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Mid-Term Exam Review

Mid-Term Exam Review. API 135/Econ 1661 March 5, 2011 Liz Walker. Agenda. Tips and reminders for test day Study recommendations Overview of material Practice Problems Conceptual Problems Q&A Appendix: other practice problems for your reference or our discussion, time pending.

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Mid-Term Exam Review

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  1. Mid-Term Exam Review API 135/Econ 1661 March 5, 2011 Liz Walker

  2. Agenda • Tips and reminders for test day • Study recommendations • Overview of material • Practice Problems • Conceptual Problems • Q&A • Appendix: other practice problems for your reference or our discussion, time pending

  3. Test Tips and Reminders • Show up early! Bring a calculator, straight-edge, and pencil • Make sure you can recreate the graphs/models • Know all the labels • Know what you are graphing and label points • Demand? • Inverse Demand? • Net Marginal Benefits? • Present Value? • Write out the intuition • Know and use the vocabulary • Re-read the question and make sure you answer all parts

  4. Study recommendations • Take the 2009 Practice Mid-term without reference to your notes • Read Section Handouts if you did not go • Re-do your problem sets • Re-read class notes

  5. Outline of Content • Fundamentals • Welfare Economics • NPV • Estimation Methods • Costs • Benefits (more focus here) • Natural Resources • Non-renewable • Renewable

  6. Fundamentals: Externality • Environmental pollution is an externality • Occur because many environmental amenities exist outside of markets • One individual or firm doesn’t feel the full costs (or benefits) of his or her actions • Others are thus impacted by activities outside of their own control, without compensation • Examples: air/water , trash, noise • We use welfare economics to measure the costs and design policies to correct externalities • This is why we consider government interventions

  7. Fundamentals: Resource types

  8. Fundamentals: Welfare Economics • Economists measure social welfare in terms of costs and benefits • We aim to design policies which maximize net benefits to society • Marginal costs are the costs of the last unit • When there are externalities, markets fail to achieve efficiency Benefits (avoided damages) Marginal Benefits

  9. Fundamentals: Negative Externalities Increase Marginal Costs (one example) With externalities, we see total social marginal costs greater than private marginal costs Social Marginal Cost Demand (Marginal Benefits) Private Marginal Cost

  10. Fundamentals: Evaluating Welfare • Pareto Criterion: A policy change is an improvement if at least some people are made better off and no one is made worse off • Kaldor-Hicks Criterion: world is made better off overall (welfare improvement) if size of gains and size of losses are such that gainers could fully compensate losers and still be better off (“potential Pareto Improvement”) • Kaldor-Hicks is more useful, rules out net negatives • Kaldor-Hicks is a necessary condition for satisfying the strict Pareto Criterion • More modest criteria is cost effectiveness: minimizing costs because can’t measure benefits

  11. Example: Evaluating Policies • Pareto Criterion: A policy change is an improvement if at least some people are made better off and no one is made worse off • Pareto Optimality: No other feasible policy could make at least one person better off without making anyone else worse off • Think of this as referring to society Possible Payments to Adam and Beth Which satisfy Pareto Criterion? Beth’s Payment • Policy A does • Policy B does not • Policy C does not • Policy D does • All policies in light gray triangle $100 Policy B Policy D Which satisfy Pareto Optimality? • Policy A does not • Policy B does not • Policy C does • Policy D does • All policies on feasibility frontier (because nothing “better” from there) Policy A Policy C $25 Status Quo Feasibility Frontier Adam’s Payment $25 $100

  12. Fundamentals: The Coase Theorem • Idea is that we can assign property rights such that individuals can bilaterally negotiate regarding an externality between the generator and the recipient • These negotiations will then lead to an efficient outcome regardless of the initial assignment of property rights • Conditions: • No transaction costs • No income effects • No third-parties • Allocation of property rights may impact distribution of costs and benefits

  13. Fundamentals: Net Present Value • To achieve dynamic efficiency (multiple time periods), undertake policy with highest net present value • Key formula: • T could be anything from one (two-period case) to infinity • If all policies have negative NPV, keep the status quo • Discount rate should reflect social opportunity cost (same as interest rate in many examples) • This is much preferred to B/C ratios – we’ll discuss why!

  14. Fundamentals: Equivalent Annual Net Benefits

  15. Costs: Conceptual • The economic cost of an activity is the value of whatever must be given up for the activity (opportunity cost) • Opportunity cost typically exceeds monetary outlays • Transfers between members of society, such as taxes paid by firms or individuals to governments, should not be counted as costs • Any social deadweight loss from regulation/ taxation and any labor costs to collect and process taxes, however, should be counted

  16. Costs: Example of Social Welfare Costs • Losses in consumer and producer surplus from increased marginal cost across regulated industry • Always draw out graph on the left and then shift Welfare Effects of Industry-Wide (Flat) Increase in Marginal Cost Price Price MC1 = S1 D D CS1 MC0 = S0 MC0 = S0 CS0 P1 P0 P0 PS1 PS0 Quantity Quantity Q0 Q1 Q0

  17. Costs: Methods and Elasticity • Methods • Direct Compliance Cost Method • Partial Equilibrium Analysis (behavioral response) • General Equilibrium Analysis • Want to know how consumers and firms will react to changes in prices for the good/service regulated • Depends on price elasticity of supply and demand • Elasticity = % ΔQ/% ΔP = (ΔQ/Q)/ (ΔP/P) = (ΔQ/ΔP)*(P/Q) = (1/Slope)*(P/Q) • Lower slopes have higher elasticities, greater the behavioral response to regulationsand greater the social welfare cost.

  18. Costs: Estimation Methods • Direct Compliance Cost Method • Sum up compliance costs obtained from engineering estimates, and multiply by quantity, then possibly add government administrative costs • Assumes no behavioral response • Least expensive method of cost analysis • May be appropriate when elasticities (behavioral responses) are small or compliance costs (and price increases) are small • Partial Equilibrium Analysis • Look at effects on supply and demand in affected market • Incorporates behavioral responses • But assumes that effects of regulation are confined to one market or a few • General Equilibrium Analysis [necessary for power, climate change] • Look at effects on all sectors of economy • Complex and expensive, but may be necessary if regulating a key industry • Two principal approaches: input / output (I/O) models and computable general equilibrium (CGE) models

  19. Benefits: Conceptual Measures for Environmental “Goods” Marginal Willingness to Pay (MWTP) = Demand=MB Measures for Environmental “Bads” Marginal Willingness to Accept (MWTA) Why might these not be equal? **Sum of the area under demand curve is WTP

  20. Benefits: Types of Use Use Value • Benefits from using a good or service Non-use Value • Option Value • Benefits people receive from having the option to use the good or service in the future • Existence Value • Benefits people receive from knowledge of the existence of goods or services

  21. Benefits: Empirical Estimation Methods Revealed Preference Methods • Uses individuals’ observed behaviors in markets to infer their WTP for environmental goods • Preferred by economists for USE value • Examples: Travel Cost (Hotelling-Clawson-Knetsch), Hedonic Property Value or Hedonic Wage Stated Preference Methods • design surveys • Only choice for non-use value • Examples: Contingent valuation, contingent ranking Experimental Methods • constructed market, choice real, context artificial ** See handout online. It’s actually LECTURE 8 PAGE 11

  22. Benefits: Other Methods • Averting behavior = change in behavior to lower risk • Based on perceived, not actual • Applicable to morbidity risk • Hard to separate risk-reduction from other benefits • Difficult to get good data on • Societal revealed preference • Infers benefits from costs of previous regulatory actions • Requires people voluntarily taking the action, paid costs, B>C • No basis in economic theory - not revealed preference • Cost effectiveness comparison • Cost of illness • Does not estimate WTP/WTA but change in explicit market cost

  23. Warning: “Avoided Cost” is NOT a benefit estimation method Let’s discuss an example: • The City of Miami, Florida proposes to invest in a new water reservoir for its public water system, and estimates its cost. To justify this substantial expenditure of public funds, the Mayor explains that if the new reservoir is not constructed then the next most costly way to increase Miami’s water supply will be to invest in a desalinization plant, which will be even more expensive. Hence, the Mayor explains, the social benefits of building the new reservoir clearly exceed its social costs. There are no environmental or other externalities involved with either alternative. How would you assess this reasoning from an economic perspective? ** This is incorrect because it ignores demand for the public good (water), i.e., water’s real benefits to the society.

  24. Benefit Estimation I: Travel Cost Method • This is a type of revealed preference • Step 1: Plug in any missing variables: visitors, visitation rate, population, (will have travel cost) • Step 2: Plot travel cost (y) vs. visitation rate (x) • Step 3: Pick one location. Replace TC with TC + Fee. Plug in TC value. Replace VC with # visitors. Now you have visitors as a function of Fee. That is demand. • Step 4: Repeat for other origins. • Step 5: Aggregate curves (see next pages). Can calculate surplus/value as area under sum of curves.

  25. Benefit Estimation I : Aggregation of Demand Curves (Private Goods) Algebraically, it is QT = 200 – 2P Note: The algebra and the graph won’t be this simple if demand functions are different Let’s say Q is a private good. Person 1 demand for Q is: Q1 = 100 – P Person 2 demand for Q is : Q2 = 100 – P So, what is the aggregate market demand for Q?

  26. Benefit Estimation I: Aggregation of Demand Curves (Public Goods) Now assume Q is a public good (non-rivalrous and non-excludable) Does that change how we aggregate demand curves? Algebraically, it is P= 200 – 2Q You work with inverse demand curve

  27. Benefit Estimation II: Hedonic pricing models • This is a type of revealed preference • These models use attributes of market products, including environmental attributes to explain variation in product prices • P = f (x, z, e) • P: price of market product (e.g., house) • x: vector of non-env. product attributes (e.g., lot size, bedrooms) • z: vector of non-env. local attributes (e.g., crime rate) • e: environmental attribute (e.g., local air pollution) • Marginal implicit price of environmental attribute or marginal willingness to pay for environmental attribute:

  28. Issues with hedonic pricing models • Simultaneity: Prices are determined by both supply and demand, but these models treat supply as exogenous (i.e., unaffected by environmental attributes). If supply is elastic, then could also see an increase in available land. • Selection: Individuals differ in their tolerance of negative environmental attributes. Those most tolerant of pollution will be located in dirty areas. • Information: Individuals’ perceptions of environmental attributes may differ from measurements. • Omitted variable bias: Coefficients are too large or small if an explanatory variable associated with the dependent variable and correlated with other explanatory variables is left out • Scope: Relatively narrow range of applications

  29. Benefit Estimation III: Contingent valuation • This is a type of stated preference • Use carefully designed surveys to elicit value individuals place on a change in environmental quality or service • This is hypothetical elicitation • Can be used when revealed preference methods aren’t possible and to elicit non-use value • Issues/problems with CV • Information: Respondents may not know much about the environmental amenity or service or the change • Hypothetical bias: Respondents may not give accurate values because the payment or acceptance is hypothetical • Strategic response: Respondents may not give accurate values because they want to influence environmental policy • Anchoring: Responses may be sensitive to starting points • Warm glow: Respondents may give accurately high values to make themselves feel good about their environmentalism

  30. VSL Calculations • Convention to measure small risk changes (our valuation of risk is non-linear) • NOT constant over different baselines or over different incremental changes • Does not mean that an individual would pay $6 million to avoid (certain) death this year, or accept (certain) death this year in exchange for $6 million • Does imply that a large number of similar people would together pay $6 million to eliminate the risk that is expected to kill one of them randomly this year

  31. Natural Resources: Renewable and Non-renewable • Renewable resources can be naturally replenished • Solar energy, surface water (generally) • Non-renewable resources have replenishment rates so low that we can ignore them • Often classify based on current stock, potential reserves, total resource endowment ** McKelveyDiagram of Resource Stocks is a great resources (only if you are interested, not critical for exam). Find on Lecture 9-10 or Page 136 of Tientenberg.

  32. Example: Standard Non-Renewable Resource Problem (overview) • Premise: We have some resource that is non-renewable and non-recyclable. We want to allocate extraction of that resource between now and future dates. Production today precludes production in the future. • Goal: Maximize Net Present Value of net Benefits (dynamic efficiency) • Strategy: For two period case we solve equation below.

  33. Example: Standard Non-Renewable Resource Problem (set up) What we’re given: P = 8 – 0.4q (inverse demand function) MC = 2 r = 0.1 Traditional static solution (abundant): MB=MC 8 – 0.4q = 2 6/0.4 = q = 15 Complication: - We now have two periods and only 20 units! • How do we divide over the two periods? • Calculate NPV of MNB and equate P 8 MB MC 2 Q 20 0 q*1 = 15

  34. Example: Standard Non-Renewable Resource Problem (approach 2-period) Step 1: Write down marginal benefits in each period. Demand Function: q(p) MB= Inverse Demand Function MBt=inverse of Dt in that period NPV(MBt)=(MBt)/(1+r)t PV(MB1)=p(q1)= 8-0.4q1 PV(MB2)=p(q2)/(1+r)t = [8-0.4q2]/(1+0.1) 1 ** Note: one period difference

  35. Example: Standard Non-Renewable Resource Problem (approach 2-period) Step 2: Identify marginal cost function in each period (Note: only use MEC to calculate PVMNB!! Then solve for MUC implicitly.) MC = MECT + MUCT Marginal extraction cost (MEC) Marginal user cost (MUC): “scarcity rent” (discuss in a few slides) Step 3: Calculate present discounted value of marginal net benefits for each period, and set equal using total quantity as a constraint. PV(MNB1) = MB1 – MEC1 = 8 – 0.4q1 - 2 PV(MNB2) = (MB2 – MEC2)/(1+r)t = (8 – 0.4q2 – 2)/(1.1) Q = q1 + q2 = 20 6-0.4q1 = 5.45-0.36(20-q1) q1 = 10.23 q2 = 9.76

  36. Example: Standard Non-Renewable Resource Problem (graph 2-period) Step 4: Draw the PDV of marginal net benefits in each period on the same graph. Base case: r = 10% Stock = 20 PV of Marg. Net Benefits In Period #1 6 PV of Marg. Net Benefits In Period #2 5.45 Marginal Net Benefit in Period #2 Marginal Net Benefit in Period #1 q1 0 20 15 10 0 q2 20 15 10 q1= 10.23 q1= 9.76

  37. Calculating Marginal User Cost • Marginal user cost is: • opportunity cost of forgone future consumption • the opportunity cost of extracting a unit of the resource in one period instead of leaving it in the ground until the next period • additional marginal value of a resource due to its scarcity ** Note that when we initially solve the problem, we ignore MUC. These are rents due to the price above the equilibrium price that we can charge. You solve out for this at the end P – MEC = MUC ** Price Demand MUC1 p1 MEC q1

  38. Example: Standard Non-Renewable Resource Problem (changes to base case) • What happens when you increase the discount rate, r? • Intuitively: Higher discount rate means you are reducing the net benefit of extracting in period 2 (get relatively more from cash now). Thus, you extract more now and less in period 2. Because q1 goes up, p1 goes down. MUC1 will decrease and MUC2 will increase • Algebraically: PDV[MNB2]= (p(q2)-MEC2)/(1+r) Consider r’>r • MNB2 and MNB2’ • MNB2 = (p(q2)-MEC2)/(1+r) • MNB2’ = (p(q2)-MEC2)/(1+r’) • MNB2> MNB2’

  39. Example: Standard Non-Renewable Resource Problem (changes to base case) Graphically: r’> 10% PV of Marg. Net Benefits In Period #1 6 5.45 PV of Marg. Net Benefits In Period #2 with r PV MNB2 with r’ 5 20 q1 0 10 15 q1 q1’ q2 20 10 q2 q2’ 0

  40. …what happens to price and MUC? (r’>1) Period 1 Price Demand - We can see from the graph that a fall in the price in period one would result in a lower marginal utility cost MUC1 MUC1’ p1 p1’ MEC Quantity q1 q1’ q1 < q1’ So p1> p1’ So MUC1> MUC1’ Reminder: MUC= P - MEC You all can do the same thing for period 2 tomorrow and come to my office hours if you have questions!

  41. Other changes you should consider 4. What happens when demand goes down in period 2? (analogous to #4 on problem set 2) p1 = 8-0.4q1 p2 = 6-0.4q2 We can talk through this one! 3. What happens when the marginal extraction cost goes down in only the second period? (e.g., due to improved technology) Example: MEC1 = 2 in period 1 MEC2 = 1 in period 2 Interest rate is still r = .1 Check out Robyn’s section notes for the answer to this one!

  42. …still more changes you should consider 4. What happens when the marginal extraction costs is lower in both periods? 5. What happens when demand in period two is greater than indicated above, but demand in period one is unchanged? Both of the above are on sample mid-term online. We can discuss together.

  43. One final reminder: don’t forget to discount • Changes in period two are discounted! • Therefore if MEC for example changes by $1 in both periods, that’s a change of $1 in period 1 but a change of $1/(1+r) in period 2. • So if r = 10%, the change in period 2 is only $1(1.1) = approximately 91 cents in present value terms • Think: how do we show this change on the graph? (Hint: In calculating MNB)

  44. Summary of implications At the dynamically efficient allocation of a non-renewable resource with constant MEC: • Hotelling’s Rule: the MUC rises over time at the rate of interest (the opportunity cost of capital) • Assumes a model of constant MEC, private competitive owners of non-renewable resource • Formula: • Extraction decreases over time (more clear in n-case model) • Scarcity is a value concept, not a physical one. A resource is scarce if the difference P − MC (= SCARCITY RENT) is large.

  45. N-period case • MUC rises as long as MEC constant • Will gradually deplete the resource

  46. Transition to a Substitute • When total Marginal Cost of good one reaches that of good two, then transition occurs • Transition is smooth

  47. Non-renewable resources (if time) Problem Set 2, Number 3: During the consideration in Congress in 1991 of a comprehensive energy act, the debate included many references to "America's excessive dependence on foreign oil." Is there a reasonable need for public policy to address our "dependence on foreign oil," or will the market-generated mix of imports and domestic production provide the appropriate balance in this area? Why, why not?

  48. Renewable Resources • Below MVP, growth rate < yield rate so that stock declines • Above MVP, then growth rate > yield rate so that stock increases • Logistical growth

  49. Renewable Resources • Assumptions to simplify analysis/graphs: • Price/fish constant over all catch levels • ConstantMC of fishing effort • Quantity of caught proportional to existing stock • Ec= as long as Total Benefits are greater than total costs-- competitors will enter the market: why? • EMSY = maximum sustainable yield • Ee = Efficient effort that maximizes Net Benefits: MB=MC

  50. Renewable Resources: Market exploitation under open access • In an open-access fishery, the rent is a stimulus for new fishermen to enter • As long as TB > TC competitors will enter the market • Under open-access, there will be an inefficient level of effort: • Effort will increase until TB=TC • Economic and biological overfishing • Rents dissipate entirely Total cost Total benefits (total revenues) Competitive equilibrium under open access

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