Economics 423, Midterm Examination #2, Spring 2004 – Professor Hackett 

Name: _______________KEY______________ [Worth one point :-) ]

PART I. MAJORS-ONLY (students enrolled in the 4th unit): Please provide the best answer to each of the following three questions, each of which is worth 10 points:

1. Suppose that there are 2000 units of a nonrenewable resource available over two periods (0 and 1). Demand in each period is given by P = 4000 - Q. Marginal cost is a constant 200 in both periods. The discount rate is 20 percent.

What is the dynamically efficient allocation of the 2000 units of the nonrenewable resource, and what will be the prices in the two periods? (within $50 of satisfying Hotelling's rule; show your work)

Q₀ = 1254.55 P₀ = 2745.45

Q₁ = 745.45 P₁ = 3254.55

See PowerPoint for Chapter 5 for solution methodology....

2. Suppose that the basic setup of the problem above were the same, except that demand in both periods is larger. In particular, re-compute the dynamically efficient allocation of the 2000 units of the nonrenewable resource when demand in each period is given by P = 5000 - Q (within $50 of satisfying Hotelling's rule; show your work).

Q₀ = 1345.45 P₀ = 3654.55

Q₁ = 654.55 P₁ = 4345.45

See PowerPoint for Chapter 5 for solution methodology....

3. Use the space below to carefully draw a single fully labeled diagram correctly showing the two price paths (for P₀ and P₁) over time for questions 1 and 2 immediately above.

Your diagram should plot price against time, and show the price path for question 1 below that of question 2. Both are upward sloping.....

PART II. NON-MAJORS ONLY (students only enrolled for 3 units) Please provide the best answer to each of the three questions below, each of which is worth 10 points.

1. (i) Carefully draw a single fully labeled diagram below correctly showing a natural resource commodity market (e.g., pulp for paper) with three supply curves -- one for cheap material sourced directly from trees, one for more expensive material sourced from sorted recycled paper, and the combined market supply. (ii) Assuming there is just a single pulp price, clearly indicate on your diagram how a rise in pulp price increases the quantity of recycled paper supplied.

See diagram in PowerPoint slide show in Chapter 5 for recycling....

2. (i) Carefully draw a single fully labeled diagram below correctly showing Keohane's equilibrium political economy market model of effective support for legislation or administrative rules. (ii) Show how the equilibrium is changed when those groups that demand effective support are joined by several new and powerful interest groups.

See diagram in PowerPoint slide show in Chapter 7....

3. Suppose that proposed environmental legislation includes a provision that those who violate the law must pay a penalty equal to twice the economic gains from violating the law. It is common knowledge that 75 percent of all facilities are inspected for compliance each year, and that in recent years judges have imposed the full statutory penalty 90 percent of the time that a violation is detected. Based on this information, will the proposed legislation create deterrence (i) for risk-neutral violators, (ii) for risk-loving violators, and/or for (iii) risk-averse violators?

(i) Is the risk-neutral violator deterred? Circle one: YES NO CANNOT BE

DETERMINED

(ii) Is the risk-loving violator deterred? Circle one: YES NO CANNOT BE

DETERMINED

(iii) Is the risk-averse violator deterred? Circle one: YES NO CANNOT BE

DETERMINED

0.75 * 0.9 * 2X = 1.35X = expected penalty

X = gain from being out of compliance

Since 1.35X > X, both risk-averse and risk-neutral violators will be deterred. We don't have enough information to say whether or not a risk-loving violator will be deterred. It depends on how risk-loving the person happens to be....

Part IV. ALL STUDENTS: There are five questions below. Please answer any three of them, and cross out the ones you do not wish to answer with a BIG X. Each question is worth 10 points.

1. Suppose that the marginal benefit from reducing emissions is given by the equation MB = 200 - 2Z, and marginal cost from reducing emissions is given by the equation MC = Z. Note that "Z" is the percentage of total emissions to be reduced. Solve for the percentage of total emissions reduced that maximizes total net benefits. Show your work.

200 - 2Z = Z ==> 200 = 3Z ==> Z = 200/3 = 66.67 = percentage of total emissions reduction that maximizes total net benefits

2. 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 50 percent, and that the probability of a judge imposing the statutory penalty given detection is 60 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.

0.5 * 0.6 * $20,000,000 = $6 million expected penalty < $10 million gain ==> no deterrence.....

3. Given the information in question 5 above, what is the minimum statutory penalty that would be just sufficient to create deterrence for this risk-neutral firm? Show your work.

0.5 * 0.6 * X = $10 million ==> X = ($10 million)/0.3 = $33,333,334 million + a smidgen more....

4. Suppose that a job is identical to many others in a competitive labor market except that there is an additional 7 per 100,000 annual chance of accidental death, and that the job pays a risk premium of $1,000 per year. Use the "value of a statistical life" approach to determine the implied economic value of a statistical life. Show your work.

7 per 100,000 = 7/100,000 = 0.00007 increased probability of premature death.

VSL = (wage premium)/(increased probability of death) = $1,000/0.00007 = $14.286 million.

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)
A	600	200		300	60,000	120,000
B	600	400		300	120,000	240,000
C	600	600		300	180,000	360,000
D	600	800		300	240,000	480,000
E	800	1,000	400		400,000	0
F	800	1,200	400		480,000	0
G	800	1,400	400		560,000	0
TOTAL	4800	---	1200	1200	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.

PART V: ALL STUDENTS. 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 Risk-averse	1. __M_ Treaty to control greenhouse gases that the US has refused to join.
b. Marginal benefit equals marginal cost	2. __A_ 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. Firms have heterogeneous marginal abatement costs	5. __B_ Occurs at the level of pollution control where total net benefits are maximized.
f. Command-and-control regulation	6. __E_ 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”	11. __O_ Law that requires a minimum percentage of a state's total electricity production come from renewable sources.
l. Ecosystem services not traded in markets	12. __G_ People with this attitude towards risk will not be deterred from environmental crime if the expected penalty equals the gain from being out of compliance
m. Kyoto Protocol	13. __P_ Example of the direct cost of environmental regulation.
n. Montreal Protocol
o. Renewable Portfolio Standard
p. The cost of pollution abatement equipment like scrubbers.