EC265

 –  Fall  2011  
 
Answers  to  Problem  Set  #1  
 
QUESTION  1  (10  points  –  each  sub-­‐question  with  2  points)  
 
Application  3.1  Open  Access  and  Logging  
 
The  following  data  refers  to  the  number  of  logging  operations  working  in  a  stretch  
of  tropical  rainforest.    Excluding  externalities,  the  private  cost  of  a  logging  operation  
is  $25  thousand  per  week.    Logs  sell  for  $1  a  piece.    Fill  in  the  chart  below.    
           
#  of   Total  Harvest     Average  Harvest   Marginal  
operations   (1000  logs)   (1000  logs)   Harvest  
(1000  logs)  
0          0      
1      40      
2      75      
3   105      
4   130      
5   150      
6   165      
7   175      
8   180      
9   182      
 
1.    What  is  the  number  of  logging  operations  in  the  forest  that  maximizes  total  
profits  in  the  industry  (ignoring  externalities)?  How  much  total  resource  rent  is  
generated  at  this  level  of  harvest?  
 
2.  With  open  access  to  the  forest,  how  many    folks  will  wind  up  logging?    With  open  
access,  will  there  be  any  resource  rent  earned  by  the  loggers?  

3. Which of the following are externalities associated with logging?

___ Loss of genetic material for medical or agricultural applications
___ Low wages for forestry workers
___ Release of carbon-dioxide stored in the “carbon sink” of the forest
___ Building of roads by the companies to access timber

4. Suppose the total externalities associated with deforestation could be valued

at $10,000 per operation. What is the efficient number of operators? What is the
open access number of operators?
5. Suppose access to the forest is controlled by a (perfectly enforced) fee
system. What (weekly) fee would have to be charged to insure an efficient
harvest level?
 
Answers  
           
#  of   Total  Harvest     Average  Harvest   Marginal  
operations   (1000  logs)   (1000  logs)   Harvest  
(1000  logs)  
0          0      
1      40   40   40  
2      75   37.5   35  
3   105   35   30  
4   130   32.5   25  
5   150   30   20  
6   165   27.5   15  
7   175   25   10  
8   180   22.5   5  
9   182   20.2   3  
 
1.    What  is  the  number  of  logging  operations  in  the  forest  that  maximizes  total  
profits  in  the  industry  (ignoring  externalities)?  4  How  much  total  resource  rent  is  
generated  at  this  level  of  harvest?    Rent  =  15+10+5=30,  or  130-­‐4*25=30.  
 
2.  With  open  access  to  the  forest,  how  many    folks  will  wind  up  logging?    With  open  
access,  will  there  be  any  resource  rent  earned  by  the  loggers?  7.    No.  

3. Which of the following are externalities associated with logging?

_x__ Loss of genetic material for medical or agricultural applications
___ Low wages for forestry workers
__x_ Release of carbon-dioxide stored in the “carbon sink” of the forest
___ Building of roads by the companies to access timber

4. Suppose the total externalities associated with deforestation could be valued

at $10,000 per operation. What is the efficient number of operators? 2. What is
the open access number of operators? 7.

5. Suppose access to the forest is controlled by a (perfectly enforced) fee

system. What (weekly) fee would have to be charged to insure an efficient
harvest level? The cost of operation would have to rise to eliminate profit beyond
the efficient level, where the average harvest is 37.5. A tax of between 10 and
12.5 would raise costs sufficiently from discouraging the 3rd operator from
entering. If the answer was interpreted as referring to the non-externality case,
the correct answer is a tax of between 7.5 and 5.
 
   
QUESTION  2  (9  points  –  each  sub-­‐question  worth  3  points)  
 
Application  3.2:  The  Open  Access  Problem  (ANALYTICAL,  1)    
 
  Surrounding   the   Great   Lake   are   four   paper-­‐mills,   each   producing   100   tons   of  
paper  per  year.    The  paper  is  sold  on  the  national  market  for  $2  per  ton,  and  including  
all  the  costs  of  production,  costs  for  each  firm  are  $1  per  ton.    Thus  each  firm  earns  a  
pure  economic  profit  of  $1  per  ton.    These  paper  mills  require  fresh  water  to  operate,  
and  also  produce  a  pollutant  called  gunk,  which  they  dump  into  the  Great  Lake.      
  New  paper  mills  can  also  locate  on  the  Great  Lake,  and  produce  at  a  base  cost  of  
$1  per  ton.    However,  for  each  new  paper  mill  which  arrives,  the  water  will  become  
more  polluted  with  gunk,  and  each  firm  will  have  to  install  a  water  treatment  facility  to  
obtain  fresh  water.    This  externality  associated  with  new  plants  will  raise  the  costs  of  
paper  production  at  all  facilities,  including  the  new  one,  by  $.15  per  ton  for  each  new  
mill.  
 
 1.    Assume  there  is  free  access  to  the  Great  Lake.    If  paper  mills  will  continue  to  locate  
as  long  as  their  is  any  economic  profit  to  be  earned,  how  many  new  mills  will  be  built?  
What   is   the   number   of   mills   that   maximizes   total   combined   profits   for   the   paper  
producers?   (Hint:   Average   revenue   remains   constant   at   $2.     Create   a   table   which  
compares   average   revenues   with   average   and   marginal   costs   as   new   firms   locate  
around  the  lake.)    
 
 2.    Draw  a  diagram  of  the  marginal  cost  and  marginal  revenue  curves  with  the  number  
of   mills   on   the   horizontal   axis.     Assume   that   government   regulation   restricts   lake  
access  to  the  profit-­‐maximizing  number  of  firms.    Show  the  resource  rent  that  would  
be  earned  by  the  mills  which  are  allowed  to  operate.      
 
 3.     Suppose   that   government   regulation   reduced   the   number   of   mills   by   one   from   the  
number  that  would  have  resulted  given  free  access.    Show  that  the  increase  in  profits  
to  the  remaining  firms  (the  resource  rent)  is  sufficient  to  compensate  the  firm  that  is  
denied  access  its  lost  profits.      
 
Answers  
 
Here  is  the  necessary  table.  
 
#  of  Mills       Average   Average   Total   Marginal  
        Revenue   Cost     Cost    Cost  
 
  4        200     100      400        -­‐-­‐  
  5        200     115      575      175  
  6        200     130      780      205  
  7        200     145     1015          235  
  8        200     160     1280      265  
  9        200     175     1575      295  
   10        200     190     1900      325  
    11        200     205     2255      355  
 
Average   revenue   is   constant:   100   tons   *   $2   per   ton.     Costs   at   each   plant,   and   thus  
average  costs,  go  up  by  $15  each  time  a  new  mill  enters.    Total  cost  is  just  average  cost  
times  the  number  of  plants.    And  marginal  cost  is  the  change  in  total  costs  as  additional  
plants  come  on  line.  
 
1.    Given  free  access,  6  new  mills  will  locate  on  Great  Lake,  for  a  total  of  10.    Revenue  
for  the  tenth  mill  will  be  $200,  while  private  costs  will  be  $190,  generating  a  positive  
economic   profit   for   each   firm,   including   the   tenth,   of   $5.     The   11th   mill   would   lose  
money.      
  The   profit-­‐maximizing   number   of   mills   is   5   in   total.     The   entry   of   the   fifth   plant  
causes  total  costs  at  all  plants  to  rise  by  $175,  but  revenues  go  up  by  $200.    The  sixth  
plant,  however,  increases  industry-­‐wide  costs  by  $205  against  revenue  of  only  $200.    
Thus   industry   profits   fall   as   entry   proceeds   beyond   five   plants.     (To   check   this,  
calculate  total  profits  at  4,  5,  6,  and  7  plants:  4*(200-­‐100)=$400,  5*(200-­‐115)=$425,  
6*(200-­‐130)=$420,  7*(200-­‐145)=$385.  
 
2.     The   resource   rent   earned   at   the   efficient   level   (5   mills)   would   be   the   area   between  
marginal  cost  and  marginal  revenue  from  zero  to  five  mills  (not  shown).  The  reduction  
in   resource   rent   when   more   than   5   mills   enter   (the   grey   triangle)   occurs   because  
marginal  cost  is  greater  than  marginal  revenue  beyond  that  point.    
 
 
 
 
 
 
 
 
 Efficient and Open Access Entry

Marginal  Cost  
Cost and Revenue ($)

400
Lost  Resource  Rent  
350
300
250
200
150 Revenue    
(average  and  
100 marginal)  

5 6 7 8 9 10 11 12
Average  Cost    
 
Number of Mills

 
 
 
3.     The   government   restricts   access   to   the   lake   to   9   plants   in   total.     Show   that   the  
increase  in  profits  to  the  9  firms  is  greater  than  the  lost  profit  to  the  10th  firm  which  is  
denied  access.  
 
lost  profit  =  $200-­‐$190=$10  
 
increased  profit  =  9  *  $15  =  $135  (9  companies  do  not  have  to  invest  $15)  
 
net  increase  in  profits  =  $135  -­‐  $10  =  $125  
 
QUESTION  3  (6  points)  
 
A  good  answer  will  note  that  these  corporate  raiders  will  be  maximizing  profits  if  
the  market  interest  rate  is  greater  than  the  rate  of  growth  of  the  natural  resource  
(like  the  fisheries  example  in  the  appendix  to  chapter  3.)    The  government  should  
act  if  society  decides  that  the  pursuit  of  sustainability  dominates  the  interests  of  the  
private  landowner.  
 
   
QUESTION  4  (12  points  –  each  sub-­‐question  worth  4  points)    
 
Application  4.2:  More  on  Efficient  Smoking  (Analytical,  1)  
 
  These  smoking  problems  are  a  little  silly  but  are  good  at  illustrating  some  basic  
lessons  about  efficiency.    So,  this  time,  Groucho  and  Harpo  work  together  in  the  same  
office.     Groucho   smokes;   Harpo   hates   smoke.     Groucho   currently   smokes   12   cigars   per  
day.     He   faces   marginal   costs   of   reducing   smoking   (withdrawal   pains)   equal   to   $x,  
where  x  is  the  number  of  cigars  reduced.    In  other  words,  the  cost  of  giving  up  the  first  
cigar  is  $1,  the  second,  $2,  etc...Harpo  receives  marginal  benefits  (reduced  discomfort  
and  risk  of  cancer)  equal  to  $(12-­‐x)  from  reducing  the  number  of  cigars  smoked.  
 
It  is  possible  to  rent  a  Clean-­‐Air  Machine  that  reduces  smoke  in  the  air  by  50%  for  
$10   per   day.     It   is   also   possible   to   relocate   Groucho   in   a   different   office   so   Harpo  
would  not  have  to  breathe  any  smoke  at  all  for  $40  per  day.  
 
1.   Draw   a   diagram   showing   the   marginal   costs   and   marginal   benefits   of   pollution  
reduction,   with   the   number   of   cigars   reduced   on   the   horizontal   axis.     Use   this  
diagram  to  determine  the  efficient  number  of  cigars  reduced  if  there  is  no  machine  
rental  or  relocation  allowed.  
2.  Suppose  that  the  clean  air  machine  is  installed.  What  is  the  efficient  number  of  cigars  
reduced  now?  
3.   Groucho   is   smoking   12   cigars   a   day.   Is   it   more   efficient   to   rent   the   machine   or  
relocate  Groucho  to  another  room?  
4.  This  problem  has  no  transactions  costs  or  free-­‐riding.    The  Coase  theorem  says  that,  
in   this   kind   of   simple   example,   the   efficient   outcome   should   be   achieved   through  
negotiation   even   if   Harpo   has   the   power   to   banish   Groucho   to   another   office   at  
Groucho's  expense.    Explain  why.  
 
   
Answers  
 
Here's  the  graph:    
 
Marginal Benefits and Costs

14
MB  
12

10

6
MC  
4

0
0 2 4 6 8 10 12

Cigars Reduced

 
 
First  note  that  with  no  law  against  smoking,    Groucho  will  smoke  12  cigars  a  day,  since  
smoking  any  less  is  costly  to  him.  It  is  evident  from  the  graph  that  the  efficient  level  of  
smoking  equals  6  cigars.  
 
Alternately,   since   the   efficient   outcome   will   occur   where   MC=MB,   you   can   solve   the  
two  equations  for  x:    
 
MC=x  
MB=12-­‐x.  
MC=MB  -­‐-­‐>  1x=12-­‐x  -­‐-­‐>  2x=12  -­‐-­‐>  x=6.  
 
2.   The   clean   air   machine,   by   reducing   the   smoke   from   each   cigar,   also   reduces   the  
marginal   benefits   of   clean-­‐up   by   half   for   each   cigar   reduced.     Thus   for   the   first   cigar  
reduced,  the  benefits  are  6  (not  12)  and  for  the  second  they  are  5.5,  not  11.  This  new  
MB  schedule  changes  the  graph  to  look  like:  
 
 14

Marginal Benefits and Costs

12

10 MB  
8

4 MC  
2

0
0 2 4 6 8 10 12

Cigars Reduced

   
 
 
Now,  the  efficient  level  of  cigars  reduced  is  4,  with  8  smoked.    
 
Algebraically,  the  new  MB  schedule  is  MB=6-­‐x/2,  so  now:  
 
MC=MB  -­‐-­‐>  1x=6-­‐x/2  -­‐-­‐>  3x/2=6  -­‐-­‐>  3x=12  à  x=4.  
 
3.  We  know  that  with  machine  rental,  4  cigars  will  be  reduced.    Suppose  Groucho  
has  the  right  to  smoke,  and  so  the  status  quo  has  him  smoking  12  a  day.    Harpo  has  
three  choices:  
 
a.  not  rent  the  machine  and  not  relocate  Groucho,  but  pay  Groucho  not  to  smoke.  
 
b.  rent  the  machine  and  then  pay  Groucho  not  to  smoke.    
 
c.  pay  to  relocate  Groucho.      
 
 Which  would  he  choose?    
 
  Not  renting  the  machine  requires  Harpo  to  compensate  Groucho  for  the  MC  of  
reducing   cigars:   1+2+3+4+5+6=   $21   in   costs.   Harpo’s   benefits   are  
12+11+10+9+8+7=$57,  so  net  benefits  are  57-­‐21=$36.  
 
Machine  rental  costs  $10,  plus  Harpo  has  to  pay  Groucho  at  least  his  MC  of  reduction  
for  the  first  four  cigarettes.  The  costs  of  machine  rental  are  thus:    10+1+2+3+4=$20.    
  Relative  to  the  status  quo  of  12  cigars  smoked,  the  benefits  of  machine  rental  
have   two   components.     First,   Brittany   gets   the   full   benefits   of   seeing   4   cigarettes  
reduced:  12+11+10+9=$42.    Second,  she  gets  the  50%  improvement  in  air  quality  for  
the  remaining  8  cigars  that  are  smoked:  4+3.5+3+2.5+2+1.5+1+.5=$18.      
  So,  net  benefits  are  42+18-­‐20=  $40.  
 
  Finally,   relocation   costs   $40,   and   brings   Harpo   the   total   area   under   the   MB  
curve  in  benefits.  (Since  Groucho  can  smoke  all  he  wants  after  relocation,  he  bears  no  
costs).   Therefore,   the   net   benefits   to   Harpo   of   paying   for   relocation   are:  
(12+11+10+9+8+7+6+5+4+3+2+1)-­‐40  =$38.  
 
So  the  efficient  choice  is  machine  rental.  
 
4.  Rather  than  be  banished,  Groucho  would  rent  the  machine,  then  pay    Harpo  to  
allow  him  to  stay  and  smoke  8  cigars.  If  Groucho  rents  the  machine,  he  would  pay  
the  following  costs:  $10  for  machine  rental,  plus  1+2+3+4=$10  in  nicotine  
withdrawals  on  4  cigars  given  up,  plus  4+3.5+3+2.5+2+1.5+1+.5=$18  in  bribes  to  
Harpo  to  allow  him  to  smoke  8  cigarettes.    The  total  is  $38,  less  than  the  $40  
required  to  relocate.    So  rather  than  banish  Groucho,  Harpo  could  come  out  ahead  
by  demanding  a  little  more  than  the  $18  just  necessary  for  him  to  allow  Groucho  to  
smoke  his  8  cigars.  
This  again  demonstrates  the  Coase  theorem:  in  the  absence  of  transaction  costs,  
efficient  outcomes  will  be  achieved  regardless  of  the  initial  distribution  of  property  
rights.  
 
Question  5  (10  points  –  each  sub-­‐question  worth  2  points)  
 
Application  4.3:  The  Stray  Cow  Problem1  (Analytical,  2)  
 
  Rancher  Roy  has  his  ranch  next  to  the  farm  of  farmer  Fern.    Cattle  tend  to  roam  
and  sometimes  they  stray  onto  Fern's  land  and  damage  her  crops.    Roy  can  choose  the  
size   of   his   herd.     His   revenues   are   $6   for   each   cow   he   raises.     The   schedules   of   his  
marginal   cost   of   production   (MCP)   and   the   damage   each   additional   cow   creates  
(marginal  cow  damage  or  MCD)  are  given  below.  
 
      #  of  Cattle     MCP     MCD  
               1       $3     $1    
               2          3        2  
               3          4        3  
               4          5        4  
               5          6        5  
               6          7        6  
 
                                                                                                               
1
Acknowledgements are due to the unknown author of the original version of
this problem, which I borrowed from a University of Michigan problem set.
   Farmer  Fern  can  choose  either  to  farm  or  not  to  farm.    Her  cost  of  production  is  
$10,   and   her   revenue   is   $12   when   there   are   no   cattle   roaming   loose.     For   each  
additional  cow  her  revenue  is  reduced  by  the  amount  in  the  MCD  column  above.  
  To   answer   the   following   questions,   you   need   to   figure   out   four   things:     the  
profit  maximizing  number  of  cows  for  Roy  to  own,  his  profits,  whether  or  not  Fern  will  
farm  and  what  her  profits  will  be.    Remember  that  efficient  outcomes  maximize  the  net  
monetary  benefits  to  both  parties;  in  other  words,  total  ranching  plus  farming  profits.    
Finally,  a  diagram  won't  help  for  this  problem.  
 
 1.   What   will   be   the   outcome   if   there   is   no   liability   (Roy   does   not   pay   for   any  
damages  caused)?  
 2.   What  will  be  the  outcome  if  Roy  is  liable  for  damages?  
 3.   What  is  the  efficient  outcome  (the  outcome  that  maximizes  total  profits)?  
 4.   Suppose   that   it   is   possible   to   build   a   fence   to   enclose   the   ranch   for   a   cost   of   $9.    
Is  building  the  fence  efficient?  
 5.   Suppose   the   farmer   can   build   a   fence   around   her   crops   for   a   cost   of   $1.     Is  
building  this  fence  efficient?  
 
Answers  
 
 Just   remember,   both   the   farmer   and   rancher   will   seek   to   maximize   profits.     For   the  
farmer,   its   a   question   of   farming   or   not   farming,   so   we   just   have   to   see   if   farming  
generates  any  profit  at  all.    For  the  rancher,  we'll  need  to  compare  marginal  costs  with  
marginal  revenue.  
 
 
      RANCHER       FARMER  
1.    #  cattle          MCP      MCD    MR      MC                 TR       TC  
   1                  $3      $1                  $6    $3                   $12       $10+15  
   2                      3          2                        6        3  
   3                      4          3                        6        4  
   4                      5          4                        6        5  
   5                      6          5                        6        6  
   6                      7          6                        6        7  
 
With   no   liability,   the   rancher's   MC   are   just   his   MCP,   so   he'll   run   5   cattle   (or   4,   he's  
indifferent).     If   he   runs   5,   that   imposes   additional   costs   equal   to   $15   on   the   farmer,   so  
the  farmer  won't  farm.  
   
  
      RANCHER       FARMER  
2.    #  cattle          MCP      MCD       MR        MC     TR                      TC  
   1                  $3      $1        $6    $4                   $12+3        $10+3  
   2                      3          2              6        5  
   3                      4          3              6        7  
   4                      5          4              6        9  
   5                      6          5                6        11  
   6                      7          6                6        13  
 
If  rancher  Roy  is  held  liable  by  farmer  Fern,  he  now  absorbs  the  MCD  into  his  marginal  
costs.    Now  he  should  run  two  cows,  earning  a  total  profit  of  2+1.    The  farmer  suffers  
damage  of  $3,  but  also  receives  $3  in  compensation,  so  she  could  decide  to  farm  and  
earn  a  profit  of  2.      
  BUT,   the   Coase   Theorem   tells   us   that   in   the   absence   of   transactions   costs,  
property   rights   shouldn't   effect   the   market   outcome.     Is   there   a   better   deal   for   the  
farmer?    YES!  If  the  rancher  runs  5  cows,  he  earns  a  profit  of  3+3+2+1=$9.    He  would  
be  willing  to  pay  the  farmer  up  to  6  (the  difference  between  9  and  3)  to  do  so...    thus  
Fern  is  better  off  being  paid  not  to  farm,  while  letting  Roy  run  5  cows.  
 
3.     The   Coase   theorem   tells   us   that   market   outcomes   will   be   efficient   in   the   absence   of  
transactions  costs,  so  5  cows  is  the  efficient  number.  
 
4.     No.     If   a   fence   was   built,   the   rancher   would   run   5   cattle   and   impose   no   external  
damages  on  the  farmer,  who  would  thus  farm.    In  this  case,  net  benefits  would  be  the  
profits  of  the  two  (9+2)  less  the  cost  of  the  fence  8,  or  $3.    The  farmer  is  better  off  being  
paid  not  to  farm.    Thus  this  is  not  an  efficient  investment.  
 
5.     This   is   an   efficient   investment.     Now   total   profits   would   be   9+2-­‐1=$10,   which   is  
greater  than  the  $9  available  without  the  fence.      
 
Questions  6  and  7  (8  points  each)  
 
Good  answers  will  use  sound  reasoning  and  evidence  to  make  their  case.    Answers  
to  question  6  must  include  good  examples,  well  cited,  from  online  sources.