PS5_answers - Econ 131 Problem Set 5 1. Chapter 2 of the...

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Unformatted text preview: Econ 131 Problem Set 5 1. Chapter 2 of the textbook states that market failure in sustainable goods markets results from adverse selection (p. 25). Explain how government policy can address this issue and promote sustainable production. Due to the unobservability of the production process, consumers cannot differentiate between products that are produced in a sustainable way and products that are not. Hence, consumers are not willing to pay for the higher price of sustainable goods. The government can implement either one or both of the following policies: a. Subsidy to sustainable industries to allow them to compete in terms of prices with non- sustainable goods, b. Certification of sustainable goods to incorporate the information about the production process that is not observable. 2. The demand for printing paper on the Island of Trevia is represented by MB(Q)=5-0.5Q. The supply of paper from new raw materials is MC(Q)=0.5Q. a. What would the market allocation be? Under what conditions would it represent the social optimum? MB(Q)=MC(Q), hence, Qm=5, Pm=2.5. If there were no pollution and no damage from cutting down trees to produce paper, then the market equilibrium would be the social optimum. In practice, this is not the case. b. After many years of paper produced and ending in the landfill, the government realized that reusing the paper might be a good idea. One of the Trevian scientists found a way to recycle paper. The MC curve using this technology is MC(QR)=5+0.5QR. Assuming that only the government cares about sustainability and the consumers are indifferent between recycled and non-recycled paper, are the firms likely to adopt the new technology? And if not, how could the government promote sustainable production of paper? The firms would not switch to the new technology, as it is more costly than the technology in (a) and the consumers are not willing to pay more for sustainable goods. (To be more specific, letting MC(QR)=MB(Q), we have QR,m=0, i.e. if firms switched to the sustainable technology, there will be no quantity demanded and hence their surplus would be zero. Obviously, in (a) the firms had positive surplus equal to 0.5*2.5*5. Hence, it is clear that they would not have an incentive to switch to the sustainable technology.) In this situation, the government could subsidize the sustainable technology with a subsidy equal to $5 per unit of paper produced. c. Now assume that there is a sub-group of consumers that cares about sustainability with MB(QR)=10-0.5QR. How would your answer to (b) change? In this situation, there is a separate market for recycled paper with the market allocation defined by MB(QR)=MC(QR), Hence, QR,m=5, PR,m=7.5. The surplus for the firm is now 0.5*2.5*5, which is the same as in part a. Hence, firms would be indifferent between the two technologies. 3. Debt-for-nature swaps represent a mechanism to incentivize protection of nature in developing countries. What are likely difficulties in applying such a policy? Can you think of optimality criteria that you learnt in this class that can inform policy in this context? The main difficulty of such policies is that they rely heavily on the estimation of benefits and costs that are hard to measure, including willingness-to-pay, willingness-to-accept, and existence values. It is also likely that each country, whether the developed or developing country, could have different estimates for the same quantities. One can think of this policy as a project and implement similar efficiency criteria. For the developed country, the benefit from preservation, which can be measured in terms of total willingness to pay, should be greater than or equal to the total cost from preservation which is equal to the discounted stream of debt that is forgiven, i.e. net benefits should be greater than or equal to zero. As for the developing country, the benefit from preservation, which is the discounted stream of debt that is forgiven, should be greater than or equal to the total costs from preservation, which comprises the loss of earnings potential for individuals in related industries. 4. A large rainforest spans two bordering countries (country A and country B). Both countries have the option of cutting down a portion of the forest within their respective borders in order to use the land. Country A is a developed country that has a low marginal benefit of additional deforestation. The marginal benefit (in thousands of dollars) to country A for each 1000 acres of forest cut down within its borders is given by , where x is in thousands of acres deforested in the country. Country B is a lesser developed country which depends heavily on the timber and land made available through deforestation. The marginal benefit, in millions of dollars, to country B for each thousand acres of forest removed within their borders is given by . Assume the private marginal cost of clearing the forest in both countries is equal to $20,000/thousand acres of forest cleared. a. In the absence of any regulations on deforestation, what will be the equilibrium quantity of forest cleared in each country? Both countries will individually set their MB equal to the private MC: A study is done to estimate the true social cost of deforestation. The study finds that the citizens of Country A place a large value on forest preservation. The study finds that the citizens of Country A are willing to pay to preserve an additional 1000 acres of forest land (in either country). Assume that the WTP to avoid deforestation in Country B is found to be equal to zero. b. If Country B continues to remain at their competitive equilibrium level of deforestation, what level of deforestation in Country A will maximize the welfare of the citizens of Country A? The WTP to avoid clearing any extra acres of forest (beyond the 160 being cleared in Country B) will always exceed the (MB MPC) in Country A. Therefore, the optimal level of deforestation in Country A is zero acres. c. Suppose Country A outlaws cutting down the forest within their borders. What is the total surplus for Country A under this policy? How much does the policy increase (or decrease) total surplus for Country A (compared to the total surplus that would be obtained by remaining at the competitive equilibrium level of deforestation)? If they remained at the competitive equilibrium level of deforestation in Country A, the total economic surplus for Country A would have been equal to the total surplus from the extra land minus the total willingness to pay to avoid having 190 thousand acres cleared. The TES is shown below (in thousands of dollars): By outlawing deforestation in Country A, the TES in Country A will now only be the loss incurred by having 160 acres cleared in Country B. The TES in this case is shown below: Therefore, the ban on clearing forest area in Country A increases the total economic surplus in the Country by $2,175,000. Suppose in addition to the above regulation, Country A offers the following subsidy to Country B. Country A will pay Country B a subsidy of "s" thousand dollars for every thousand acres of deforestation reduced in Country B. d. What level should Country A set the subsidy in order to maximize the total surplus for Country A? Country A should pay Country B to reduce the level of deforestation in Country B up to the point where the WTP of Country A to save any additional forest land exactly equals Country B's willingness to accept for preserving additional forest. The optimal level of forest to be cut down in Country B is solved for below: When Country B cuts down 80 thousand acres, the WTP of country A to preserve an extra unit of forest equals the marginal gain Country B would receive from clearing an additional unit of the forest (WTP = $40 thousand dollars/thousand acres). Therefore, the optimal subsidy is $40,000/thousand acres. e. What will the total surplus be for Country A at this new optimal level of deforestation? (Hint: you need to consider the subsidy payment being transferred to Country B.) The total economic surplus for Country A when the ban on deforestation and the subsidy are both used is equal to the loss from having 80 thousand acres cleared in Country B minus the subsidy payment to Country B. The TES (in thousands of dollars) is shown below: 5. In the previous question, a developed country subsidizes forest preservation in a lesser developed country. Is this result consistent with the Kuznets Curve presented in chapter 6 of the text? Explain. The Kuznets Curve theory states that as the wealth of a country initially increases, the environmental quality will decrease. As income per capita continues to grow however, there comes a point where this relationship reverses as the public places a greater relative value on the environment. This theory does fit the description in the previous question. The wealthier, more developed Country A is taking steps to improve environmental quality while the lesser developed Country B is degrading the natural environment. ...
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This note was uploaded on 12/09/2009 for the course ECON 131 taught by Professor Groves during the Fall '09 term at UCSD.

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