Economics 423, Midterm Examination #1, Spring 2002 – Professor Hackett 

Name: ____________Key_____________________

PART I: Short answer (8 or 9 points each). Clearly label your answer to parts (a), (b), (c), etc.

1. (9 pts) Suppose that in addition to the status quo (current management system), four policy options are being considered in the context of a natural resource management decision. Five members of society are affected by the management decision. The table below shows how these five people feel about the proposed management options relative to the status quo. The numbers represent the amount (in units of utility) by which the different options make them better off or worse off relative to the status quo.

	Jethro	Liu	Susan	Antonio	Kim	Total
Option A	50	-10	20	31	100	191
Option B	20	0	10	-10	150	170
Option C	0	5	5	20	20	50
Option D	-20	20	0	-20	200	180

1.a. Add up the total utility for each option and report it in the table above.

1.b. Which of the options above, if any, satisfies the Pareto criterion for efficiency? ____C____

1.c. Which of the options above, if any, satisfies the Kaldor-Hicks criterion for efficiency? ____A_____

1.d. Which of the options above, if any, is utilitarian-ethical based on the standard model? ____A_____

2. (8 pts) (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.

a. An uncompensated cost generated as a byproduct of production and exchange that is imposed on other members of society (and aspects of the environment that they are concerned about).

b. Pollution from a power plant.

c. Firms supply along the private-cost supply rather than the social-cost supply, resulting in price being based on marginal private cost rather than marginal social cost; this subsidized price induces consumers to buy too much of the good/service generating the (-) externality.

d. Pigouvian taxes.

3. (8 pts) (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.

a. An unpaid-for benefit generated as a byproduct of production and exchange that is enjoyed by other members of society.

b. Open space vistas/wildlife habitat/flood water storage provided by ag lands.

c. Market demand reflects private benefits to the buyers, but not the full social benefits; therefore market demand is understated, and not enough of the good/service generating the (+) externality is produced and consumed (in the example in b. above, not enough ag lands are kept in ag use rather than converted to development).

d. Consumer (or producer) subsidies.

PART II: Matching (3 points each). 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. Transaction costs	1. __Q__ Bases the ethics of an action on the intrinsic rightness of the action.
b. State (government) property	2. __P__ Bases the ethics of an action on the likely outcomes of the action.
c. Pareto efficient	3. __C__ This efficiency criterion can only be satisfied when a policy option makes nobody worse off relative to the status quo.
d. Kaldor-Hicks efficient	4. __K__ The property rights regime in which the rights of access, withdrawal, management, and exclusion are held in common by a group of proprietors.
e. Opportunity cost	5. __I__ This occurs in markets when negative externalities are taxed, or positive externalities are subsidized.
f. Positive externality	6. __N__ Occurs when price is below equilibrium in a competitive market, and quantity demanded exceeds quantity supplied.
g. Buy too much	7. __F__ An external benefit generated from production and exchange and enjoyed without payment by members of society.
h. Pigouvian tax	8. __O__ The gains from trade that flow to consumers and producers in price-mediated market exchange.
i. Externalities are internalized	9. __G__ In markets suffering from unresolved negative externalities, consumers do this as a consequence of paying a "subsidized" price based on marginal private cost rather than marginal social cost.
j. Usufructuary rights	10. __H__ A policy intervention that requires firms to pay marginal external cost, and thereby causes market supply to be based on marginal social cost rather than marginal private cost.
k. Common property	11. __E__ The value of the "next best" alternative that must be given up when a choice is made in the context of scarcity.
l. Private property	12. __D__ This efficiency criterion is satisfied when a policy option is selected that generates the largest gain in net social utility, even if some are made worse off.
m. Open access	13. __J__ Certain use and withdrawal rights to property that is owned by others.
n. Shortage (excess demand)	14. _M__ The property rights regime in which no entity holds recognized access, withdrawal, management, exclusion, or alienation rights to a resource.
o. Consumer & producer surplus	15. __L__ The property rights regime in which business firms or individuals hold the rights of access, withdrawal, management, exclusion, and alienation to a resource, and are recognized as owners.
p. Consequentialism
q. Categorical imperative
r. Monopoly

PART III. Computational analysis. Answer any 2 of the 4 questions below. (15 points each)

Suppose that in a well-functioning competitive market, demand is given by the equation P = 1050 – 0.1Q, and (private-cost) supply is given by the equation P = 50 + 0.2Q, where "P" is price and "Q" is market quantity of some good or service. 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 1 above, the equation for the social-cost supply curve is given by P = 150 + 0.2Q.

1. Compute the market equilibrium P and Q using the private-cost supply equation, which assumes that firms can freely pollute. Show your work.

50 + 0.2Q = 1050 - 0.1Q ==> Q = 3333.33, P = 50 + 0.2(3333.33) = $716.67

2. Compute the dollar amount of total external cost generated when firms can freely pollute in the market equilibrium above. Show your work.

MEC * Q = TEC

$100 * 3333.33 = $333,333.33

3. Compute the market equilibrium P and Q using the social-cost supply equation, which assumes that a Pigouvian tax is imposed on producers. Show your work.

150 + 0.2Q = 1050 - 0.1Q ==> Q = 3000, P = 150 + 0.2(3000) = $750

4. Deadweight social loss occurs in markets with unresolved negative externalities, but is eliminated by the use of a Pigouvian tax. In this sense Pigouvian taxes can enhance market efficiency. Compute the dollar amount of deadweight social loss when firms can freely pollute.

DWL = [MEC *(Q_pvt - Q_soc)]/2

DWL = [$100 * (3333.33 - 3000)]/2 = $16,666.67