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Unformatted text preview: EEP 101/Econ 125
GSI: Diana Lee and Biswo Poudel
Spring 2010 Problem set 3
Due Thursday, April 15th at lecture
Late problem sets will not be accepted. 1. Natural Resources Suppose lolli—trees grow in Lolli—land with a growth rate given by G (st) = st— 18—620 where
s is the stock of lolli—trees and t is measured in years. Lolli—trees produce lollipops and
are therefore highly desired by the candy—loving residents of Lolli—land. One harvested
lolli—tree sells for a market price of 5 dollars. The is a ﬁxed cost of harvesting lolli—trees
equal to 100 dollars, but variable costs decrease with the size of the stock, at the rate
of —s so that the total cost of harvesting is given by T0 = 100 — 3. Finally, Lolliland
is in a boom period with a relatively high interest rate of 5%. (a) Suppose Chucky, the mayor of Lolli—land, realizes that lolli—trees are on the brink
of extinction due to a series of severe droughts over the past few years. There
are currently only 10 lolli—trees left in Lolli—land. Chucky decides to enforce a ban
on any lolli—tree harvesting and allow lolli—trees to return to their natural steady
state. Find the growth rate G and stock 3 that would be the long run result of
Chucky’s policy. The natural steady state occurs when the stock is at its carrying capacity. This
is because at that point, there is zero net growth and thus the stock remains the
same size from year to year. To ﬁnd this, we set the growth equation equal to zero and ﬁnd the maximum stock that makes it zero.
2 s—ﬁszo
3:0,100 Thus, at the carrying capacity, 3 = 100 and G = 0. 1 (W Calculate the number of years t that it would take for the lollitree orchard to
reach its carrying capacity. (You can round the growth rate for each year to the
nearest integer.) To do this question, you should consider the growth of the orchard each year and
iterate until the stock grows until 100. Time Beginning stock st Growth: C(st) 2 st — % Ending stock: 8,; + C(st) 0 10 10—%ﬁ=:9 10+9=19
1 19 1 ——%i==15 19—15=34
2 34 34—%%==22 34—22256
3 56 56——%g?==25 56+25=81
4 81 81— gig ==15 81——15==96
5 96 96—§i9==4 96—42100 Thus, at the end of 6 years (counting year zero), the orchard will reach its carrying
capacity at 100 trees. Suppose now that Angelica runs a ﬁrm interested in harvesting lolli—trees. Find
the optimal number of trees that she would sell each period. Set up the proﬁt maximization. Proﬁt is given by: «=5Q—ﬁQ—ww0—g
Taking the derivative we have g=5u—§Q+1=0 5—§+1=0
62%
3:60 The number of trees she will sell is given by the harvest, so we need to plug back
into the growth equation. Gmm=6o—%=24 Angelica wants to harvest every period because she can do so sustainably and
make a proﬁt. She tells Chucky that she will go ahead and do so unless he pays
her enough now to compensate her for all her proﬁt both now and in the future
(into eternity). Calculate the amount that Chucky must pay Angelica to meet
her demand. Let’s calculate the proﬁt she would receive each year if she did what was optimal. 7r=5*24—(100—60)=120—40280 We can use the formula for an annuity (same as perpetuity in this class) where
NPV=§. Here x is our yearly proﬁt. NPV— 0—835 — —1600 After calculating this amount, Chucky decides that he is not willing to pay such
a large lump sum to maintain his desired level of lolli—trees. He decides instead
that he is willing to allow the stock of lolli—trees to decrease to 90% of its carrying
capacity and thus allow Angelica to harvest some trees each period. He does so
by levying a tax on Angelica. Calculate the tax per harvested tree required for
Angelica to maintain a steady state at 90% of the carrying capacity. (Hint: a
tax per tree effectively lowers the price received per tree and will thus change the
proﬁt maximization equation.) Again, let’s set up the proﬁt equation while putting in a tax. 52 7r— — 5(5 — W)_ (100 — s) — t(s — W) 7? = (5 — t)(s — ﬁzo)— (100 — 8) Taking the derivative we have s=(5—t><1—a)+1=o Recall that Chucky is using the tax to change Angelica’s optimal stock to 90. So
we can plug in s=90 to solve for the tax that will do so. (5—t)( —%)+1=0 (5 — t)(50 — 90) +50 2 0 (5 — t)(—40) + 50 = 0 40t—200+50=0 40t= 150 t* = % =3.75 Phil and Lil have invented a new technology that has a ﬁxed cost of 200 dollars but
changes the marginal variable costs to —23. Determine whether or not Angelica
will adopt the new technology if she decides based solely on the proﬁts for one
period. Recall that using a new technology may change the optimal stock that Angelica
chooses, so we must ﬁrst calculate the new optimal stock. The ﬁxed cost of 200
replaces the old ﬁxed cost of 100. Set up the proﬁt maximization. Proﬁt is given by: 7r— — 5(3 — F20)_ (200— 23) Taking the derivative we have
d—g=15(1——)+2=0 5 — — :+ 2— — 0 7— _ s— — 70 C(70) :70—49:21
7r=5*21—(200—2*70)=105—60=45 wold = 80 > mew = 45, so Angelica will not adopt the new technology. (g) Interested in pushing their product, Phil and Lil try to convince Angelica that
she should adopt the technology because its beneﬁts extend to future periods
in addition to the current period. In particular, the ﬁxed cost only has to be
paid once but the change in variable costs apply to every period. Assuming
that Angelica can continue to harvest every period into eternity, calculate the
maximum ﬁxed cost that Phil and Lil can charge for their technology and still
ensure that Angelica will adopt. (Hint: Use the difference in present values of the
proﬁt streams for the old and new technologies.) The maximum ﬁxed cost they can charge is the difference in long—run proﬁts
between the new and old technology. I calculate the case here where the ﬁxed
cost is only paid once for both the new and old technology but gave you credit if
you assumed otherwise and did the calculations correctly. NPV(7Told,nofc) — 100 = NPV(7rnew,nofc) — F0 7l—oldﬂwfc : 80 ‘l’ 100 = 180
7rn6’w,nofc : 45 ‘l‘ 200 : 245
NPV(7rold,nofc) = ﬂ = 3600 .05 NPV(7rnew,nofc)% = 4900 Plugging into the formula above,
3600 — 100 = 4900 — F0
F0 2 1400 2. Short Answer Questions (a) The above ﬁgure illustrates the price trajectory of a nonrenewable resource under
two difference interest rates. For the curve associated with TI, explain why the
price trajectory has the shape that it does. With non—renewable resources, price represents scarcity. The upward curve is
associated with a nonrenewabe resource where there is no recycling or new dis
coveries over time. With mining, the resource becomes more scarce over time,
thus causing the price to rise. The exponential shape of the curve is the result
of Hotelling’s rule, which states that the price must rise exactly with the interest
rate for the most efﬁcient use of the resource. From the graph above, determine whether r1 > r2 or r1 < r2. Explain. r2 > T1. This is because higher interest rates mean that the present is worth more
than the future (since the NPV of the future is less with a higher interest rate).
Thus, under the higher interest rate, more will be harvested now (relative to the
lower interest rate), resulting in a lower price since there is more available. With
more harvest now, though, the stock decreases more quickly and thus the price
rises more quickly. In ﬁsheries, we sometimes get what is called a backwards bending supply curve.
This is because, after a certain point, to increase the catch of ﬁsh, we end up
overﬁshing and depleting the stock of ﬁsh. This thus makes catching ﬁsh harder
and harder, which explain why the backwards bending portion shows an increase
in costs with less and less quantity. With the given supply curve, it is possible for a monopoly to produce a higher
market quantity than the competitive equilibrium? If so, graphically construct
such a case. If not, explain why not. Yes, it is possible. See graph below. Note, this occurs because the monopoly only
cares about maximizing proﬁt. When we are maximizing proﬁt, he is taking into
account the trade—off between price and quantity. By lowering its quantity, it can
raise the price, but when it lowers its quantity, it will sell less. Normally, it is
worth lowering the quantity because the gain in price more than makes up for it.
In this case, though, the monopolist actually increases its revenue by increasing
its quantity. Because of the backward bending shape of the curve, it can increase
its quantity by a large portion without lower the price very much at all. ...
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 Spring '11
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