1. What is consumer surplus? consumer surplus (per unit) is the difference between the maximum willingness to pay, and the price
actually paid. Consumer surplus is the summation of all the per
unit consumer surpluses.
2. What is producer surplus? producer surplus (per unit) is the difference between the price received and the minimum price the firm
would be willing to sell that unit for (marginal cost). Producer
surplus is the summation of all the per unit producer surpluses.
How does producer surplus relate to profits when firms 1) produce multiple units and 2) have both variable and fixed costs? Short run profits
are equal to producer surplus minus avoidable fixed costs. Long
run profits are equal to producer surplus minus all fixed costs.
3. As in our externality experiment, suppose that there are 6 types of suppliers (with different costs of production), and 6 different types of demanders
(with different values of the good). As in the experiment, suppliers can
either supply 0 or 1 unit of the good, and demanders can consume either 0 or 1 unit of the good. Suppose that the size of the externality is
20c/unit produced for all members of the market (all demanders and suppliers regardless of whether or not they purchase, sell, or abstain. Create
a market by filling in the following demand and supply tables and graph
the supply and demand functions. Plot the supply and demand functions,
and determine the equilibrium in the absence of government intervention.
What is the externality per unit of the good produced? $18 What per
unit tax would maximize social welfare? any tax less than $20 and
greater than $10 would work. What number of pollution permits
would yield the socially efficient level of pollution? 20 What advantages
are associated with pollution permits being transferable? Production is
undertaken by the lowest cost producers. What would the equilibrium price of pollution permits be if they were transferable? Assuming
that the price of the good is 37.5, then the permit price should
fall between 12.5 and 17.5 Does the initial allocation of permits matter
in terms of efficiency? As long as permits are transferable, no. Does
it matter in terms of equity? Yes, everybody prefers to be allocated
a permit, and not everybody will get one.
Demand
# Value
5
50
10
45
5
40
10
35
5
30
10
25
Supply
# Cost
5
10
10
15
5
20
10
25
5
30
10
35
1
60
50
40
p**
30
price
S
p*
externality
10
20
D
q*
0
q**
0
10
20
30
40
50
quantity
4. Why do damages from pollution create a market failure only in the case
where the damages are suffered by those not involved in a transaction?
Damages suffered by the buyer reduces their willingness to pay
for the good. Damages suffered by the seller increase the minimum for which they would be willing to sell the good. In such a
case, the only transactions that occur are the ones that generate
enough surplus to compensate for the damages.
5. In our public goods experiment, what tension existed between individual
incentives and group incentives? Regardless of the choices of others,
the choice that would maximize your individual payoff would
be to allocate all your endowment to private consumption. In
contrast, the group payoff (the sum of all the individual payoffs)
is maximized if everybody allocated their entire endowment to
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the public good.
6. What is the relationship between the public goods experiment and the
common pool resource experiment? Both experiments are examples
of reciprocal externalities: everybody affects everybody else in
a symmetric fashion. Public goods are an example of a positive
externality, and common pool resources are a negative externality.
7. Demonstrate the concept of sustainability using production possibility
frontiers and community indifference curves.Sustainability is the assumption that labour, capital and technology can be substituted
for the natural capital that is continually being degraded. For
an economy to be sustainable, the production possibility frontier must either be stationary, or shifting rightwards/upwards.
A shift from PPF1 to PPF2 demonstrates an unsustainable economy.
3
10
6
4
PPF2
PPF1
6
8
0
2
stuff we like to buy
8
Community Indifference Curve
0
2
4
10
environmental quality
8. What is the relationship between environmental economics, natural resource economics, and ecological economics?Environmental economics
is the study of how our economic activity results in waste/emissions/residuals,
and how these affect the natural environment. Natural resource
economics is the study of how to efficiently extract natural capital inputs over time. Ecological economics is a more holistic
approach (a superset of both environmental economics and natural resource economics.)
9. What is meant by the “assimilative capacity” of the environment? The
ability of the environment to absorb and make more benign the
waste that we produce.
10. How do we derive the aggregate marginal damages curve? Give an ex4
10
ample. Damages are a public bad, so the aggregation is vertical.
MD2
6
8
aggregate MD
0
2
4
$
MD1
0
2
4
6
8
emissions
11. What is the relationship between efficiency and equity? Efficiency is all
about maximizing the size of the pie, and equity is about how
the pie is divided up. If everybody got the same share of the
pie regardless of their behaviour, the size of the pie would most
certainly not be maximized. For this reason there is a trade-off
between efficiency and equity.
12. What do we mean when we say there is a threshold in marginal damages?
The earth has some ability to absorb and render benign a pollutant before any damages are incurred. Only once emissions hit
the threshold do damages occur.
13. When is it reasonable to assume that marginal abatement costs are zero
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10
for the first unit of abatement? If the last unit of the good being produced creates zero surplus for society (as in the case of perfect
competition), then production can be curtailed marginally, reducing emissions marginally, at zero cost to society. Under what
market structure would it not be reasonable to make this assumption?
Monopoly or oligopoly: market structures where the last unit of
the good sold is sold at a price that exceeds marginal cost. For
instance in the following diagram if a monopolist is selling the
last unit of output at a price that exceeds marginal cost by $4.
Under this market structure could it be conceivable that the optimal level
of emissions is what the firm would choose in the absence of regulation?
Yes. Given that the marginal abatement cost is positive at ē, for
a pollutant that is not very damaging (flat marginal damages
curve), the marginal damage curve could be everywhere lower
than the marginal abatement cost, which implies that e? = ē
6
10
4
$
6
8
Marginal abatement cost
0
2
Marginal damages
0
2
4
6
8
emissions
14. What fundamental difficulties are there in determining the dose-response
relationship between pollution and human health?
• The impossibility of controlled randomized experiments on
humans.
• the fundamental problem of causal inference: a person is
either exposed to a pollutant, or they are not: You do not
get to observe both paths.
15. Why does measuring the dollar value of a increase/decrease in output not
give a true measure of the impact of pollution on a competitive producer?
The true loss to the producer is measured by the change in
the producers surplus, denoted “change PS” in the diagram.
Measuring the value of the lost output, denoted “value change
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10
10
output” in the diagram overstates the loss to the producer: The
blue shaded area exceeds the area shaded red.
MC1
4
$
6
8
MC2
change PS
0
2
value change output
0
2
4
6
8
emissions
16. How can we use housing prices to infer peoples’ willingness to pay for a
clean environment? People’s willingness to live in a clean environment gets capitalized into the purchase price of a house: If we
have two houses that are identical in all respects other than the
local air quality is lower for one house than the other, then we
can infer that the difference in purchase price reflects the market’s willingness to pay for clean air. Of course no two houses
are identical in all respects except one, so that is where statistical analysis comes into play. Furthermore, the capitalized value
must be converted back into a stream of benefits in order to be
used in cost benefit analysis.
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10
17. What are some shortcomings of using contingent valuation surveys?
(a) Their hypothetical nature: nothing is at stake, there is no
incentive to think carefully about your preferences.
(b) Sample selection bias: the people willing to answer the survey might not be representative of the population that you
draw your sample from: this is a problem whenever a survey
is not compulsory.
18. Why are willingness-to-pay and willingness-to-accept in general different?
Why do they differ for small value comparisons? Willingness to pay depends on both preferences and your budget constraint, whereas
willingness to accept depends only on your preferences. For
small value comparisons the two should be virtually identical,
but there is mixed evidence for W T P < W T A: the relationship
depends in subtle ways on the structure of the survey.
19. When can the government attain a no-cost improvement to environmental
quality? If there is currently a policy that is distortionary, the
removal of that policy can both increase economic efficiency and
reduce externalities. The best example is agricultural subsidies,
which create a distortion towards socially excessive production.
Removing the subsidy reduces production towards the socially
efficient level, and reduces the associated pollution.
20. Even if we didn’t really care about other people per se, why would it be
important for an environmental policy to be fair, in the sense of the costs
and benefits being spread widely? What would you expect to happen if the
costs of the policy were heavily concentrated on a certain segment of the
population? (think politics) Suppose some new policy would confer
a benefit of $1 to all Canadians (36 million of us). However the
new policy would cost ten firms $1,000,000 each. Given that government policy is swayed by lobbyist and special interest groups,
one would expect this beneficial policy ($26,000,000 in net benefits) would not be implemented: The firms would have a huge
interest in ensuring the policy was not implemented whereas the
beneficiaries would utter a collective meh. Thus, fairness can be
a reasonable objective for policy even in the absence of direct
concern for the equitable distribution of net benefits. Invariably
policy will hurt someone, what we are saying is that you do not
want to give the victims much of a reason to complain.
21. If a firm shifts some of its production into “green goods” what effect does
this have on the firm’s marginal abatement cost curve? It shifts the
MAC curve downwards. Even in the absence of government
intervention, the result is a reduction in damages.
9
10
8
MD
6
MAC1
$
MAC2
0
2
4
reduced damages
0
2
4
e2
e1
6
8
emissions
22. What are the relative strengths and weaknesses of ambient and emission
standards? Ambient quality is more closely related to damages:
what we are interested in improving is ambient quality. On the
other hand, marginal abatement costs are more closely related to
emissions than ambient quality. Emission standards are preferable in settings where there are multiple sources of the pollutant,
so one can not assess which source is responsible for the poor
ambient quality. Ambient standards are preferable when there
is a single source of the pollutant, so if the ambient quality is
poor everybody knows who is responsible.
23. Would you expect enforcement costs to vary with different environmental policies? Why or why not? Yes. Recall one possible policy
is moral suasion, where no monitoring or enforcement is nec10
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essary: people choose not to pollute the environment because
they have been convinced that that is the right thing to do.
Even among coercive policies, firms will oppose the policy to
different degrees: In general, greater opposition implies more
resources need to be devoted to enforcement.
24. What are the similarities between emission taxes and abatement subsidies?
Both taxes and subsidies impose a cost of utilizing nature’s waste
disposal services. In the case of an emission tax, the cost is an
explicit cost associated with each unit of emissions. In the case
of an abatement subsidy, for every unit of emissions the firm
forgoes the the abatement subsidy on that unit: an abatement
subsidy is an opportunity cost. Why do they work the same way
in theory? In theory explicit cost and opportunity costs should
be equivalent in determining behaviour. What are some problems
associated with abatement subsidies in reality? Firms will face the
incentive to inflate their baseline emissions in order to get a
larger subsidy. Government will need to raise the revenue to
support the subsidy: this will likely reduce efficiency elsewhere
in the economy.
25. Show graphically that emission taxes create a greater incentive to innovate
than pollution standards, when innovation shifts down the firm’s marginal
abatement cost curve. If the government imposes the socially efficient pollution standard e*, then the incentive to innovate is
the reduction in abatement costs up to e*. This is the blue
cross hatched area in the diagram below. In contrast, if the
government imposes the socially efficient tax t*, the incentive
to innovate is given by the pink area. The incentive to innovate
with a tax is greater because the the firm can save on both its
abatement costs, and on its tax burden. In the example below,
the innovation completely removes the tax burden: with the new
technology the firm optimally chooses to make zero emissions.
11
10
MD
6
8
MAC1
$
t*
2
4
MAC2
0
e*
0
2
4
6
8
emissions
26. Why is the strong version of the Porter hypothesis hard to believe? The
strong version of the Porter hypothesis is that environmental
regulation can lead to greater profits. This raises the question,
why were firms not maximizing profits in the first place? Possible explanations is that environmental regulation
• encourages a shift in emphasis from seeking short run to
long run profits.
• reduces competition between firms, leading to greater profits.
27. How does a deposit/refund system encourage recycling/reduction in waste?
What shortcoming of an abatement subsidy does deposit/refund address?
A deposit/refund scheme serves as both a tax (the deposit) on
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10
potential emissions, and a subsidy on reduced emissions (the
refund). The advantage of deposit/refund over an abatement
subsidy is that the deposit/refund system can be self financing,
so the government does not need to raise revenue elsewhere to
fund the scheme.
28. What are some complications associated with transferable emission permits when emissions from multiple sources do not have equal impacts on
ambient quality? If for instance, emissions from one source are
twice as damaging as emissions from another source, you would
not want these firms to be able to trade permits one-for-one.
How can these problems be addressed?If the government required
the firm with the twice as high damages to purchase two permits from the other firm in order to emit one unit of pollution
the total damages would be kept constant, presumably at the
socially optimal level.
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Student submitted questions
1. What is the framework of Cost-benefit analysis? Cost/Benefit analysis
is a tool used to make public decisions–what policies and programs should be introduced. This is done from the standpoint of
society as a whole, making use of social valuations of all inputs
and outputs. The basic steps are to
(a) clearly specify the program or project.
(b) describe quantitatively all the inputs and outputs.
(c) estimate all the social costs and benefits of the inputs and
outputs.
(d) compare the benefits and costs.
Critiques of cost benefit analysis claim that
• it is just a means to justify ever increasing budgets for public
agencies.
• it crowds out public discourse regarding policy and projects.
• it limits public programs because benefits are typically under reported.
2. What are the three distribution of benefits and costs:
(a) proportional programs and policies.
(b) Regressive programs and policies.
(c) Progressive programs and policies.
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(d) I would add “other”. i.e. net benefit per dollar income
could be increasing over a certain range of income, and then
decreasing over another range of income.
3. What kind of sources can produce uncertainty in the Cost-benefit analysis?
nature, market prices, the fact that the government observes
neither marginal damages nor marginal abatement costs.
4. Distinguish between horizontal and vertical equity. A policy is horizontally equitable if everybody at a given income or wealth level
is affected equally by a policy. A policy is vertically equitable
if net benefits per dollar income are non-increasing in income
i.e. a proportional or progressive policy. In contrast, regressive
policies are not vertically equitable. Which is more important? I
have no idea (Is equity a) goal for benefit-cost analysis? Defend your
answer. No. Cost-benefit analysis is a tool for making decisions,
and tools don’t have goals.
5. Why are our measurements of benefits / damages always lower bound
estimates?
• The true value of the ecosystem exceeds the market value
of what we extract from the ecosystem.
• Because environmental economics is anthropocentric, the
preferences of all other species are ignored: other species
are only of value if they are tasty, are pleasant to look at,
or can be used to make nice shoes, etc.
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