Econ 3545 Environmental Economics, University of Colorado, Fall 1998
Instructor: Vijaya Sharma
Midterm 1 (Sep 24, 1998) with answers
The test is worth 20 points. Attempt all nine questions. Be precise, no question should take more than a few sentences to answer. GOOD LUCK!
1. a. Define risk averseness.
b. Define resource value of an injured environmental resource.
2. a. Distinguish between point-source and nonpoint-source pollutants.
b. Distinguish between private costs and social costs.
3. a. What is "materials balance" concept?
b. What relationship does it imply among emissions to three environmental media- land, water, and air?
4. a. How would you theoretically measure a person's willingness to pay for an improvement in environmental quality?
b. Why can two persons living in the same community have different willingness to pay for the same improvement in quality?
5. a. How does the market output compare with the efficient level of output in the presence of negative externality?
b. Present the comparison clearly in a graph. 2 points
6. Use Figure 1 to answer this question.
a. What is L?
b. Which area(s) represents the total damages at E* level of emissions?
c. Which area(s) represents the total damages saved by reducing emissions to level E*?
d. Which area(s) represents the total cost of abating pollution to level E*? 2 points
7. State the equimarginal principle. 2 points
8. a. Explain the marginal productivity approach of choosing discount rate.
b.Which discount rate does this approach use? 2 points
9. A consultant has conducted benefit-cost analysis of a project for its both smaller scope (Scope A) and expanded scope (Scope B) and has presented the following summary.
Scope A Scope B
Total benefits (in thousand dollars) $1,000 $1,350
Total costs (in thousand dollars) $ 700 $1,000
Benefit-cost ratio 1.43 1.35
Net benefits (in thousand dollars) $300 $350
a. Scope A has higher benefit-cost ratio but Scope B has larger net benefits. Which scope (A or B) will you choose for efficiency reason? Explain 1 point
The consultant has also summarized the distribution of net benefits of the project.
Scope A Scope B
Net benefits to rich families (in thousand $) $ 80 $110
Net benefits to poor families (in thousand $) $220 $240
Net benefits per rich family
in thousand dollars $8 $11
as a % of family income 10.0% 13.8%
Net benefits per poor family
in thousand dollars $2.2 $ 2.4
as a % of family income 11.0% 12.0%
b. Which kind of vertical equity characterizes the distribution of net benefits in Scope A and in Scope B? 1 point
c. Which scope (A or B) will you choose in light of both efficiency and equity considerations? Present your argument. 2 points
Please return this test with your blue book.
Answer Key to Midterm 1, Fall 1998, Econ 3545
1 a. Risk averseness is avoidance of big risks. (1 point)
1 b. Resource value of an injured resource is the value of extractive uses and recreational uses lost due to injury. (1 point)
2 a. Pollutants whose source of emission can be easily identified are point-source pollutants, whereas pollutants whose source cannot be easily identified are nonpoint-source pollutants. (1 point)
2 b. Private costs are the costs of an activity borne by the decision maker, whereas social costs include private costs and also any other costs that are borne by persons other than the decision maker. (1 point)
3 a. The amount of materials (and energy) withdrawn from the nature or environment returns to the nature in the form of residuals to air, water, and land. In other words, "what comes in has to go out". This is because of conservation of matter.(1 point)
3 b. Given the same amount of materials withdrawn from the nature, reduction in the amount of residuals dumped to one medium means increase in the amount of residuals dumped to other two media. This is because the total amount of residuals is fixed and equal to the amount of materials originally withdrawn from the nature. (1 point)
4 a. A person's willingness to pay for an improvement in environmental quality is the area under the demand curve between the original and improved levels of quality. (Obviously, we are talking about the demand for environmental quality.) (1 point)
4 b. This can be attributed to differences in income and preferences. A few students on their answers have attributed this to free riding on environmental quality (a public good). Their answer assumes that the willingness to pay is measured from the demand curve observed in the market, which is not the true demand curve. (1 point)
5 a. In the presence of negative externality, market produces more than the efficient level.
5 b.
6. a. L is the threshold level of emissions below which there are no damages from emissions. (½ point)
6 b. Total damages at E* are measured by the area below the MD curve from L to E*, i.e., area c. (½ point)
6 c. Amount of damages saved by reducing emissions to E* (from U) would be the area below the MD curve, between U and E*, i.e., area (a+b). (½ point)
6 d. The total cost of abating pollution to level E* (from U) is the area below the MAC curve, between U and E*, i.e., area b. (1 point)
7. For minimizing cost of producing a given level of output, production should be allocated across plants such that marginal costs are equalized across plants. (2 points)
8. a. According to the marginal productivity approach, the rate of return of the resources in public projects must, on average, be equal to the returns in private projects. That is, discount rate in public projects should be the rate of returns in private projects. (1 point)
8 b. This approach suggests using the average of interest rates banks charge to their business borrowers. (1 point)
9 a. Benefit-cost ratio is a misleading criteria when it comes to choosing the scope of a project. Efficiency is the maximization of net benefits. Since Scope B has higher net benefits, it is more efficient than Scope A. Therefore, choose Scope B. (1 point)
9 b. Scope A has progressive equity and Scope B has regressive equity.
9 c. My objective in this question was to highlight a possible conflict between efficiency and equity. Scope B is efficient but has regressive distribution of net benefits, whereas Scope A is less efficient but has progressive distribution of net benefits. Although I expect you to choose Scope B, I have been open to your argument. I have not deducted any point even if you chose Scope A, unless you have been inconsistent or outrightly wrong in your argument. Let me explain my choice of Scope B.
Scope B guarantees larger net benefits, more than Scope A, to both poor and rich families. The regressive distribution of net benefits, measured as the percentage of income, does not deter me from recommending Scope B. Just for the reason that rich's share is higher as a percentage of income, I consider it unfair to deny poor families higher returns possible from B.
Also consider the possibility that both rich and poor may be getting the same improvement in environmental quality and yet rich's share of net benefits may seem higher because their willingness to pay is generally higher than the willingness to pay of the poor families. (2 points)