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Econ%20131-PS1-%20Answers - Econ 131 Problem Set#1 Fall...

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Unformatted text preview: Econ 131 Problem Set #1 Fall 2009 1. You set up wireless connection in your home. Assume that you cannot protect it with a password, and hence any individual in the range of the connection can use it. What type of market failure best describes the situation at hand? Provide a similar example in the environment. The problem with this type of connection is that you cannot exclude others from using it (open access/non-excludability). It is an impure public good because it is only available to people in the range of the connection. Hence, it is not non-rival. This type of impure public good is what we refer to as the commons. It might not be very clear why it is rival. Now think of it this way, if the connection's range spans 20 square feet, then people have to `fight' over space to get the connection. So it functions like a local park. See pages 22-24 of the book for a general discussion of the commons. An example of an open access resource in environmental economics is fisheries. Everybody can fish, but the fish that one fisher catches is not attainable to any other fisher. 2. We have discussed four types of market failure in class, ecosystem externalities, global public goods, tragedy of the commons, and incomplete information. For each type, explain carefully which necessary conditions for efficiency of a market mechanism are violated. Market Failure Violation Ecosystem Total social cost of producing or consuming a good is not accounted for Externality in the cost of production. As a result, the marginal social cost is not equal to marginal private cost. As a result, the equilibrium price and quantity do not reflect the full cost to the society, and hence the equilibrium is inefficient. Global (Pure) The commodity is not a private good. It is neither excludable nor rival in Public Good consumption. Hence, if one person buys the commodity, other individuals can benefit at no cost to them, i.e. they can free-ride. As a result, the price, which is equal to the marginal cost of the commodity is equal to the marginal benefit of the individual who bought the commodity, but not the marginal benefit to the entire society. The latter is equal to the marginal benefit of all individuals who free-ride, in addition to the marginal benefit of the individual person who bought the good. This is the reason why free-riding leads to underprovision of public goods. Common Property The commodity is not excludable and hence not a private good. As a Resource result, each individual's consumption leads to an external cost to others, as it means that there is less for the others, as the property is rival. The situation incentivizes individuals to rapidly consume the common property without regard to scarcity. Thus, the marginal social cost is not taken into account in the use of the commodity, only the marginal private cost is. Incomplete The" full-information" assumption is violated. The actions of producers Information and consumers are not fully observable. Hence, there is incentives for both consumers and producers to mislead others and hence prices do not reflect all information. 3. Give an environmental example for each of the following: moral hazard and adverse selection. Explain carefully why they are examples of hidden information. Moral Hazard: The example in environmental economics is insurance against spills from oil tankers. Spills from oil tankers can happen accidentally. However, there are many ways to prevent such spills, such as training of staff and other precautionary measures. However, it is very costly. As a result, an insurance company in that field will not be able to make any profits, as oil tankers that are insured are not going to take all precautionary measures needed, and hence `accidental' spills will happen more frequently. Adverse Selection: The example in environmental economics is the vessel buyback programs. These programs are designed to reduce the number of fishing vessels. However, the vessels that are offered for a buyback are typically the ones that are already very old and possibly not used any more. 4. Letting consumers and producers be price-takers as well as utility/profit maximizers, carefully explain why the supply curve is equal to the marginal cost curve, and why the demand curve is equal to the marginal benefit curve. The supply curve of a producer reflects the quantity that the producer is willing to produce at a given price, or inversely the price at which the producer is willing to produce a given quantity. As a profit maximizer, given a price, he/she will produce up to the quantity where the marginal cost equals the marginal revenue, i.e. the price. As by convention, we draw the supply curve with quantity on the x-axis. The supply curve reflects the marginal cost at each quantity. Similarly, the demand curve represents the quantity, which the individual is willing to consume at a given price. As the consumers are utility/benefit maximizers, they will consume no more when their benefit from consuming an extra unit (marginal benefit) is less than their marginal cost (which is the price they are given). Hence, they consume the quantity at which their marginal benefit is equal to the price they are given. Thus, the demand curve represents the marginal benefit curve at each quantity. 5. The production of bubble gum exhibits the following social marginal cost (supply) curve, P=2+0.5Q, and the social marginal benefit (demand) curve is given by P=6-2Q. a. Assuming that all necessary conditions for efficiency is present in this market, find the price and quantity that maximize total net benefits, P* and Q*. Explain intuitively why P* and Q* maximize total net benefits. (Hint: what would be the marginal benefit and marginal cost if one extra unit beyond Q* was consumed or if one less unit of Q* was consumed .) Q*=1.6, P*=2.8. The marginal benefit at Q = 1.8 is 2.4, the marginal cost is 2.9. Hence, the marginal benefit is less than the marginal cost. It hence reduces total net benefits to produce more than 1.6 of bubble gum. b. Illustrate on a graph and compute total willingness to pay, total variable costs, producer surplus and consumer surplus. Total willingness to pay is 2.8*1.6+0.5*3.2*1.6=9.78. Total variable costs are 1.6*2+0.5*0.8*1.6=6.1. Producer surplus is 0.5*0.8*1.6=0.64. Consumer surplus is 0.5*3.2*1.6=2.56. c. Now assume that there is a negative externality that leads the social marginal cost curve to be P=3+0.5Q (the demand is unaffected). Before doing any mathematics, intuitively speaking, is the new efficient quantity, Q**, greater or smaller than Q* in part a? As there is a negative externality, it makes sense that Q* is greater than Q**. Intuitively, the private actors do not take the negative externality into account, they will produce more than the social optimum, Q**. d. Now compute P** and Q** that maximize total net benefits under the externality. Q**=1.2(<Q*), P**=3.6. The next four problems are based on the following Regulation vs. Market example: A city provides water to two households. Household one's demand for water is given by , where q is in gallons and p is in $/gallon. Household two's demand for water is given by 6. If the city charges $10/gallon, how much water will each household consume? How much surplus value does each household receive? . The city is going through a drought and must cut total water consumption by 60 gallons. Fearful of upsetting the households, the mayor argues against raising the price. Instead, the mayor wants to require each household to cut consumption by 30 gallons. 7. How much surplus value would each household receive? Would this policy result in an efficient allocation of water between the two households? The mayor's advisor suggests increasing the price of water in order to achieve the required 60 gallon reduction in total water consumption. 8. What would the new price need to be in order to achieve a 60 gallon reduction in consumption? How much surplus would each household receive? Would this policy result in an efficient allocation of water between the two households? 9. Would either household be better off under the advisor's policy? Could the city find a way to compensate the households in order to gain support for the policy? Answer: Depends on how the additional revenue is distributed! Under the mayor's plan, total revenues are: (10)(75) = $750. Under the advisor's plan, total revenues are: (50)(75) =$3750, or $3000 more. If the first household is given at least $1350 and the second at least $500, both will be better off under the advisor's plan and would leave $1150 more in revenues to either give both households or use on other things that would give the households at least that much additional surplus. ...
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