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PS7AnswerKey - Econ 131 Problem Set#7 Question 1 In the Island of Trevia the textile industry dumps pollutants into the river(a The Ministries of

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Unformatted text preview: Econ 131 Problem Set #7 Question 1 In the Island of Trevia, the textile industry dumps pollutants into the river. (a) The Ministries of the Economy and the Environment conducted a study to estimate the MB and MC of water pollution. You are an advisor to both ministries and are asked to help them use the studies to determine the optimal level of pollution. To determine the optimal level of water pollution, Q*, we have to equate the estimated MB and MC of pollution. (b) Now that the optimal level of pollution is determined, both ministers ask you to recommend a policy to achieve the optimal level of pollution. (i) Which policy (or policies) would achieve the optimal level of pollution in the least costly way if all firms in the textile industry are identical? If all firms are identical, then this means that there MAC curves are the same. Hence, a command and control policy that makes each firm produce Q*/N units of pollution would be equivalent in terms of abatement costs to a tax policy (where t*=MC(Q*) from part a) or cap and trade policy (where total number of permits equal Q*). (ii) If you mentioned more than one policy in (i), would you recommend a specific one in terms of dynamic efficiency? The tax policy and cap-and-trade policy are dynamically efficient, the common-and- control policy is not . (iii) How would your answer change in (i) and (ii) if all firms in the textile industry were not identical? If firms were not identical, then the answer to (i) would be the tax policy or the cap-and- trade policy only. When firms are not identical, command-and control does not minimize abatement costs. The answer to (ii) would not change. (iv) How would your answer change in (i) and (ii) if you know that the estimated MB and MC curves may be measured with a lot of error? If the estimation error is likely to be large, then it is better to stick to the cap-and-trade policy and to hold a portion of the permits to regulate the market. Question 2 If a country has two sources of energy, one is depletable, A, and the other is renewable, B. (a) If the country is only using resource A, when is it going to switch to resource B? It will switch to resource B, when the MC of extraction of resource A is greater than or equal to the MC of extraction of resource B. (b) Assume the marginal cost of extracting of resource A is constant, is the country going to switch before or after resource A is depleted? It will switch to resource B after the depletion of resource A, as the fact that resource A is being used means that its MC of extraction is less than resource B. Hence, if the MC of extraction of A is constant, then it will never be greater than MC of resource B. (c) Now assume that the marginal cost of extraction of resource A increases linearly, how is the switch point in this case compare to the switch point in part (b)? It depends on the MC of extraction of resource B and the slope of the MC of resource A. However, it is likely in this case that the switch point will happen before the depletion of resource A. (d) Now assume that the marginal cost of extraction tends to infinity the reserves of resource A tend toward depletion, is the switch point from resource A to resource B going to be before the depletion of resource A or after? In this case, the switch point will definitely be before depleting resource A. Question 3 Hotelling's model of resource extraction predicts that the real price per unit of a non-renewable resource in a competitive industry will change over time according to the following equation: . If we look at the real price of crude oil over the past 40 years, the price has not increased as the Hotelling model predicts. Instead, the price has moved around an average of $35/barrel (2008 dollars). Over the same time, technological improvements have reduced the cost of extracting oil from the ground. Could advances in extraction technology have prevented the price of oil from steadily increasing over the past 40 years? (Hint: how would extraction technology advances impact the MC in the above equation?) Yes; reductions in extraction costs would work to prevent the price from increasing over time. . Therefore, if improvements in extraction Solving for P2, we get technology reduce the MC of extraction (MC2 < MC1), the price in period two will be decreased. Question 4 According to an IEA official, "One day we will run out of oil. It will not be today or tomorrow, but one day we will run out of oil." What is wrong with this statement? (Hint: what will happen to the price and quantity demanded of oil as it becomes scarcer?) The problem with this statement is that it ignores the possibility of switching to backstop technologies (renewable energy sources for example). As the amount of available oil continues to decrease, the marginal cost of extracting additional oil will be driven up. As the marginal cost of extraction increases, the price of oil will increase. This will lead to an increase in the demand for alternative sources of fuel. Therefore, a switch will be made towards using a backstop technology before all of the available oil is used. Question 5 Fossil fuels (coal, natural gas, oil) are the most common sources of energy. When these fuels are burned, harmful pollutants are emitted into the atmosphere. Chapter 14 of the text describes the following three broad methods for reducing the amount of pollution emitted: 1) change the economic incentives, 2) expand technological options, and 3) information programs. Describe each method and provide an example of a specific policy for each option. 1) Changing the economic incentives involves changing the relative prices of different forms of energy. For example, a tax could be placed on fossil fuels. Alternatively, a subsidy could be placed on the use of renewable fuels (or on the reduction of fossil fuel use). 2) Expanding the technological options involves increasing the set of alternative sources of fuels as well as reducing the costs of generating energy from alternative sources. For example, a government can support research and development of renewable energy generation through research subsidies or tax breaks. 3) Information programs aim to reduce the use of fossil fuel by providing information on methods to increase energy efficiency. For example, the Energy Star program provides information to consumers on which appliances require the least amount of energy to run. ...
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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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