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

Name: ______________Key___________________

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

PART I: Short answer (2 questions, 10 points each, 20 points total). Be sure to respond to each part of each question. Clearly label your answer to parts (a), (b), (c), etc.

1. (a) Name two things that will cause marginal Hotelling rent to increase for a non-renewable resource. (b) If demand and marginal extraction cost remain constant over time, if resource stocks slowly decline, and if there is a positive discount rate, what will be the direction of the trend in resource price over time?

(a) Two of the following: Increasing demand, reduced marginal extraction cost, reduced stock of the resource, more time periods

(b) The trend will feature increasing prices.

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) Using your diagram, show how supply and/or demand changes, and how the equilibrium level of effective support changes, if a change in a legislature's leadership reduces the total time and effort cost to those legislators carrying the proposed regulation.

(a) Draw a diagram like Figure 7.1 on page 171 of your textbook. Be sure to fully label the diagram.

(b) Show an outward shift in the supply curve, as the change in the legislature's leadership reduces the cost of supplying the legislation, resulting in a higher equilibrium level of effective support.

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. Cap and trade system	1._L__ A rule for reducing appropriation from a common-pool resource that makes smaller appropriators worse off and larger appropriators better off.
b. Wage premium paid for accepting a higher chance of a fatal occupational injury.	2._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.
c. Incentive not to comply with environmental regulation	3._Q__ 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	4._I__ Occurs in the Gordon model of a common-pool resource under open-access conditions when average revenue product equals average cost.
e. Examples of ecosystem services not traded in markets	5._B__ Information that can be used to calculate the value of a statistical life.
f. Incentive to comply with environmental regulation	6._J__ Refers to pollution abatement and control expenditures paid by firms, consumers, and government.
g. Total benefit equals total cost	7._K__ Occurs in CVM studies when the value of a subunit such as an alpine lake is equal to that of a much larger wild area that includes the alpine lake.
h. Demand for regulation increases	8._A__ A system of tradable pollution allowances that reduces the total industry-wide cost of compliance with environmental regulation.
i. Hotelling rents are fully dissipated	9._F__ Exists when the benefit (e.g., cost savings) is smaller than the expected penalty from being out of compliance with environmental law.
j. Direct compliance costs	10._M__ This will happen when several environmental groups quit the coalition of interest groups lobbying for an environmental regulation.
k. Embedding bias	11._P__ This fishery management tool can create a race for fish.
l. All appropriators must reduce harvest by the same quantity	12._E__ Flood water retention, CO2-O2 gas exchange, water purification in aquifers, and nutrient cycling in wetlands.
m. Demand for regulation decreases	13._G_ Occurs at the level of pollution control where total net benefits are zero.
n. Hedonic regression method
o. Only the largest appropriators must cut back harvest levels.
p. Limited fishing seasons that close when the total allowable catch is landed
q. Rule of capture externality
r. Individual transferable quotas
s. Marginal benefit equals marginal cost

PART III. Computational analysis (3 questions, 13 or 14 points each, 41 points total)

1. (13 points) Suppose that there are 200 units of a nonrenewable resource available over two periods (0 and 1). Demand in each period is given by P = 300 - 0.5Q. Marginal cost is a constant 20 in both periods. The discount rate is 30 percent.

Derive the dynamically efficient allocation of this nonrenewable resource over the two periods (within $2 of marginal Hotelling rent). Show your work (attach scratch paper as necessary).

First pick a likely allocation of the resource over the two periods, like 160 and 40

Second, compute price in both periods:

P₀ = 300 - 0.5(160) = 220

P₁ = 300 - 0.5(40) = 280

Third, compute the PDV of marginal Hotelling rent (aka marginal profit) for each period and compare them:

PDV (P₀ - MC) = (220 - 20)/(1+.3)⁰ = 200

PDV (P₁ - MC) = (280 - 20)/(1+.3)¹ = 200

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 40 percent. If the statutory penalty calls for a fine equal to four times the annual cost savings, will this monitoring and enforcement system create deterrence? Show your work.

0.7 x 0.4 x $40,000,000 = expected penalty = $11.2 million

Benefit from being out of compliance (cost savings in this case) = $10,000,000

Therefore, since the expected penalty exceeds the benefits from being out of compliance, deterrence is created for this risk-neutral firm.

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 x 0.4 x P = $10,000,000. Solve for P ==> P = $35.72 million (or a bit more to create an incentive)

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	50		300	$15,000	$30,000
Merope	600	100		300	$30,000	$60,000
Kelaino	600	100		300	$30,000	$60,000
Elektra	600	150		300	$45,000	$90,000
Sterope	800	200	400		$80,000
Taygete	800	250	400		$100,000
Maia	800	400	400		$160,000
Industry Total	4,800	---	1,200	1,200	$460,000	240,000

a. (4 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, including the industry total.

b. (4 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, including the industry totals.

c. (4 points) How much compliance cost (if any) is saved from having fully tradable allowances, relative to the "command-and-control" outcome in part a. above?

$460,000 - $240,000 = $220,000