ECON 423: Environmental and Natural Resources Economics

Old Midterm Exams

Econ 423 Environmental and Natural Resources Economics

Exam 2 Spring 1999 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, such as petroleum.

 

a. Based on HotellingÕs rule, what will be the trend in resource prices over time if no new stocks are found, and demand and marginal extraction costs remain constant? Briefly explain why.

 

HotellingÕs rule provides that the optimal allocation is spread over the relevant time period. With positive discount rates, more is consumed in current time periods, and less in the future. Thus prices rise.

 

b. How will the price dynamics in (a) affect the market demand for substitute resources, and research and development efforts for more resource-efficient or alternative technologies?

 

As price rises, demand will increase for substitutes (called the "principle of substitution"). As demand for alternatives grows, the profitability of R&D also rises, and thus more R&D will occur. The post-OPEC growth in alternative energy R&D is an example.

 

c. Does HotellingÕs 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:

 

HotellingÕs rule implies (2), unless the discount rate is enormous. If there were an abrupt change in available quantities from one year to the next, the sharp change in price would cause producers to reallocate production, thus smoothing out the price shock.

 

d. Suppose we observe the price of a non-recyclable and non-renewable resource traded in a competitive market, such as petroleum, decline over time. List and very briefly describe at least three reasons why this might occur.

 

  • Technological innovation results in a sharp drop in the price of a substitute (e.g., alternative energy).
  • Technological innovation results in a sharp drop in marginal extraction cost, and/or innovation that allows additional resource recovery from previously exhausted fields.
  • Discovery of new reserves.
  • Collapse of a resource producer cartel such as OPEC.

 

2. HotellingÕs 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").

 

a. Explain the key reason why this is implied by HotellingÕs rule.

 

For the case of commercially valuable resources (unlike biodiversity), the private owner will find that the PDV of profit is maximized by spreading out production, saving some resource for the future. The amount saved for the future is inversely related to the discount rate.

 

b. Explain the key reason why this does not occur for open-access common-pool resources (CPRs).

 

The key is OPEN ACCESS, not CPR. Under open-access conditions, if one appropriator attempts to follow HotellingÕs rule and save some resource for the future, other appropriators can harvest those resources and sell them today as long as there is some profit to doing so. Thus under open-access conditions it is extremely difficult to save resources for the future as required by HotellingÕs rule.

 

c. Relate the correct answers to a. and b. above to a brief but critical evaluation of the extent to which competitive markets serve as efficient allocators of scarce natural resources.

 

Under certain conditions competitive markets result in efficient resource allocation. HotellingÕs rule identifies a way to allocate a commercially valuable resource in such a way as to be dynamically efficient. When depletable natural resources are supplied from open-access CPRÕs or other resources for which property rights and/or appropriation rules are not defined or enforced, the commercial market in which the resource is sold is not dynamically efficient. Thus we cannot count on markets to always efficiently resolve scarcity problems.

 

3. [True/False; use a fully-labeled diagram to show why]: Scott GordonÕs economic model of a fishery CPR indicates that if appropriators from a fishery CPR can successfully coordinate harvest rates to make the group as a whole best off, resource appropriators will harvest up to the point where Hotelling Rents are fully dissipated. In contrast, under open access conditions, the appropriators would set binding harvest targets at a lower level where Hotelling Rents are maximized and the resource is sustained.

 

False. The opposite is true.

 

See the diagram on page 78 of the Hackett textbook, or on the course website at: http://www.humboldt.edu/~envecon/diagrams/5.4.GIF

 

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. Briefly describe (a) what is measured, (b) the merits and (c) the shortcomings of the travel cost method of nonmarket environmental benefits valuation.

 

(a) The TCM measures the cost borne by those who travel to visit a site, with particular application to recreational destinations. These costs provide a lower-bound estimate of the economic value that people get from active use of an area.

 

(b) A key merit of the TCM is that the monetary value estimates are based on actual spending or "dollar votes," and thus are not hypothetical as with the contingent valuation method.

 

(c) A key shortcoming of the TCM is that it does not provide a way to measure the economic benefits derived from option, bequest, or existence values held by people who do not actually visit the site.

 

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 firmsÕ 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 output must rise. Example: Breakeven Q = TFC/(P-AVC), where TFC is total fixed cost, P is price, and AVC is average variable cost of producing a unit of output Q. If regulation (or anything else, for that matter) causes TFC to rise, and if P and AVC do not change, then breakeven Q must rise.

 

(b) If market demand is constant, then larger breakeven output levels imply that the maximum number of firms the industry can support will decline. Fewer firms may lead to an increased likelihood of collusion, an indirect cost associated with environmental regulations.

 

7. Suppose that a number of large power producers recently invested a total of $6.34 billion to generate electricity with fewer emissions than what is currently allowed by the EPA. These firms made that investment in anticipation that selling emissions allowances would provide an important source of repayment of that investment. Why might the investment made by these firms create more of a Stiglerian than an Olsonian regulatory environment?

 

The fact that a number of large power producers have a lot of money at stake gives them a strong incentive to invest in lobbying and other political inputs to maintain the regulation that they depend on to repay their "clean" investments. This will tend to stabilize the regulation, and thus is Stiglerian rather than Olsonian (small, diffuse benefits associated with regulation).

 

8. Suppose that an environmental offender saves $30,000 each year in tipping fees by illegally burning garbage. If the probability of the offender being caught in a given year is 40 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:

 

Minimal deterrence is provided when a financial penalty or sanction "X" is a penny or more larger than given in the following (assuming risk-neutral firms):

 

(probability of detection)*(probability of sanction/detection)*sanction "X" = $30,000.

 

è 0.4 * 1.0 * X = $30,000; Therefore, X = $30,000/0.40, or sanction "X" = no less than $75,000.

 

9. List and very briefly describe the conditions under which a firmÕs market reputation with consumers impacted by pollution are most likely to be effective in causing firms 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 $1000/ton, and its past emissions were 100 tons/year. Firm Y has a constant marginal abatement cost of $5000, and its past emissions were 50 tons/year. Firm Z has a constant marginal abatement cost of $10,000, and its past emissions were 150 tons/year. Compute the annual pollution abatement and control costs in this industry (a) with and (b) without fully marketable allowances. (c) What are the cost savings from fully marketable allowances trading? Show your work.

 

(a) With marketable allowances: Firm X sells all 50 of its allowances to Firm Z, and thus must clean up all 100 tons/yr of its emissions. Likewise Firm Y sells all 25 of its allowances to Firm Z, and thus must clean up all 50 tons/yr of its emissions.. Therefore total cleanup cost (pollution abatement and control costs or PAC) for Firm X is $1000*100 = $100,000; PAC for Firm Y is $5000*50 = $250,000. Firm Z has 150 allowances (the 75 it originally had plus the 75 it bought), and so does not have to reduce emissions. Total industry PAC cost is $350,000.

 

(b) Without marketable allowances: Firm X has abatement costs of $1000*50 = $50,000; Firm Y has abatement costs of $5000*25 = $125,000; Firm Z has abatement costs of $10,000*75 = $750,000. Total industry pollution abatement and control (PAC) costs are $925,000.

 

(c) Cost savings from fully marketable allowances is $925,000 - $350,000 = $575,000.