Course : Resource and Energy Economics (ECO353E)

Lecturer :
Student name :
Student ID : MEL 10605

Problem 1
Given symmetric firms in a perfectly competitive industry,
Number of firm : N (i = 1, 2, …, N)
Market price : P (P = 10)
Firm i :
- Product output : xi (xi > 0)
- Emission rate
Per unit output : ri (ri > 0)
- Pollution level : ri xi
- Production and pollution
4𝑥𝑖2
control costs function : Ci(xi, ri) = 3𝑟𝑖
- Initial permit allocation : 𝑒𝑖𝑇 (The permits are tradable)
Total pollution target : 𝑒 = ∑𝑁
𝑇 𝑇
𝑖=1 𝑒𝑖 = 10
Actual pollution level : 𝑒 𝐴 = ∑𝑁
𝑖=1 𝑟𝑖 𝑥𝑖
The permit price : 𝜆 (𝜆 > 0)

Calculation :

(1.1) Optimization of firm i :

Profit of firm i :
𝜋𝑖 (𝑥𝑖 , 𝑟𝑖 ) = 𝑃𝑥𝑖 − 𝐶𝑖 (𝑥𝑖 , 𝑟𝑖 ) + 𝜆(𝑒𝑖𝑇 − 𝑟𝑖 𝑥𝑖 )
4𝑥𝑖2
= 10𝑥𝑖 − + 𝜆(𝑒𝑖𝑇 − 𝑟𝑖 𝑥𝑖 )
3𝑟𝑖
Profit maximization :
4𝑥𝑖2
max 10𝑥𝑖 − + 𝜆(𝑒𝑖𝑇 − 𝑟𝑖 𝑥𝑖 )
𝑥𝑖 ,𝑟𝑖 3𝑟𝑖
𝜕𝜋𝑖 (𝑥𝑖 ,𝑟𝑖 ) 8𝑥
= 10 − 3𝑟𝑖 − 𝜆𝑟𝑖 = 0 ……………….....…...……………(1.1)
𝜕𝑥𝑖 𝑖
𝜕𝜋𝑖 (𝑥𝑖 ,𝑟𝑖 ) 4𝑥𝑖2
= 3𝑟 2 − 𝜆𝑥𝑖 = 0 ……………………….…………...……(1.2)
𝜕𝑟𝑖 𝑖
From equation (1.2) :
4𝑥𝑖2
− 𝜆𝑥𝑖 = 0
3𝑟𝑖2
4𝑥
𝑥𝑖 (3𝑟 2𝑖 − 𝜆) = 0 ; since xi > 0 then
𝑖
4𝑥𝑖
−𝜆=0
3𝑟𝑖2
3
xi = 4 𝜆𝑟𝑖2 ………………………...………….…………………..…(1.3)
Substitution equation (1.3) to equation (1.1) :
8 3
10 − (3𝑟 ) (4 𝜆𝑟𝑖2 ) − 𝜆𝑟𝑖 = 0
𝑖
10 − 2𝜆𝑟𝑖 − 𝜆𝑟𝑖 = 0
10 − 3𝜆𝑟𝑖 = 0
 10
ri = 3𝜆 ……………………………………..……….…….…………(1.4)
Substitution equation (1.4) to equation (1.3) :
3 10 2 25
xi = 4 𝜆 (3𝜆) = 3𝜆 ………………………………………………….(1.5)

(1.2) Equilibrium of permit price

Market clearing condition for permits :
Actual pollution level = Total pollution target
𝑒 𝐴 = 𝑒𝑇
∑𝑁 𝑁 𝑇
𝑖=1 𝑟𝑖 𝑥𝑖 = ∑𝑖=1 𝑒𝑖
∑𝑁𝑖=1 𝑟𝑖 𝑥𝑖 = 10 ….……………………….………………………….(1.6)

For symmetric firms :

r1 = r2 = …. = rN
x1 = x2 = …. = xN
Equilibrium permit price can be drawn from equation (1.6) :
∑𝑁 𝑖=1 𝑟𝑖 𝑥𝑖 = Nrixi = 10 ………………….…………………………..(1.7)
10 25
𝑁 (3𝜆) (3𝜆) = 10
250
𝑁 9𝜆2 = 10
25
𝜆2 = 𝑁 ; since 𝜆 > 0 then
9
5√𝑁
𝜆∗ = 3

(1.3) Equilibrium output xi and pollution rate ri

Equilibrium output :
25 25 3 5
𝑥𝑖∗ = 3𝜆∗ = ( 3 ) (5√𝑁) =
√𝑁

Equilibrium pollution rate :

10 10 3 2
𝑟𝑖∗ = 3𝜆∗ = ( 3 ) (5√𝑁) =
√𝑁

Equilibrium pollution level :

2 5 10
𝑒𝑖∗ = 𝑟𝑖∗ 𝑥𝑖∗ = ( ) ( ) = 𝑁
√𝑁 √𝑁
If firm i has 𝑒𝑖𝑇 > 𝑒𝑖∗ then that firm is a permit seller, meanwhile if firm i has 𝑒𝑖𝑇 < 𝑒𝑖∗ then
that firm is a permit buyer.
Problem 2
This problem is about tax scheme and tradable permit scheme under uncertainty.

(2.1) Uncertainty about abatement cost

Suppose the regulator knows the external cost but does not know exactly the pollution
control cost of each firm. Since regulator uses an estimated MAC, there will be some
problems in determining the proper level of tax and pollution. Suppose the proper levels
of tax and pollution are t* and e*, respectively. These levels are based on the true MAC
and the true MEC. Based on estimated MAC, the regulator sets the level of tax at t, the
level of pollution at ep (for tradable permit scheme) and et (for tax scheme).

A. Case 1 : MEC is relatively steep

Abatement cost is under estimated :
Suppose the regulator estimates the MAC lower than its real level. The tax level, t,
will be set lower than t*. Under tradable permit scheme, firms should operate at ep
which is lower than e* (figure 2.1a). There will be a loss (cost inefficiency) because
firms suffer from additional cost of pollution control. Under tax scheme, firms will set
their MAC to t because they know their true MAC. Firms will operate at et which is
higher than e* (figure 2.1b). There will be a loss (cost inefficiency) because the
society suffers from additional external cost. We can see that loss under permit
scheme is less than that under tax scheme. In this case, tax scheme is “risky”, and we
favor tradable permit scheme over tax scheme.

(a) Tradable permit scheme (b) Tax scheme

Figure 2.1 Under estimated abatement cost, MEC relatively steep

Abatement cost is over estimated :

Suppose the regulator estimates the MAC higher than its real level. The tax level, t,
will be set higher than t*. Under tradable permit scheme, firms will operate at ep which
is higher than e* (figure 2.2a). There will be a loss (cost inefficiency) because the
society suffers from additional external cost. Under tax scheme, firms should set their
true MAC to t. Firms will operate at et which is lower than e* (figure 2.2b). There will
be a loss (cost inefficiency) because firms suffer from additional cost of pollution
control. We can see that loss under permit scheme is also less than that under tax
 scheme. In this case, tax scheme is “risky”, and we favor tradable permit scheme over
tax scheme.

(a) Tradable permit scheme (b) Tax scheme

Figure 2.2 Over estimated abatement cost, MEC relatively steep

B. Case 2 : MEC is relatively flat

Abatement cost is under estimated :
In this case, the loss under permit scheme is more than that under tax scheme (figure
2.3), or tradable permit scheme is “risky”, and we favor tax scheme over tradable
permit scheme.

(a) Tradable permit scheme (b) Tax scheme

Figure 2.3 Under estimated abatement cost, MEC relatively flat

Abatement cost is over estimated :

In this case, the loss under permit scheme is also more than that under tax scheme
(figure 2.4), or tradable permit scheme is “risky”, and we favor tax scheme over
tradable permit scheme.
 (a) Tradable permit scheme (b) Tax scheme
Figure 2.4 Over estimated abatement cost, MEC relatively flat

(2.2) Uncertainty about external cost

Suppose the regulator knows the abatement cost but does not know exactly the external
cost. Since regulator uses an estimated MEC, there will be also some problems in
determining the proper level of tax and pollution. Suppose the proper levels of tax and
pollution are t* and e*, respectively. However, based on estimated MEC, the regulator sets
the tax level at t, the level of pollution at ep (for tradable permit scheme) and et (for tax
scheme).

A. Case 1 : MAC is relatively steep

External cost is under estimated :
Suppose the regulator estimates the MEC lower than its real level. The tax level, t,
will be set lower than t*. Both under tradable permit scheme and tax scheme, firms
will set their true MAC to t. They will operate at ep or et which is higher than e* (figure
2.5a). There will be a loss (cost inefficiency) because the society suffers from
additional external cost. We can see that losses under permit scheme and tax scheme
are the same.

External cost is over estimated :

Suppose the regulator estimates the MEC higher than its real level. The tax level, t,
will be set higher than t*. Both under tradable permit scheme and tax scheme, firms
will operate at ep or et which is higher than e* (figure 2.5b). There will be a loss (cost
inefficiency) because firms suffer from additional cost of pollution control. In this
case we also can see that losses under permit scheme and tax scheme are the same.
 (a) Under estimated (b) Over estimated
Figure 2.5 Tradable permit scheme and tax scheme for a relatively steep MAC

B. Case 2 : MAC is relatively flat

External cost is under estimated :
As in case of relatively steep MAC, there will be a loss (cost inefficiency) because the
society suffers from additional external cost (figure 2.6a). We can see that losses
under permit scheme and tax scheme are the same because firms will operate at the
same level of e, both under tradable permit scheme and tax scheme.

External cost is over estimated :

This is also similar to the case of relatively steep MAC. There will be a loss (cost
inefficiency) because firms suffer from additional cost of pollution control (figure
2.6b). In this case we also can see that losses under permit scheme and tax scheme are
the same.

(a) Under estimated (b) Over estimated

Figure 2.6 Tradable permit scheme and tax scheme for a relatively flat MAC
Problem 3
Given a model of renewable resource; case of a single fish species, at steady-state harvesting :
Stock (biomass) : S (S > 0)
Fishing effort : E (E > 0)
Cost per unit effort :W=4
Fish price : P = 10
𝑑𝑆 𝑆
Rate of natural growth : 𝑆̇ = 𝑑𝑡 = G(S) = 2𝑆 (1 − 10)
1
Harvest : H(E,S) = 10 𝐸𝑆
Calculation :

(3.1) Stock as a function of effort

At steady-state :
H(E,S) = G(S)
1 𝑆
𝐸𝑆 = 2𝑆 (1 − 10)
10
1 𝑆
𝐸 =2−5
10
𝐸
S(E) = 10 − 2 ……………………………...……………………. (3.1)

Figure 3.1 Stock as a function of effort

(3.2) Harvest as a function of effort

1
H(E,S) = 10 𝐸𝑆
1 𝐸
= 𝐸 (10 − )
10 2
𝐸
H(E) = 𝐸 (1 − 20) …………………………………..…………... (3.2)

The maximum value of harvest :

𝐸
max 𝐻(𝐸) = max 𝐸 (1 − 20)
𝐸 𝐸
1 2
𝑑𝐻(𝐸) 𝑑(𝐸−20 𝐸 )
= =0
𝑑𝐸 𝑑𝐸
𝐸𝑀𝑆𝑌
1 − 10 = 0
EMSY = 10 ………………………………………..………… (3.3)

Hmax = H(EMSY)
10
= 10 (1 − 20) = 5
Hmax = 5 ……………………………………………….…... (3.4)
 Figure 3.2 Harvest as a function of effort

(3.3) Profit as a function of effort

𝜋(𝐸) = R(E) – C(E)
= P.H(E) – WE
𝐸
= 10𝐸 (1 − 20) − 4𝐸
𝐸
𝜋(𝐸) = 𝐸 (6 − 2 ) …………………..……………………………. (3.5)

Figure 3.3 Revenue, Cost, and Profit as a function of effort

Figure 3.4 Rate of Natural Growth and Harvest as a function of Stock

(3.4) Harvest, stock, and effort for regulated fishery
Under regulated fishery, the number of fishermen or the quota of harvest is regulated for a
maximum rent or profit. Rent maximization is given by :
𝐸
max 𝜋(𝐸) = max 𝐸 (6 − 2 )
𝐸 𝐸
𝑑𝜋(𝐸) 𝑑(6𝐸−1𝐸2)
2
= =0
𝑑𝐸 𝑑𝐸
6 − 𝐸𝑅𝐸𝐺 = 0
EREG = 6 (Figure 3.3)

𝐸𝑅𝐸𝐺
H(EREG) = 𝐸𝑅𝐸𝐺 (1 − )
20
6
= 6 (1 − 20) = 4.2
HREG = 4.2 (Figure 3.2 and Figure 3.4)
𝐸𝑅𝐸𝐺
S(EREG) = 10 − 2
6
= 10 − 2 = 7
SREG = 7 (Figure 3.1 and Figure 3.4)

(3.5) Harvest, stock, and effort for open-access fishery

Under open-access fishery, there are new entrants coming in as long as the rent is positive.
In the long-run equilibrium, open-access scheme is limited by the circumstance where
value of the rent is zero, i.e. when return equals cost.
𝜋(𝐸) = 𝑅(𝐸) − 𝐶(𝐸) = 0
P.H(E) – WE = 0
𝐸𝑂𝐴
10𝐸𝑂𝐴 (1 − 20 ) − 4𝐸𝑂𝐴 = 0
2
𝐸𝑂𝐴
6𝐸𝑂𝐴 − =0
2
𝐸𝑂𝐴
𝐸𝑂𝐴 (6 − 2 ) = 0
Since EOA > 0 then
𝐸
6 − 𝑂𝐴 =0
2
EOA = 12 (Figure 3.3)
The range of effort under open-access scheme is from EREG to EOA, i.e. 6 < EROA < 12.

𝐸𝑂𝐴
H(EOA) = 𝐸𝑂𝐴 (1 − )
20
12
= 12 (1 − 20) = 4.8
HOA = 4.8 (Figure 3.2 and Figure 3.4)
The maximum harvest that can be achieved under open-access scheme equals to Hmax at
equation (3.4). In this case HREG < HOA, therefore the range of harvest under open-access
scheme is from HREG to Hmax, i.e. 4.2 < HROA < 5, as shown in figure 3.5.
𝐸𝑂𝐴
S(EOA) = 10 −
2
12
= 10 − =4
2
SOA = 4 (Figure 3.1 and Figure 3.4)
 The range of stock under open-access scheme is from SOA to SREG, i.e. 4 < SROA < 7, as
shown in figure 3.5.

Figure 3.5 Harvest level under Open-access Scheme

(3.6) Maximum Sustainable Yield (MSY), Stock, and Effort corresponding to MSY
Maximum sustainable yield is the maximum harvest on a sustainable basis. It equals the
maximum value of natural growth rate.
𝑆
Max 𝑆̇ = max 𝐺(𝑆) = max 2𝑆 (1 − 10)
𝑆 𝑆 𝑆
𝑑𝐺(𝑆) 𝑑(2𝑆−15𝑆2 )
= =0
𝑑𝑆 𝑑𝐸
2𝑆𝑀𝑆𝑌
2− 5 =0
SMSY = 5 (Figure 3.1 and Figure 3.4)

̇
MSY = 𝑆𝑚𝑎𝑥 = G(SMSY)
5
= 2(5) (1 − 10) = 5
MSY = 5 (Figure 3.2 and Figure 3.4)
This MSY value equals Hmax in equation (3.4).

From equation (1), we can derive EMSY as follow,

𝐸
SMSY = 10 − 𝑀𝑆𝑌2
EMSY = 20 – 2SMSY
= 20 – 2(5)
= 10 (Figure 3.3)
This EMSY value also equals the result in equation (3.3).

The value of MSY, stock, and effort correspond to MSY also can be determined based on
the assumption that there is no cost for MSY. Therefore profit equation is
𝜋(𝐸) = R(E) – C(E)
= P.H(E) – 0
𝐸
= 10𝐸 (1 − )
20
𝐸
= 𝐸 (10 − 2 )
 𝐸
max 𝜋(𝐸) = max 𝐸 (10 − 2 )
𝐸 𝐸
𝑑𝜋(𝐸) 𝑑(10𝐸−1𝐸2)
2
= =0
𝑑𝐸 𝑑𝐸
10 − 𝐸𝑀𝑆𝑌 = 0
EMSY = 10 (Figure 3.3)

𝐸𝑀𝑆𝑌
MSY = H(EMSY) = 𝐸𝑀𝑆𝑌 (1 − )
20
10
= 10 (1 − 20) = 5
MSY = 5 (Figure 3.2 and Figure 3.4)
𝐸𝑀𝑆𝑌
S(EMSY) = 10 − 2
10
= 10 − 2 = 5
SMSY = 5 (Figure 3.1 and Figure 3.4)

(3.7) Comparison the stock, effort, and harvest level between regulated fishery and open-
access fishery

Regulated Open Access Comparison Remark

SREG = 7 SOA = 4 SREG > SOA Under open-access scheme, resource can
be overexploited. Therefore, stock
decreases.
EREG = 6 EOA = 12 EREG < EOA Under open-access scheme, as long as the
profit is positive, there will be new
entrants coming in. It raises effort until
profit equals zero.
HREG = 4.2 HOA = 4.8 Ambiguous It depends on effort and stock level.
Greater effort will increase harvest.
However, greater effort will also decrease
stock further. If stock is very small,
harvest will decrease even though there is
a great effort.

(3.8) Comparison the stock, effort, and harvest level between regulated fishery and
maximum sustainable yield

Regulated MSY Comparison Remark

SREG = 7 SMSY = 5 SREG > SMSY MSY is the maximum harvest of the
resource on a sustainable basis. It assumes
that cost equal zero. Resource under MSY
is more exploited than that under regulated
scheme. Therefore, stock under MSY is
less than that under regulated scheme.
EREG = 6 EMSY = 10 EREG < EMSY In order to gain maximum harvest, greater
effort should be given. This comparison
also means that zero cost could not be
achieved in the real world. Therefore, the
optimal effort is always less than
maximum effort.
HREG = 4.2 MSY = 5 HREG < MSY Since cost will always occur in the real
 world, the optimum effort is always less
then maximum effort, and the
consequence is that harvest under
regulated scheme is less than maximum
harvest.

Problem 4
Given a two-period model of non-renewable resource management :
Period : t = 1, 2
Each period :
- Quantity extracted : xt
- Price : Pt
- Demand curve : Pt = 360 – 0.3xt
- Supply curve : MCt = 30 + 0.25xt
Discount rate : r = 0.1
Initial resource stock : k = 360

Calculation :

(4.1) The Marginal Net Benefit as a function of xt

For each period :
MNBt = Pt - MCt
= (360 – 0.3xt) – (30 + 0.25xt)
= 330 – 0.55xt

(a) For t = 1 (B) For t = 2

Figure 4.1 MNB as a function for xt

(4.2) The present value of MNB at period t = 2

1
MNB2PV = 1+𝑟 𝑀𝑁𝐵2 …………………………………….………….(4.1)
1
= 1+0.1 (330 − 0.55𝑥2 )
= 300 – 0.5x2

(4.3) Socially optimal extraction and the MNB for each period
Condition for socially optimal :
MNB1 = MNB2PV
330 – 0.55x1* = 300 – 0.5x2*
0.55x1* – 0.5x2* = 30 ……………………...…………………………..(4.2)

Total extraction :
x1* + x2* = k
x1* + x2* = 360 …………………….…………………………………..(4.3)

Solution for x1* and x2* from equations (4.2) and (4.3) :

0.55x1* – 0.5x2* = 30 × 1 0.55x1* – 0.5x2* = 30

x1* + x2* = 360 × 0.55 0.55x1* + 0.55x2* = 198
-1.05 x2* = -168
−168
x2* = −1.05 = 160
x1* = 360 – x2* = 360 – 160 = 200

We favor present extraction over future extraction, or we extract more in period 1 and less
in period 2.

The MNB for each period with discount rate :

MNB1* = 330 – 0.55x1*
= 330 – 0.55(200)
= 220

MNB2PV* = 300 – 0.5x2*

= 300 – 0.5(160)
= 220
Thus, MNB1* = MNB2PV* (socially optimal)

The optimal extraction schedule requires that the present value of MNB must be the same
in each period. Graphically, the discounting shifts the MNB2 downward, which moves the
intersection of MNB1 and MNB2 rightward, causing optimal x1 > x2. From equation (4.1)
we can draw the MNB of period 2 without discount rate :
MNB2* = (1 + r)MNB2PV* = (1 + r)MNB1*
= (1 + 0.1)220
= 242

These results are shown in figure 4.2.

 Figure 4.2 Socially optimal extractions (initial case)

The increase of the MNB :

𝑀𝑁𝐵2∗ −𝑀𝑁𝐵1∗
∆𝑀𝑁𝐵 ∗ = × 100%
𝑀𝑁𝐵1∗
242−220
= 220 × 100%
= 10%
In order to maximize the total net benefit over period, the MNB must rise at a rate that is
equal to the discount rate over period. This "step rule" is known as "Hotelling's rule".

(4.4) Case of a decline in discount rate from 0.1 to 0.05

Suppose the other parameters remain the same as the basic setup. There will be a change
in the present value of the MNB in period 2. The present value of MNB at period t = 2:
1
MNB2PV = 1+𝑟 𝑀𝑁𝐵2
1
= 1+0.05 (330 − 0.55𝑥2 )
2200 11
= − 21 𝑥2
7

Condition for socially optimal :

MNB1 = MNB2PV
2200 11
330 – 0.55x1* = 7 − 21 𝑥2∗
11 110
0.55𝑥1∗ − 21 𝑥2∗ = ……..………………………………….………..(4.4)
7

Total extraction :
x1* + x2* = k
x1* + x2* = 360 …………………………………….…………………..(4.5)
Solution for x1* and x2* from equations (4.4) and (4.5) :
11 110 11 110
0.55𝑥1∗ − 21 𝑥2∗ = 7 × 1 0.55𝑥1∗ − 21 𝑥2∗ = 7
x1* + x2* = 360 × 0.55 0.55x1* + 0.55x2* = 198
451 1276
− 420 𝑥2∗ = − 7
−6960
x2* = −41 = 169.76
x1* = 360 – x2* = 360 – 169.76 = 190.24

A decline in discount rate will decrease the extraction in period 1 (from 200 to 190.24)
and increase the extraction in period 2 (from 160 to 169.76).

The MNB for each period with discount rate :

MNB1* = 330 – 0.55x1*
= 330 – 0.55(190.24)
= 225.37
2200 11
MNB2PV* = − 21 𝑥2∗
7
2200 11
= 7 − 21 (169.76)
= 225.37
Thus, MNB1* = MNB2PV* (socially optimal)

From equation (4.1) we can draw the MNB of period 2 without discount rate :
MNB2* = (1 + r)MNB2PV* = (1 + r)MNB1*
= (1 + 0.05)225.37
= 236.64

These results are shown in figure 4.3.

Figure 4.3 Socially optimal extraction (a decline in discount rate)

 The increase of the MNB :
𝑀𝑁𝐵2∗ −𝑀𝑁𝐵1∗
∆𝑀𝑁𝐵 ∗ = × 100%
𝑀𝑁𝐵1∗
236.64−225.37
= × 100%
225.37
= 5%
Thus, the MNB rises at a rate that is equal to the discount rate (Hotelling’s rule). A decline
in discount rate creates an incentive to use the resource at a slower mode as shown in the
figure 4.4.

Figure 4.4 The change in the MNB (a decline in discount rate)

(4.5) Case of an increase in initial resource stock from 360 to 460

Suppose the other parameters remain the same as the basic setup. There will be no change
in the Marginal Net Benefit of period 2, but there will be a change in total extraction.

Condition for socially optimal :

MNB1 = MNB2PV
330 – 0.55x1* = 300 – 0.5x2*
0.55x1* – 0.5x2* = 30 ……………………...…………………………..(4.6)

Total extraction :
x1* + x2* = k
x1* + x2* = 460 …………………………….…………………………..(4.7)

Solution for x1* and x2* from equations (4.6) and (4.7) :

0.55x1* – 0.5x2* = 30 × 1 0.55x1* – 0.5x2* = 30

x1* + x2* = 460 × 0.55 0.55x1* + 0.55x2* = 253
-1.05 x2* = -223
−223
x2* = −1.05 = 212.38
x1* = 460 – x2* = 460 – 212.38 = 247.62

An increase in initial resource stock will increase extractions in all periods. Extraction in
period 1 increases from 200 to 247.62, and extraction in period 2 increases from 160 to
212.38.
The MNB for each period with discount rate :
MNB1* = 330 – 0.55x1*
= 330 – 0.55(247.62)
= 193.81

MNB2PV* = 300 – 0.5x2*

= 300 – 0.5(212.38)
= 193.81
Thus, MNB1* = MNB2PV* (socially optimal)

From equation (4.1) we can draw the MNB of period 2 without discount rate :
MNB2* = (1 + r)MNB2PV* = (1 + r)MNB1*
= (1 + 0.1)193.81
= 213.19
These results are shown in figure 4.5.

Figure 4.5 Socially optimal extraction (an increase in initial resource stock)

The increase of the MNB :

𝑀𝑁𝐵2∗ −𝑀𝑁𝐵1∗
∆𝑀𝑁𝐵 ∗ = × 100%
𝑀𝑁𝐵1∗
213.19−193.81
= × 100%
193.81
= 10%
Thus, the MNB rises at a rate that is equal to the discount rate (Hotelling’s rule). An
increase in initial resource stock does not change the percentage of difference between
MNB2 and MNB1 as shown in the figure 4.6.
 Figure 4.6 The change in the MNB (an increase in initial resource stock)

(4.6) Case of a decrease in demand from Pt = 360 – 0.3xt to Pt = 260 – 0.3xt

Suppose the other parameters remain the same as the basic setup. There will be a change
in the Marginal Net Benefit function.

The MNB as a fuction of xt for each period :

MNBt = Pt - MCt
= (260 – 0.3xt) – (30 + 0.25xt)
= 230 – 0.55xt
The present value of MNB at period t = 2
1
MNB2PV = 1+𝑟 𝑀𝑁𝐵2
1
= 1+0.1 (230 − 0.55𝑥2 )
230
= − 0.5𝑥2
1.1

Condition for socially optimal :

MNB1 = MNB2PV
230
230 – 0.55x1* = 1.1 − 0.5𝑥2∗
230
0.55x1* – 0.5x2* = ……..………………….…………………….....(4.8)
11

Total extraction :
x1* + x2* = k
x1* + x2* = 360 …………………….…………………………………..(4.9)

Solution for x1* and x2* from equations (4.8) and (4.9) :
230 230
0.55𝑥1∗ − 0.5𝑥2∗ = 11 × 1 0.55𝑥1∗ − 0.5𝑥2∗ = 11
x1* + x2* = 360 × 0.55 0.55x1* + 0.55x2* = 198
1948
−1.05𝑥2∗ = − 11
−1948
x2* = −1.05×11 = 168.66
x1* = 360 – x2* = 360 – 168.66 = 191.34
A decrease in demand will decrease extraction in period 1 from 200 to 191.34, and
increase extraction in period 2 from 160 to 168.66.

The MNB for each period with discount rate :

MNB1* = 230 – 0.55x1*
= 230 – 0.55(191.34)
= 124.76
230
MNB2PV* = − 0.5𝑥2∗
1.1
230
= − 0.5(168.66)
1.1
= 124.76
Thus, MNB1* = MNB2PV* (socially optimal)

From equation (4.1) we can draw the MNB of period 2 without discount rate :
MNB2* = (1 + r)MNB2PV* = (1 + r)MNB1*
= (1 + 0.1)124.76
= 137.24
These results are shown in figure 4.7.

Figure 4.7 Socially optimal extraction (a decrease in demand or an increase in supply)

The increase of the MNB :

𝑀𝑁𝐵2∗ −𝑀𝑁𝐵1∗
∆𝑀𝑁𝐵 ∗ = × 100%
𝑀𝑁𝐵1∗
137.24−124.76
= × 100%
124.76
= 10%
Thus, the MNB rises at a rate that is equal to the discount rate (Hotelling’s rule).A
decreasing in demand does not change the percentage of difference between MNB2 and
MNB1 as shown in the figure 4.8.
 Figure 4.8 The change in the MNB
(a decrease in demand or an increase in supply)

(4.7) Case of an increase in supply from MCt = 30 + 0.25xt to MCt = 130 – 0.25xt
Suppose the other parameters remain the same as the basic setup. There will be a change
in the Marginal Net Benefit function.

The MNB as a fuction of xt for each period :

MNBt = Pt - MCt
= (360 – 0.3xt) – (130 + 0.25xt)
= 230 – 0.55xt
The MNB for this case is the same as MNB for the case in section (4.6), therefore we can
expect that both an increase in supply from MCt = 30 + 0.25xt to MCt = 130 – 0.25xt and a
decrease in demand from Pt = 360 – 0.3xt to Pt = 260 – 0.3xt will give the same effect on
extraction and MNB of each period.

The present value of MNB at period t = 2

1
MNB2PV = 1+𝑟 𝑀𝑁𝐵2
1
= 1+0.1 (230 − 0.55𝑥2 )
230
= − 0.5𝑥2
1.1

Condition for socially optimal :

MNB1 = MNB2PV
230
230 – 0.55x1* = 1.1 − 0.5𝑥2∗
230
0.55x1* – 0.5x2* = ……………………...……………………….....(4.10)
11

Total extraction :
x1* + x2* = k
x1* + x2* = 360 ……………………………………….………………..(4.11)
Solution for x1* and x2* from equations (4.10) and (4.11) :
230 230
0.55𝑥1∗ − 0.5𝑥2∗ = 11 × 1 0.55𝑥1∗ − 0.5𝑥2∗ = 11
x1* + x2* = 360 × 0.55 0.55x1* + 0.55x2* = 198
1948
−1.05𝑥2∗ = − 11
−1948
x2* = −1.05×11 = 168.66
x1* = 360 – x2* = 360 – 168.658 = 191.34

Increasing in demand will decrease extraction in period 1 from 200 to 191.34, and
increase extraction in period 2 from 160 to 168.66.

The MNB for each period with discount rate :

MNB1* = 230 – 0.55x1*
= 230 – 0.55(191.34)
= 124.76
230
MNB2PV* = − 0.5𝑥2∗
1.1
230
= 1.1 − 0.5(168.66)
= 124.76
Thus, MNB1* = MNB2PV* (socially optimal)

From equation (4.1) we can draw the MNB of period 2 without discount rate :
MNB2* = (1 + r)MNB2PV* = (1 + r)MNB1*
= (1 + 0.1)124.76
= 137.24
These results are shown in figure 4.7.

The increase of the MNB :

𝑀𝑁𝐵2∗ −𝑀𝑁𝐵1∗
∆𝑀𝑁𝐵 ∗ = × 100%
𝑀𝑁𝐵1∗
137.238−124.762
= × 100%
124.762
= 10%
Thus, the MNB rises at a rate that is equal to the discount rate (Hotelling’s rule). An
increase in supply also does not change the percentage of difference between MNB2 and
MNB1 as shown in the figure 4.8.
Problem 5
(5.2) Economic instruments for fishery management
In the circumstance of increasing doubts about the effectiveness and efficiency of
regulation as a means of fisheries management, government has to switch its means to
economic instruments. Basically, economics instruments aim to alter the private costs and
benefits of a development activity so that any unaccounted social costs and benefits of
environmental uses can be internalized in order to ensure desired environmental improvement.
More detail, the advantages of economic instruments are: (1) they provide environmental
protection at a minimum cost; (2) they generate incentives for on-going environmental
improvement; (3) due to their flexibility, they provide a wider range of response from producers
and consumers; (4) they can be a source of government revenue; and (5) they directly promote
an economically efficient allocation of scare resources.
Governments facing budgetary restraints may favor instruments which promise
integrated compliance and a capacity to generate funds. In the fishery case, the economic
fishery management can be conducted through direct economic restriction and indirect
economic restriction. The direct economic restriction in forms of limitations on days at sea,
fishing time, engine size, holding capacity of the vessels, etc. fail to generate economic
improvements because they do not impose the shadow cost of harvesting on the fishing firms.
As the result, fishers are still encouraged to expand uncontrolled inputs until all profits in the
fishery have been wasted. Meanwhile the indirect economic restriction is more capable for
optimal management of ecosystem fishery. This restriction consists of: (a) taxes and subsidies,
and (b) appropriately defined property rights.
Tax is regarding as a source of government revenue. Taxes on harvest are theoretically
attractive as a fishery management tool. Taxes have a great advantage that any tax collection in
excess of collection costs represents fishery rents. However, taxes application is subjected to
some practical problems. First, the determination of tax level needs sufficient and accurate
information. Sometime it’s quite hard to get accurate information. Second, taxes must be
adjusted continuously over time if they are to be optimal.
Subsidies in fishery are direct and indirect payments made by governments to the
fishery sector, which result in a private benefit. Subsidies to the fishery sector may be either
direct (e.g. vessel buyback schemes) or indirect (e.g. foregone tax revenue on fuel), and may be
provided for goods, services, income or price support. Subsidies that reduce the costs of fishing
and increase profits for the industry will enhance the fishing capacity. However, in the absence
of effective management systems, the excessive fishing capacity results in increased effort and
overexploitation of fishery resources and ultimately reduced industry profits and viability.
Subsidies also distort competition by lowering production costs for certain producers, giving
them an artificial competitive advantage. This may allow them to sell their product at lower
price than other producers who do not receive the benefit of such subsidies. Therefore, there is
an urgent need to reduce capacity-enhancing subsidies and focus on developing profitable and
sustainable industries that can adapt to changing economic and environmental conditions.
The management of fishery also can be conducted on the basis of Individual
Transferable Quotas (ITQ). It introduces private property rights into fishery that were
previously common property. The Quota Management System (QMS) allocate quotas among
fishers on the basis of their historical catch. Fishers who want to catch more than their quota
must purchase an additional quota from other fishers. The transferability of quotas ensures that
the most efficient fishers will continue to operate in the fishery in the long run because they
value the property rights inherent in the quotas more highly than less efficient fishers.
Relatively efficient fishers will be net buyers in the market for quotas, while inefficient fishers
will be net sellers of quotas.
ITQ regulation also ensures longer fishing seasons compare to derby fishery system.
Under derby fishery system, the fish in the sea is still essentially a common property. Fishers
still have the incentive to race each other in an attempt to capture profits from a resource they
view as free. Therefore, fishing seasons could be shortened because stock can be depleted faster.
Under ITQ regulation, fishers do not need to race against each other. In their quota holdings,
fishers have a guaranteed property right to catch a specified quantity of fish anytime they
consider as the most profitable. Longer fishing seasons also mean that fresh fish supply to the
market can be maintained.
Nevertheless, the implementation of quota management system is also subjected to
some practical problems. One of them is relatively high monitoring and enforcement costs.
Government needs to provide an effective monitoring mechanism in order to ensure that a
fisher’s catching does not exceed the quota. In addition, total quotas should be set with a
consideration to maintain the stock at or above the level that can produce the maximum
sustainability yield. Sometime quotas determination cannot be separated from interest issues.
There is a possibility that government will give greater weight to short-run commercial interests
rather than to long-run environmental considerations.

(5.3) Case of multi-period extraction in non-renewable resource

The present value criterion allows us to extend the two-period analysis of non-renewable
resources to a multi-period analysis. The two-period model illustrates Hotelling's Rule, but we
would not arbitrarily decide to deplete the stock in just two periods of extraction. It is more
realistic that our objective is to maximize the present value of the total resource rent stream by
determining both the number of years in the optimal depletion schedule as well as the optimal
quantities of extraction in each year. Instead of the use of sophisticated calculation, we can
apply the optimal step rule obtained in the two-period analysis to solve multi-period problem.
Here we discuss only the discrete multi-period extraction. Suppose the initial resource
stock is k0, the Marginal Net Benefit of each period of extraction is MNBt = a – bxt, and the
depletion period is T. Hotelling's Rule says the optimal MNB trajectory should follow the path
in equation (5.1).
𝑀𝑁𝐵 𝑀𝑁𝐵 𝑀𝑁𝐵 𝑀𝑁𝐵𝑇
𝑀𝑁𝐵0 = (1+𝑟)1 = (1+𝑟)22 = ⋯ = (1+𝑟)𝑇−1𝑇−1 = (1+𝑟)𝑇 ……………….. (5.1)

We do not know the starting value for MNB0, but we know the ending value for MNBT. At
depletion period t = T, stock equals zero, kT = 0, and extraction also equals zero, xT = 0,
therefore MNBT = a. From this final period we can use Hotelling's Rule to solve for MNB in the
previous period.
𝑀𝑁𝐵
𝑀𝑁𝐵𝑇−1 = (1+𝑟)𝑇 ………………………………………………….. (5.2)
From equation (5.2) we can solve xT-1 from MNBT-1.
(𝑎−𝑀𝑁𝐵𝑇−1 )
𝑥𝑇−1 = ………………………………………………… (5.3)
𝑏
This step rule is applied for each backward time from t to t-1.
𝑀𝑁𝐵
𝑀𝑁𝐵𝑡−1 = (1+𝑟)𝑡 …………………………………………………… (5.4)
From equation (5.4) we solve xt-1 from MNBt-1.
(𝑎−𝑀𝑁𝐵𝑡−1 )
𝑥𝑡−1 = ……………………………………………….… (5.5)
𝑏
 As we solve the optimal trajectories of MNB and x backward in time, we can keep a
running total of the extraction quantities. This would be the stock needed to supply those total
extractions from period (t) until depletion period (T):
kt = xt + xt+1 + ... + xT-1 + xT ………………………………………... (5.6)
From equation (5.6) we can determine the present period (t0). It is the period when the
accumulating stock value (kt) best approximates our current or initial stock level (k0).
kt  k0 …………………………………..………………………….. (5.7)
For a numerical example, suppose :
Period : t = 0, 1, 2, …, T
Each period :
- Quantity extracted : xt
- Price : Pt = 360 – 0.3xt
- Margina Cost : MCt = 30 + 0.25xt
Discount rate : r = 0.1
Initial resource stock : k0 = 3980
Therefore the MNBt = 330 – 0.55xt
Using solution steps above, the result for the Marginal Net Benefit, quantity extracted,
remaining stock, price, and Marginal Cost for each period are given in table 5.1.

Marginal
Period Extraction Stock Price
MNBt Cost Remark
t xt kt Pt MCt
14 330.0 0.0 0.0 360.0 30.0 Depletion
13 300.0 54.5 54.5 343.6 43.6
12 272.7 104.1 158.7 328.8 56.0
11 247.9 149.2 307.9 315.2 67.3
10 225.4 190.2 498.1 302.9 77.5
9 204.9 227.4 725.5 291.8 86.9
8 186.3 261.3 986.8 281.6 95.3
7 169.3 292.1 1278.9 272.4 103.0
6 153.9 320.1 1599.0 264.0 110.0
5 140.0 345.5 1944.6 256.3 116.4
4 127.2 368.7 2313.3 249.4 122.2
3 115.7 389.7 2703.0 243.1 127.4
2 105.1 408.8 3111.8 237.4 132.2
1 95.6 426.2 3538.0 232.1 136.6
0 86.9 442.0 3980.0 227.4 140.5 Present

Table 5.1 Marginal Net Benefit, Extraction, Stock, Price, and Marginal Cost of Multi-
period Extraction

The values in the stock column are the cumulative sum of the extractions from xt up to
xT. This is the stock that would be required to supply all the annual extraction quantities from
period t until depletion period T, as shown in equation (5.6). We mark the period where the
stock value (kt) matches the current stock k0 = 3980 as the present period (t0). The period where
the stock value (kt) equals zero is the end period (T). According to table 5.1 we find T = 14.
The trajectories of MNB, x, and k from the present period (t = 0) to the depletion period
t = T are given in figure 5.1. We can see that the extraction and stock decrease toward zero
while the MNB increases along periods.
 Stock, Extraction
4500

MNB
4000 350

3500
300

3000
250
2500 Extraction
Stock 200
2000
150
1500

100
1000

50
500

0 0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

Period Period

(a) Extraction and Stock (b) Marginal Net Benefit

Figure 5.1 Trajectories of Marginal Net Benefit, Extraction, and Stock of Multi-period
Extraction

Suppose a discovery of a new resource stock increases the total stock from 3980 to 5879,
while other parameters remain constant. The trajectories of MNB for k0 = 3980 and k0 = 5879
are given in figure 5.2. We can see that the higher the initial stock level, the lower the MNB
level in each period and the longer the depletion period.
MNB
350

300

250

200 ko = 3980
ko = 5879

150

100

50

0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19
Period

Figure 5.2 Effect of an increase in the initial resource stock on the Marginal Net Benefit

Suppose there is a sequence of new discoveries on the same resource taking place over periods.
Base on the effect of an increase in the initial resource stock previously discussed, we find that at each
initial period of the new discovery, the MNB will shift down as shown in figure 5.3.
 MNB
200

180

160

140

120

100

80

60

40

20

0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
Period

Figure 5.3 Effect of intermittent increases in resource stock on the Marginal Net Benefit trajectory

Thank You.

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