True or False: In each of the questions 1-2 say if the statement is true or false and then explain why.   Credit is given for the thoroughness of the explanation. (No points are given for simply   stating true or false. In contrast, partial credit is possible for a wrong choice of true/false if at least parts of the explanation makes sense).

1.   Assume it is known that the marginal benefit to society of abatement of a ton of sulfur  dioxide is constant at $37 per abatement unit: MB=$37. On the other hand, assume the government is unsure of the marginal abatement cost to coal burning firms. In such a    situation, the government should impose a cap and trade policy in order to reduce emissions to the economically efficient level.

ANSWER:

The statement is false. We discussed in class that when there is uncertainty about marginal cost then both cap and trade and a Pigouvian tax will in general lead to an inefficient outcome.

Deadweight loss according to Weitzman’s rule is smaller for a tax relative to cap and trade

when the slope of MB is relatively flat compared to the slope of MC. In our example MB is fixed at 37, thus its slope is 0. Thus the tax will lead to nonbigger deadweight loss relative to cap and trade.

2.   Assume in the permit trading game played in class (recall the setup: nine firms with

marginal costs of abatement ranging from 2 to 10 and each firm choosing to produce two  units of output and in the process emitting two units of pollution) the setup is modified by the one change that the EPA decides to reduce the number of emission pollution permits   from 9 to 6 and gives one permit to each of the six firms with the lowest marginal cost of  abatement. Consider the following statement:

As the “willingness to pay” for permits of the six firms with lowest abatement costs will decrease relative to the setup played in class, the resulting equilibrium price for permits  will be lower than in the version of the game played in class.

ANSWER: The statement is false. More precisely, the first half of the last sentence is    false. What happens is simply that the supply of permits was reduced. As discussed, the “willingness to pay” for permits of any firm is unaffected by this change. Therefore, the equilibrium price of permits will be higher (given the shape of the demand curve).

Therefore, also the second part of the last sentence is false.

Essay type questions.

3.         What does “tragedy of the commons” refer to? Provide an explicit detailed example in your discussion.

ANSWER: “Tragedy of the commons” refers to the scenario where individual agents with unrestricted access to a good use the good beyond its socially efficient level.

We have seen several examples where this occurs. One example was a highway (connecting two cities) that offers a quicker commuting time than back roads when traffic on the highway is not   too heavy but commuting time on the highway increases with the number of people using it. The economically efficient use of the highway is up to the point where the marginal driver’s benefits of using the highway in terms of her gains in time relative to the backroads equal the marginal cost of that driver entering the highway in terms of slowing down the commuting times of all the other drivers on the highway.

However, under unrestricted access, each individual only considers her gain in commuting time   when entering the highway and individuals will use the highway until the commuting time on the highway takes as long as the commuting time on backroads, that is, in the end, there is no time gain for no one any more.

Other examples involve unrestricted (over)fishing, over(grazing) …

3.   Provide a critical discussion of the “bargaining is easy” assumption underlying Coase theorem. What is the problem in practice when this assumption breaks down?

ANSWER: We discussed in class several examples where bargaining is not easy and therefore this assumption underlying Coase theorem may not hold in practice. Namely, in Lecture 11

(pages 3-6) we covered situations with 1) “many victims” where a) freeriding by some victims (when the polluter has the property rights) may undermine a positive bargaining outcome and b)  the possibility that some victims inflate their actual damages may lead to an inefficient outcome   (when victims have the property rights), namely when the sum of inflated damages (but NOT the sum of true damages) is larger than the abatement cost and 2) “bargaining within groups” with at least three members where we showed that there might be no stable bargaining outcome.

When the assumption breaks down then after assignment of property rights to one party the resulting outcome may remain inefficient (see e.g. case 1b)).

5. Provide a detailed derivation/description (including a clearly labeled graph) of the

deadweight loss of the unregulated market outcome in a model with negative externalities of production (you can assume for simplicity that pollution arises as a fixed portion of the produced quantity of the good).

ANSWER: See lecture notes Lecture V, pages 6-8 (top) for a detailed derivation. The

top of page 8 presents the final result, namely the area of the triangle shaded in orange

equals the DWL. A less detailed version will be sufficient to get full score but it has to be made clear how both consumer and producer surplus are affected.

Numerical Problem

6.         Assume two individuals A and B live on either side of a flower garden that they own.

Both enjoy looking at the garden and generate benefits from its beauty “b”. Assume the marginal benefits of the garden as a function of the beauty of the garden are given by

A:                    MB_A =3-b

B:                    MB_B = 2-b/2.

Assume the marginal cost, MC, (i.e. the cost at beauty level b of increasing the beauty of

the garden by another unit) is increasing in b and given by

MC=b.

a)  Find the beauty level of the garden that each individual would choose in the absence of coordination.

b)  Find the beauty level of the garden that a social planner would choose (numerically and in a clearly labelled graph).

c)  Provide a brief explanation regarding your different findings in parts a) and b).

ANSWER: a),b) and c) are worth 4,6,3 points, respectively.

a)   Each individual sets MC equal to her marginal benefit. That is

For A: 3-b=b yields b=3/2

For B: 2-b/2=b yields b=4/3; which is smaller than the level for A.

Clearly, B would not provide any effort beyond b=4/3. Who takes care of the garden up to 4/3 depends on the bargaining power between the two individuals. Clearly A provides the  care between 4/3 and 3/2.

b)  The social planner looks at the sum of the marginal benefit functions.

Note that A generates positive marginal benefit for b<=3 (while B generates positive marginal benefit as long as b<=4)

Thus the marginal benefit curve, MB say, relevant to the social planner is given by

MB_A+MB_B=5-3/2b for b<=3 and

MB_B for 3<b<=4.

The intersection of MB with MC occurs at b=2 (when 5-3/2b=b or 5=2.5b).

Therefore, as expected, the social planner, taking into consideration the marginal benefits of both individuals, chooses a LARGER beauty level.

c)  We find smaller investments into beauty in a). The reason is that individuals do not take  into account the positive effect on other players benefits of their own investment into the public good. The social planner instead takes as benefits the sum of the benefits of both   players. This then leads to a higher investment.

Multiple Choice questions: Circle the correct answer. Indicate clearly what your answer is.

7.         The concept of “economic efficiency”

A. suggests picking the policy that maximizes net benefits.

B. has been criticized on the basis that discounting the benefits of future generations is unethical.

C. is often difficult to implement in practice as its components, namely benefits and costs, are often hard to measure.

D.   has been criticized because it may lead to “unfair” outcomes from a distributional point of view.

E.   A-D are true.

ANSWER: E is the correct answer (as parts A-D are all correct statements).

8.         If we have multiple polluters and each one has a different marginal cost of abatement (MCA) curve, which of the following statements about cost minimization is FALSE.

A.   It requires that the marginal cost of abatement be equal across all polluters at their level of abatement.

B.   Firms with lower MCA curves will have higher levels of abatement.

C.   It means that the total abatement cost added over all firms will be as low as possible for the given level of total abatement.

D.   It does not guarantee that we have achieved the allocatively efficient level of total abatement.

E.   It will be achieved by assigning all polluters an identical emission standard.

ANSWER: The statement in E is false and thus E is the correct answer. As we discussed many times in class, assigning identical emission standards won’t lead to equalization of marginal abatement costs across firms and therefore not to cost minimization.

9.         A. A “club good” is nonrival and nonexcludable.

B. An example of an “open access resource” is scientific knowledge.

C. The free market likely reaches undersupply of a public good because individuals in  their decision making do not take into account the benefits to other individuals of their

investment into the public good.

D. A and C.

E. A-C.            .

ANSWER: C is correct.

10.       This question is about the “permit trading” game as played in class.

A. For the firm with the lowest marginal abatement cost there can be no gains from participation in permit trading.

B. Firms with a high marginal abatement cost and no permits will be better off by purchasing a pollution permit for a price below its marginal abatement cost.

C. When all nine pollution permits are originally given to the firm with the highest marginal abatement cost then no permit trading will occur.

D. The “willingness to pay” of a firm for its first and second pollution permit depends on