rates of economic growth caused by investment in anti-pollution equipment, are examples of indirect costs.

12. In Keohane’s political economy model the demand of/for a specific regulatory policy derives from the willingness-to-pay by interest groups that support that policy, while the supply of/for a specific regulatory policy reflects the various opportunity costs of the policy maker(s).

13. In Oye and Maxwell’s political economy model of the Montreal Protocol, Olsonian regulatory circumstances imply that restrictive environmental regulations are unstable, while Stiglerian regulatory circumstances imply that restrictive environmental regulations are stable.

14. Duverger’s Law, which is linked to the median voter theorem, states that winner-takes-all plurality (or simple majority) voting systems will result in two dominant political parties, a situation in which third parties are spoilers.

15. Deterrence is created when the expected penalty exceeds the benefits associated with violating environmental or natural resource law for risk-neutral firms or people.

PART II: Matching (10 matches, 3 points each, 30 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. Firms have heterogeneous marginal abatement costs	1. _M_ This type of punishment for environmental or resource offenders has the advantage of not being insurable, tax-deductable, or capable of being passed along to consumers in the form of higher prices, but it is expensive to society and has a high burden of proof.
b. Marginal benefit equals marginal cost	2. _E_ If the expected penalty is equal to the benefit from violating environmental or resource law, this sort of individual will be deterred from violating the law.
c. Total benefit equals total cost	3. _D_ When effective, this can give firms an incentive to voluntarily over-comply with environmental or resource regulations due to the actions of vigilant, selective, and environmentally conscious consumers.
d. Market reputation	4. _I_ Environmental valuation technique that estimates the value of non-market aspects of the environment (such as a park) that are bundled together with things (such as houses adjacent to the park) that are traded in markets.
e. Risk-averse	5. _C_ Occurs at the level of pollution control where total net benefits are equal to zero.
f. Command-and-control regulation	6. _A_ In order for cap-and-trade systems to reduce industry-wide costs of compliance, this must be true for the firms in the industry.
g. Risk-loving	7. _L_ Examples of these include nutrient cycling provided by wetlands, carbon absorption by trees and plankton, fruit pollination by wild insects, and water filtering provided by aquifers and watersheds.
h. Environmental taxes	8. _K_ This can occur when a polluter buys lots of allowances in a cap-and-trade system, and can result in environmental injustice for nearby residents.
i. Hedonic regression method	9. _F_ This type of regulation is subdivided into technology-based standards and uniform performance-based standards.
j. Travel cost method	10 _H_ Examples include effluent taxes on pollution emissions and excise taxes on goods made using polluting production methods.
k. A localized pollution “hot spot”
l. Ecosystem services not traded in markets
m. Prison terms
n. Fines and monetary damages

PART III. Computational analysis (5 questions, 5 points each, 25 points total)

1. Suppose that there are 1000 units of a nonrenewable resource available over two periods (0 and 1). Demand in each period is given by P = 2000 - Q. Marginal cost is a constant 100 in both periods. The discount rate is 33.33 percent.

What is the dynamically efficient allocation of the 1000 units of the nonrenewable resource (show your work)?

Q₀ = __700___

Q₁ = __300___

Check: Marginal profit, year 0 = $1,200. PDV of marginal profit, year 1 = $1,600/1.333 = $1,200. Therefore Hotelling's rule is satisfied.

2. In order for the dynamically efficient solution to question 1 above to yield an equal division of the resource over time, what would the discount rate need to be (show your work using Hotelling’s rule)?

Discount rate = ___0__ percent

At a zero percent discount rate people are indifferent between gains now or in the future, and since demand, marginal cost, etc are "steady state" and the same in both periods, an equal quantity will be allocated.

Year 0: P = 2000-500=1,500; marginal profit = 1,400.

Year 1: P = 2000-500=1,500; PDV marginal profit = 1,400/1.00 = 1,400.

Therefore, Hotelling's rule is satisfied.

3. Suppose that a risk-neutral petroleum refinery can save $10 million per year in compliance costs by not complying with environmental regulations. Suppose that the probability of the infraction being detected by field monitors is 80 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 gained by the offender, then will this system create deterrence? Show your work.

0.8 * 0.5 * $20 million = expected penalty = $8 million.

Benefits of being out of compliance = $10 million in avoided cost.

Since the firm is risk-neutral, and since the expected penalty is less than the avoided compliance costs, no deterrence is created.

4. Given the information above, what is the minimum statutory penalty that would be just sufficient to create deterrence? Show your work.

0.8 * 0.5 * X = $10 million; X = $10 million/0.4 = $25 million.

Therefore, a penalty of $25 million (plus a bit more) will create deterrence.

5. 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	1200	100		600	60,000	120,000
Merope	1200	200		600	120,000	240,000
Kelaino	1200	300		600	180,000	360,000
Elektra	1200	400		600	240,000	480,000
Sterope	1600	500	800		400,000
Taygete	1600	600	800		480,000
Maia	1600	700	800		560,000
TOTAL	9600	---	2,400	2,400	2,040,000	1,200,000

a. 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. 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.