Student Name: Student ID: Signature:

THE UNIVERSITY OF NEW SOUTH WALES School of Economics ECON 2127: Environmental Economics Midsession Exam, 30 August 2011 SOLUTIONS

Instructions: 1. Print your name and ID on the upper right corner and sign below. 2. Exam length: 1 hour 45 minutes 3. Number of pages in exam: 14 4. Total possible marks: 100 5. Total weight of nal mark: 20% 6. All questions are NOT of equal value. Possible marks for each question are shown in the exam paper. 7. There are 2 parts to the exam. Part A consists of 4 short answer questions. Each are worth 6 marks each. Part B consists of 2 multiple part questions. Question 1 is worth a total of 26 marks and Question 2 is worth a total of 50 marks. You should attempt all questions. 8. Answers may be written in pencil or ink. 9. Answers should be written in the space provided in the exam paper. 10. The back of each exam page may be used for extra writing space or scratch working space. Writing on the back of a page will not be marked unless it is clearly indicated as a continuation of an answer from the space provided under the question. 11. If you need additional space, you may include extra pages provided by the lecturer. In this case, you will need to clearly indicate on the front of the exam how many additional pages are being included for marking. 12. This paper may not be retained by the student. Failure to return the exam will result in a mark of zero.

PART A Question 1: A polluters marginal pollution abatement costs (M AC) are shown below. Suppose a new low-cost pollution abatement technology is introduced. What do you expect this will do to to the polluters M AC curve? Illustrate this eect on the below graph. Relative to the initial M AC curve, would we need a higher, lower, or the same per unit emissions tax to induce the same level of pollution abatement? [6 marks] Answer: A new low-cost pollution abatement technology should lower the polluters marginal abatement costs since they now have cheaper abatement options. In general, this is illustrated as a downward shift in their MAC curve (although it need be linear). Because polluters will choose to abate up until their marginal abatement costs equal the emissions tax, lower marginal abatement costs require a lower tax to achieve the same level of abatement. See the below graph for an illustration.

Question 2: What is the dierence between Positive and Normative Economics? Provide an example of a Positive question and a Normative question in the context of Environmental Economics. [6 marks] Answer: Positive Economics asks the question What is and is generally judgement free. An example of a positive question is If left unregulated, how much CO2 will be emitted from automobiles in Sydney next year? Normative Economics asks the question What ought to be and therefore requires judgement. An example of a normative question is How should we regulated automobile usage in Sydney in order to decrease CO2 emissions?

Question 3: Describe one drawback to using an abatement equipment subsidy as a means to reduce pollution. [6 marks] Answer: (1) We need to know what marginal external benets associated with the socially optimal production point (M EBSE ) are in order to set the correct subsidy that will achieve QSE . (2) A per-unit abatement equipment subsidy biases polluters decisions about how to abate, which may not be optimal. For example, suppose the purchase of scrubbers is subsidized. Scrubbers are not likely to be the best abatement technology for every polluter, but polluters will be more likely to purchase them because they have been made relatively cheaper by the subsidy. (3) Subsidies must be nanced through taxes or government borrowing.

Question 4: Using the below diagram, put each of the following categories of goods into the appropriate quadrant: (1) Public Goods, (2) Private Goods, (3) Open-Access / Common Pool Resources, and (4) Club Goods. [For example put the category of goods that is both non-rival and non-excludable in the upper left quadrant.] Give one example for each category of goods and provide a brief explanation of why the example ts the category. List your example and explanation within the quadrant to which it belongs. [6 marks] Answer:

PART B Question 1 [26 total marks] Suppose there are two members of society: Fred and Wilma. Suppose also that the below graph illustrates the possible utility combinations that are attainable given the amount of resources in society. Using this graph, answer the following questions. [Note: You may want to sketch your answers on scrap paper before drawing them on the below graph in case you need to make changes]

Part (a) Using the Unanimity/Pareto Criterion, compare the following utility pairs and state whether one is Pareto Preferred (PP) to the other or if they are incomparable using this criterion. For example, if comparing hypothetical Points X and Y, you may say X is PP to Y, Y is PP to X, or Incomparable. [2 marks] Answer: Point A & Point D: Incomparable Point A & Point B: Incomparable Point B & Point C: B is PP to C Point D & Point E: Incomparable

Part (b) State whether or not each of the following utility pairs is ecient/Pareto Optimal (PO). Label each as PO, Not PO, or Cannot tell from this information. [2 marks] Answer: Point A: PO Point B: PO Point C: Not PO Point D: Not PO Point E: PO

Part (c) Draw and label the Pareto Frontier on the above graph. [3 marks] Answer: The red curve in the below graph represents the Pareto Frontier, which is the set of all Pareto Optimal allocations.

Part (d) Suppose Fred and Wilma are endowed with resources that provide them with utility levels associated with point D. Find one allocation that would provide utility levels that are Pareto Preferred to point D. Label this point F. [3 marks] Answer: Any point in the blue shaded area or on the red curve within this area is Pareto Preferred to point D. For an allocation to be Pareto Preferred to another the requirement is that the new allocation provide one person with more utility while providing the other person with the same or greater level of utility as the initial allocation.

Part (e) Is the point you found above (point F) Pareto Optimal? Why or why not? [3 marks] Answer: This depends on where you drew point F. Referring back to the graph from Part (d), if it is on the Pareto Frontier (the red curve within the blue area), then it is Pareto Optimal. If it is inside the Pareto Frontier (the blue area), then it is not Pareto Optimal.

Part (f ) Continue to suppose that Society is currently at point D and further suppose that a policy is available that would move Society to point A. Fred and Wilma get to vote on this policy, which will go into eect only if the votes are unanimously in favor of the policy. What will be the outcome - i.e. will Society remain at point D or will they unanimously vote to move to point A? Suppose now that side payments are allowed (i.e. one can transfer resources to the other if they agree to vote in a particular way). With side payments, do you expect the same outcome as above or will it likely be reversed? Explain your answer. [5 marks] Answer: Point A is Pareto Preferred to point D for Fred, but it is not Pareto Preferred to point D for Wilma. Therefore, Fred will vote in favor of the policy and Wilma will vote against it. Under the unanimity criterion, Society will choose to remain at point D. Notice, however, that the gain to Fred in moving from point D to point A is quite large, while the loss to Wilma is quite small. If side payments are allowed, it is quite likely that Fred would be willing to transfer some of the surplus he would gain from the move to Wilma in such a way that she would remain at least as well o as she was at point D and would, therefore, be willing to vote in favor of the policy. After the side payments and a unanimous vote in favor of the policy, a likely outcome is point X.

Part (g) Suppose instead that Fred and Wilma are endowed with resources that provide them with utility levels associated with point C. Further suppose that they are freely allowed to trade their resources. Find and label the set of utility pairs that might arise after all voluntary trade has taken place. Label this set Trades. [4 marks] Answer: Mutually benecial trades are those that fall within the dotted lines coming out of point C. Points outside of this area make at least one individual worse o. While points inside the dotted lines, but also inside the Pareto Frontier are mutually benecial, gains from trade still exist. Gains from trade will be fully exploited once a trade that lands the individuals on the Pareto Frontier is complete. At this point, no one can be made better o without hurting the other. Therefore, any point along the blue line labeled Trades represents a possible outcome after all voluntary trade has taken place. Which of these points Fred and Wilma will end up on will depend on bargaining power and/or prices.

Part (h) Suppose Society doesnt care about Freds well-being. In this case, which point, A, B, C, D, or E, is likely to be the most optimal from Societys point of view? What is an example of a Social Welfare function that might represent these social preferences? [4 marks] Answer: If Society doesnt care about Fred, Freds Utility will not enter into Societys Social Welfare Function. An example of such a Social Welfare function is SW = UW where UW represents Wilmas Utility. (Note: There are other examples that represent these preferences.) Under these preferences, point E will be socially optimal since Wilmas Utility is maximized at this point.

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Question 2 [50 total marks] Suppose there are two paper producing mills on an island. Their paper supply functions are given by (1) Q1 = 8P 8 and (2) Q2 = 2P 2, where Q is the quantity of paper reams per day and P is the price of a ream of paper. The island is split into three districts. Each districts demand for paper is given by (1) Q1 = 43.75 3.125P , (2) Q2 = 35 2.5P , and (3) Q3 = 8.75 0.625P . Assume that paper is neither imported nor exported so that the islands paper needs must be met by these two suppliers. While paper is of value to the community, the local government has identied several environmental concerns stemming from the production of paper. Among these concerns are deforestation, air pollution (such as N O2 , SO2 , and CO2 emissions), and water pollution. Using this information, answer the following questions.

Part (a) Is paper a private or public good? Explain your answer. [3 marks] Answer: Paper is a private good since it is both rival and excludable. It is rival because my use of a piece of paper directly aects your ability to benet from that same piece of paper. It is excludable because I can easily prevent you from using and enjoying the same piece of paper (unlike air; its pretty hard to prevent someone from breathing your air).

Part (b) Given the information above, are there any externalities in the paper market? If so, are they production or consumption externalities? Are they positive or negative externalities? Explain your answer. [3 marks] Answer: Negative production externalities are present in the paper market. This is due to the fact that during the production of paper, paper mills generate negative external eects on the environment, such as air and water pollution. While it could be the case that other externalities are also present (such as negative consumption externalities due to littering), they are not mentioned here.

Part (c) Derive the market supply function for paper on the island. [3 marks] Answer: We determine market supply by summing each individual producers supply horizontally - i.e. summing across Qs for each oered price. This can be done by summing: (1) Q1 = 8P 8

+ (2) Q2 = 2P 2 (MS) QS = 10P 10

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Part (d) Derive the market demand function for paper on the island. [Hint: Think about your answer to Part (a)] [5 marks] Answer: Because paper is a private good (more importantly, a rival good), we determine market demand by summing each individual districts demand horizontally, not vertically - i.e. summing across Qd for each oered price. We only sum vertically when the good is non-rival and everyone can enjoy the same unit of consumption. Market demand is calculated by summing:

(1) + (2) + (3)

Q1 = 43.75 3.125P Q2 = 35.00 2.500P Q3 = 08.75 0.625P

(MD) QD = 87.50 6.25P

Part (e) What is the market equilibrium price and quantity of paper? Show this graphically. Your graph need not be drawn to scale, but be sure to label market supply and demand curves and numerically label all intercepts and equilibrium values. [5 marks] Answer: Mathematically, market equilibrium occurs where Market Supply = Market Demand. Labeling the equilibrium price and quantity with a M E for market equilibrium, we have: Market Supply = Market Demand 10PM E 10 = 87.50 6.25PM E 16.25PM E = 97.50 PM E = 97.50/16.25 PM E = $6

And from the Market Supply equation (note, you could also use market demand here): QM E = 10PM E 10 QM E = 10(6) 10 QM E = 60 10 QM E = 50

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Graphically, market equilibrium occurs where Market Supply intersects Market Demand :

Part (f ) Suppose the government decides to conduct a thorough investigation of the environmental damages that can ensue from the production of paper. They determine that the marginal external cost of paper production with respect to forest health is given by M ECf orest = 0.06Q, the marginal external cost of paper production with respect to air quality is given by M ECair = 0.16Q, and the marginal external cost of paper production with respect to water quality is given by M ECwater = 0.04Q. No external benets have been identied. Given this information, derive the equation for marginal social benets (MSB) and the equation for marginal social costs (MSC). [7 marks] Answer: Total marginal external costs (M ECtotal ) of producing paper include all three costs mentioned above. M ECtotal can be calculated by vertically summing the three individual MEC functions. We sum vertically because each unit of production has three external costs associated with it and we want to sum these three costs for each unit.

M ECf orest = 0.06Q + M ECair = 0.16Q + M ECwater = 0.04Q M ECtotal = 0.26Q

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Marginal Social Benets (MSB) = Marginal Private Benets (MPB) + any marginal external benets (MEB). MPB is captured by the demand equation. According to the government analysis above, there are no external benets. Therefore: M SB = M P B + M EB M SB = D + 0 M SB = 14 0.16Q

Marginal Social Costs (MSC) = Marginal Private Costs (MPC) + any marginal external costs (MEC). MPC is captured by the supply equation. After summing the three types of marginal external costs, we found M ECtotal = 0.26Q. Therefore: M SC = M P C + M EC M SC = S + M EC M SC = [1 + 0.10Q] + [0.26Q] M SC = 1 + 0.36Q

Part (g) Given your answer to Part (f), what is the socially optimal equilibrium price and quantity of paper? Graphically illustrate this equilibrium, including MSB, MSC, market supply, and market demand on the same graph. Again, while your graph need not be drawn to scale, be sure to label all curves and numerically label all intercepts and equilibrium values. [7 marks] Answer: Mathematically, the socially optimal equilibrium occurs where MSC = MSB. Labeling the equilibrium price and quantity with an SE for social equilibrium, we have: MSC = MSB 1 + 0.36QSE = 14 0.16QSE 0.52QSE = 13 QSE = 25

And from the MSC equation (although you could also use the MSB equation): PSE = 1 + 0.36QSE PSE = 1 + 0.36(25) PSE = 1 + 9 PSE = $10

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Graphically, the socially optimal equilibrium occurs where MSC intersects MSB :

Part (h) What is the value of Total Surplus (or Social Welfare) under the market equilibrium? What is the value of Total Surplus (or Social Welfare) under the socially optimal equilibrium? Which is larger? Why is this? [7 marks] Answer: Social Welfare (SW) is the area below MSB up to the equilibrium quantity level minus the area below MSC up the equilibrium quantity. This is the same as Total Social Benets (TSB) minus Total Social Costs (TSC). When the market equilibrium prevails, this is: SWM E = T SBM E T SCM E SWM E = ( 1 ) ($14 $6) (50) + ($6) (50) ( 1 ) ($19 $1) (50) + ($1) (50) 2 2 SWM E = $200 + $300 $450 + $50 SWM E = $500 $500 SWM E = $0

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When the socially optimal equilibrium prevails, SW is: SWSE = T SBSE T SCSE SWSE = ( 1 ) ($14 $10) (25) + ($10) (25) ( 1 ) ($10 $1) (25) + ($1) (25) 2 2 SWSE = $50 + $250 $112.50 + $25 SWSE = $300 $137.50 SWSE = $162.50

We can also see this graphically. When the market equilibrium prevails:

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And when the socially optimal equilibrium prevails:

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SWSE is greater than SWM E by $162.50. This means that social welfare would increase by $162.50/day if we increased price to $10/ream and decreased quantity to 25 reams/day. SWSE is greater than SWM E because the additional social cost of each ream of paper is greater than the additional social benet of each ream of paper once quantity surpasses 25 reams/day. With each additional ream of paper produced past 25, we slowly chip away at social welfare until, in this case, it equals zero.

Part (i) The government realizes that, without intervention, the island is producing too much paper and that the community would be better o if production decreased. They decide to impose a at per-unit output tax in order to reduce paper production (by at, I mean the same rate per each unit of output). What is the optimal tax rate? Will this tax move the market to the socially optimal equilibrium? Illustrate the eect this tax will have on Market Supply, Market Demand, and the Market Equilibrium. [7 marks] Answer: The main goal of a tax is to force the market to internalize the externality associated with paper production. The government wants to set the tax so that suppliers will choose to produce at the socially optimal level, given demand. They can achieve this by setting the tax so that suppliers marginal private costs (MPC) become equal to marginal social costs (MSC) at the socially optimal equilibrium. The dierence between MPC and MSC at the socially optimal equilibrium is M ECSE , which is $6.50. If the government charges a per-unit tax of $6.50, then it will cost suppliers an additional $6.50 to produce each ream of paper. This represents a parallel shift in supply that goes through the socially optimal equilibrium. Mathematically, MPC becomes: M P Ctax = M P C + tax M P Ctax = [0.10Q + 1] + [6.50] M P Ctax = 0.10Q + 7.50

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Setting new marginal private costs (M P Ctax ) equal to demand and letting M E denote the new market equilibrium , we have: M P Ctax = D 0.10QM E + 7.50 = 14 0.16QM E 0.26QM E = 6.50 QM E = 25

Graphically, this looks like

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Part (j) Describe two limitations to using a per-unit output tax to attempt to solve the externality problem. [3 marks] Answer: (1) We need to know what marginal external costs are in order to determine what the socially optimal level of production is and what tax will achieve this. (2) A per-unit output tax only encourages a reduction in output (paper production) in oder to reduce pollution. It doesnt encourage the use other abatement technologies (like cleaner methods of producing paper). (3) Enforcement and monitoring costs may be higher than with command and control methods.

Bonus Question: What is one of the most important things that I want you to learn from this class? [TBD marks] (a) How to pick a good stock portfolio (b) How to look like youre paying attention in class when in fact youre watching YouTube videos (c) How to select a ripe avocado in the supermarket (d) We face trade os. We cant have something (e.g. clean air) without giving up something else (e.g. driving our cars less).

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