Econs 326 Midterm Exam You Are Required to Answer the FIRST

Name: ______EconS 326

Midterm Exam

You are required to answer the FIRST question. Pick two out of the remaining three questions to answer. Your answer should be in full sentences and reflect full grasp of the material. All questions are equally weighted. If you answer all questions only questions 1 to 3 will be graded.

1. Venezuela is endowed with a population base of high skilled workers, a significant amount of forestland and a large oil reservoir. Assume that the forestland is open access to any Venezuelan citizen. Also assume that extraction from the oil reservoir leads to air pollution. a. If we wanted to obtain a measure of economic growth in Venezuela, what measure could we use? Explain at least one drawback to this measure. If we wanted to obtain measures of sustainable development in Venezuela, what measures can we use? b. Give an example of how weak sustainability, strong sustainability and environmental sustainability can be achieved given all the assets in the economy of Venezuela. c. Explain the concept of sustainable development. How can Venezuela achieve sustainable development given all the assets in its economy? d. The precautionary principle can be used to regulate pressures on the forest stock. What does the precautionary principle say with regards to protecting forests in the country? Explain a drawback of using the principle from a policymaker’s point of view.

a. Economic growth refers to changes in national income or output. Gross domestic product (GDP) or gross national product (GNP) are classic measures for a country. There are several drawbacks with using GDP or GNP as a measure of economic welfare: (1) it does not say anything about allocation of output to the populace (income distribution) and (2) does not fully capture all assets of the economy such as natural resources. There are also several drawbacks as a measure of economic growth as well because of problems with comparability across countries due to the exchange rate problem and differences in purchasing power. Sustainable development encompasses welfare that encapsulates economic, social and environmental aspects. Therefore, some measures of sustainable development include measures of poverty, income inequality, freedom, governance, health, literacy, corruption, forestland stocks, water quality, participation in the policy decisions, etc. b. a. Weak sustainability – The aggregate value of the assets of the economy has to be non- decreasing. In this case, the value of oil stock can go down as long as the value of human capital and value of forestland stock compensate for its decline. Strong sustainability – Individual value of each asset in the economy must not decline. This implies the value of the fishery stock does not decline, the value of the human capital does not decline and the value of oil stock does not decline.

1 Environmental sustainability – Physical flow of environmental assets need to be maintained. In this case, the amount of timber harvested is less than or equal to the amount of new growth/replanted forest. Oil production needs to be stopped.

In order to achieve sustainable development, economic welfare has to be maximized subject to a sustainability criterion. To maximize welfare, deadweight loss needs to be reduced. There is deadweight loss in the market for harvest timber because forests are open access. There is deadweight loss in the extraction of fossil fuel because of a negative production externality. One way to reduce deadweight loss in the timber market is to enforce property rights of the government and implement a fee structure of extracting timber. Because of the negative externality in oil extraction, one can tax such extraction. Implementing both regulations will increase economic welfare (through a reduction in deadweight loss), increase environmental welfare because of improved forestland stock management and less pollution, and improve social welfare because more low income families who are likely to benefit with improved environmental quality. The next step is to make sure a sustainability criterion is achieved as outline in part (b). So for example, if I pick weak sustainability, I have to ensure that the total value of all assets should not decline. If one stock value declines like oil, the value of forestland and value of human capital stock must compensate for this reduction. d. The precautionary principle states that any uncertainty should be interpreted toward a measure of safeguard. In this case, if the benefits of protecting the forestland stock are not fully realized then the precautionary principle implies that policies should be made to prevent complete deforestation. Unfortunately, even though it gives direction to policy, it does not tell us the magnitude of such a policy. In this case, we are not sure how much of the forest to preserve.

2 2. Aviation turbine fuel or jet fuel is used for aircrafts that are powered by gas-turbine engines. Carbon dioxide is emitted when aircrafts use jet fuel. Also, when fossil fuels are used in the production of jet fuel, carbon dioxide is also expelled. a. Given the above scenario, is the equilibrium level of jet fuel in the market “too much” or “too little” compared to the social optimum? Explain why this occurs. Support your answer by drawing the private and social, marginal cost and marginal benefit curves for refrigerators. Identify the deadweight loss if any exists. b. Identify a regulation that the government can use to achieve the socially optimal level of refrigerators. Explain how this regulation works. c. Explain how the Coase theorem could hypothetically work to achieve the optimal level of carbon dioxide emissions in this context. Enumerate at least one major drawback that hinders the creation of a market for carbon dioxide without any third party regulators in the real world. d. Assume that the marginal savings for jet fuel producers is unknown. If the marginal damages from carbon dioxide rises very rapidly, would an environmental standard on emissions (quota) or a tax on emissions be a better option? Explain and prove your answer with a graph. a. Too much jet fuel is produced relative to the socially optimal level. In the jet fuel market, there are two externalities: a negative consumption externality when using the fuel and a negative production externality when creating the fuel. Since these two effects are not internalized in the market, production and pricing of the good are based only on the private marginal cost and marginal benefit curves which are not equal to the social marginal cost and marginal benefit curves. Damages from the externality are not considered so too much of the good is produced resulting in a deadweight loss equal to the area abc below:

price MCS b MCP s P a

p P c MBP

MBS

s p Q Q quantity

b. A tax on the producer and on the consumer can internalize the effect of the externality. To avoid paying the tax, less output is produced and consumed. Note that the tax rate should be

3 equal to marginal external cost plus marginal external benefit which is the distance from b to c. A quota equal to Qs could also remove the deadweight loss.

c. Coase theorem states that if there are no transactions costs, there is full information and property rights are well defined, interested parties, i.e. those that emit CO2 from jet fuel and those that are hurt by CO2 emissions from jet fuel, will be able to bargain to arrive at the socially optimal solution. In reality, transactions costs are not minimal. It will take time and money to get agents together along with representatives of those that are affected by CO2. Also, it is not clear who has de facto rights over clean air. Finally, not every may be aware of damages from CO2 d. An environmental standard or quota is more preferable in this case because the deadweight loss with this type of pollutant is lower than the deadweight loss with an environmental tax. See graph below. This is because if you know when the marginal damages will suddenly rise, it is best to put a quota before this happens to ensure that the critically threshold will never be reached. With a tax, you can miss if you do not know true MS.

Market: CO2 pollution

price b MD

p P a e tax c d

true MS

estimate MS

p Envt Std Q quantity

DWL with envt std =aed DWL with tax = ebc

4 3. Agricultural research by a faculty member in a local university provides private benefits for that faculty member in the form of higher income and a better academic reputation. We can represent this private marginal benefit as 100 2 where Q is the quantity of published reports every year. Since the published reports can be read by anyone, it creates a positive external benefit. Let us assume that it is equal to 50 for every unit of report published. The marginal private cost is always constant at 10 and there is no externality during the production process. a. Plot the private and social Marginal Benefit and Marginal Cost curves on a graph. Identify the deadweight loss area if any exists. Label the graph completely. b. What is the socially optimal number of research projects? If we let the market work on its own, how many published research reports would be produced every year? Calculate the deadweight loss area if any. c. Identify one government regulation that can be used to achieve the socially optimal level of research projects. Explain how this can work. d. How is sustainable development achieved in this scenario?

price

a P S p MC =MC c

MBP MBS

Qp Qs Quantity of

research projects Deadweight loss is abc

b. To derive the market equilibrium, equate . We obtain, 100 2 10. Solving for Qp we find Qp = 45. The price is simply 10. The socially optimal level is derived by equating . In this case, 100 2 50 150 2. Also, since there is no externality in production. Thus Qs = 70. Price is still 10. Thus, the socially optimal level of research projects is 70 but if we let the market work on its own only 45 would be produced. The deadweight loss area is abc. Given the area for a triangle it is equal to (70-45) x (60-10) / 2 = 625.

5 c. One option is for the government to provide subsidies for research. For every research project, the government subsidizes the cost of funding it. This would reduce the marginal cost of production. d. Sustainable development implies (1) maximization of welfare (environmental, social, economic aspects) subject to (2) meeting a sustainability criterion. To achieve part (1) one must recognize that a positive externality exists leading to a deadweight loss. The government can provide a subsidy to get closer to the socially optimal level of research output and reduce the deadweight loss. This reduction in deadweight loss raises economic welfare. Since the research is on ways to control agricultural runoff, this may increase environmental welfare. Finally, if such research is implemented in the real world, the poor may benefit from the reduction in pollution. To achieve (2), one can employ the strong sustainability criteria. As long as the value of human capital is not decreasing in the economy when maximizing economic welfare, we will achieve strong sustainable development.

4. In the production of herring, boats, labor, fuel and the stock of herring are important inputs. Assume that in the North Sea, herring is an open access resource where any boat can enter the sea and extract herring. a. Given the above scenario, is the level of herring harvest “too much” or “too little” or equal to the social optimum? Explain why this occurs. Support your answer by drawing the private and social, marginal cost and marginal benefit curves for herring. Identify the deadweight loss area if any exists. b. Explain the concept of the tragedy of the commons in this context. What will likely happen to the fish stock of herring without any regulation? Explain why. c. Identify a regulation that the government can use to achieve the socially optimal level of herring harvest. Explain how this regulation works. d. Part of the North Sea is claimed by Norway. How is sustainable development for Norway achieved given that the North Sea is easily accessible to other neighboring countries such as the United Kingdom and Denmark?

a. Too much herring production occurs. In this scenario, the stock of herring is an open access resource which means it is rival and non-excludable. There are private costs to herring production, which boat owners consider in their decision making process such as the cost of the boat, fuel, and labor. But there is also a cost to one input not paid for: the cost of the herring fish stock. This leads to a difference in private and social marginal cost and over production of herring. The deadweight loss is shown in area abc.

price MCS

a MCP

PS b

MBP=MBS

s p Q Q quantity

b. The tragedy of the commons in this case implies that since there is no single owner of the herring fish stock, each boat will claim an amount of the stock that is relatively higher because they do not have to pay for it. The stock of fish is rival and non-excludable. (Alternatively, a fisherman’s harvest from the fish stock reduces another fisherman’s ability to harvest). It is possible that the fish stock will be depleted without a formal or informal regulatory mechanism.

c. One option is for the government to institute a tax depending on how much herring is harvest. Alternatively, a quota can be used identifying the maximum number of herring that can be harvested at each period in time. d. Sustainable development in Norway implies (1) maximization of welfare subject to (2) meeting a sustainability criterion. To achieve part (1) one must recognize that a deadweight loss exists because of the open access nature of the resource. An international regulator needs to exist to regulate use of the common pool resource by all countries near the North Sea. The international regulator can use either a tax, quota or tradeable permit system. Implementing this would lead to an increase in economic welfare (because of the reduction of deadweight loss), improvement in environmental welfare because of a prevention of the depletion of the fish stock and an improvement in social welfare especially if the poor have a higher value of fish in their diet. To achieve (2), one can employ the weak sustainability criteria. The total value of all assets in the economy must not decrease. If the value of the fish stock is decreasing, then the value of other assets such as labor and capital need to rise to compensate for the reduction in the value of fish stock to meet weak sustainability.