UBC

Department of Economics
ECON 471

Solution to Midterm

Ratna K. Shrestha
October 29, 2012
Time: 50 minutes
Full Marks: 50

Name: ________________ ________________

(Last) (First)

Student ID #_________________________
_______________________________________________________________________

The first 4 questions carry 50 marks. If you answer Q.5, you may get up to 2
bonus marks.

Marks

Short-Answer Questions: 1. ____

2. ____

3. ____

4. ____

5. ____ (2 bonus marks)

____________________
Total
Answer the following questions as shortly as possible (without missing
important points). To receive the full marks, your answers must be well
organized and must reflect the underlying concepts involved.(50 +2 points)

1. Suppose drinking (and driving) causes harm to the society (in terms of risk to
other drivers and pedestrians) while it gives enjoyment to the driver (who drinks
and drive). The harm and net benefits for three different levels of drinking are as
given below:

Harm to Society Net Benefit to the Drivers

No Drinking $00 $00
Moderate Drinking $100 $ 180
Excessive Drinking $150 $ 210

The drivers care about only themselves and not the society.
(a) If the drivers have right to drink and drive, what is the resulting market
equilibrium outcome? Give reasons. (5 points)

Market equilibrium outcome is Excessive Drinking as this outcome gives

the highest benefits to the drivers equal to $210, (who only care about
themselves).

(b) What is the efficient outcome and why? How can Coasian bargaining
achieve this efficient solution (assuming bilateral bargaining is possible
without any transaction costs). (5 points)

Moderate drinking is the efficient solution as that level of drinking gives

the highest net benefits to the society as a whole including the drivers (180
- 100= $80). Note that ED gives net benefits of 210 - 150 = 60 < 80.

When drivers switch to MD from ED, they lose 210 - 180 = $ 30 but society
gains by 150 -100 = $ 50 (reduction in harm). So bargaining is possible.
Society pays any amount between 30 and 50 to the driver to switch from
ED to MD, which the drivers gladly accept with the realization of the
efficient solution.
2. A farmer produces wheat in a fixed parcel of land according to the production
technology given by Y = 2L0.5 where L is the amount of labor devoted to farming.
The markets for both wheat and labor are competitive with the equilibrium price
of wheat P = $ 100/ton and the wage rate W = $15/hours.
(a) Write down the expression for farmer's profit maximization. Use this
expression or condition to find if the farmer's current employment level of
25 hours is too high or too low. (8 points)

VMPL = P * dY/dL = 100/L0.5 = 100/L0.5.

The condition for profit maximization is: dл/dL = 0

or VMPL = W
or, 100/L0.5 = 15

At L = 25, VMPL = 100/250.5 = 20 > W (= $15)  the current level of L = 25 is too

high.

(Note: I would like to see the answers the way question is being asked, not that
you always answer in the same generic way, irrespective of how the question is
formatted).

(b) Now suppose that this land is open access (in the sense that new farmers
can enter the farmland and can start farming). How many labor hours will
the farmers employ altogether? (6 points)

When the resource is open access, new firms enter to exploit the resource until
profits are zero. That is:
  py  wL  100 * 2 L0.5  15L  0
L0.5  200 / 15
L = 177.77 units.

Thus in the open access equilibrium, 177.77 labor units (which is higher than
profit -maximizing level) will be employed.
3 (a) List 3 Daly's rule for the sustainable use of resources. (3 pts)

1) Renewable resources must be used no faster than the rate at which they
regenerate ( or harvest rate < rate of replenishment).
2) Nonrenewable resources must be used no faster than renewable substitutes
can be put into place.
3) Pollution and wastes must be emitted no faster than the natural system can
absorb or assimilate them.

(b) List 4 major solutions to the common property resource problems caused by
open access. Briefly explain (not more than 100 words or 2 or 3 lines) about one
of the solutions you listed. (6 pts)

1)Privatization of the open access property.

2) Limitation on the use of property such as user fees or use quota (e.g.,
harvesting quota in fishery)
3) Turn the property into common or community property (e.g., community
forestry where user group manages the commons).
4) Outright ban on the use of resources.

When the open access resource is turned into a private property, the owner will
bear all the costs and benefits associated with the use of the resource and thus
will act so as to maximize her net present value of the profits over all the time
periods until the resource is exhausted. Therefore, in the absence of externality,
this property right regime leads to an efficient solution unlike under the open
access regime, in which case the resource is over-exploited (until profits are
zero), often leading to "tragedy of the commons."

4. Suppose the inverse market demand function for a nonrenewable resource is:
P = 14 – Q and the MC of extraction is $4 throughout the two periods of
extraction (period 0 and period 1). The total stock of resource available is 20
units and the market discount rate is 10% throughout the periods.
a) Assuming market for the resource is competitive, set up the maximization
problem of a typical firm (note only one firm). (3 pts)

A typical miner maximizes its present value of profits

P1q1  4q1
Max   P0 q0  4q0 
1.1
subject to n( q0  q1 )  20
 where n = number of miners.
Lagrangian
P1q1  4q1
L  P0 q0  4q0    (20  nq0  nq1 )
1.1

b) Use Lagrange Multiplier method to solve the above maximization

problem. (Hint: while solving this problem (after taking derivative),
solve for the total industry extraction level in each period, not individual
extractions). (8 pts)

Taking derivatives,
L
 P0  4  n  0  P0  4  n ......(1)
q0
L P1  4 P 4
  n  0  1  n ......(2)
q1 1.1 1.1
L
 20  nq0  nq1  0  Q0  Q1  20 ......(3)


(Note that if you take derivatives with respect to Q, that means you are choosing
total Q (of all the firms) that maximizes your individual profits, which does NOT
makes sense or is conceptually wrong !!)

From (1) and (2)

P 4
P0  4  1
1.1
10  Q1
10  Q0 
1.1
1.1Q0  Q1  1 ..........................(4)

From (3) and (4)

Q0 = Q1 = 10
4(c) Draw a fully labeled diagram showing the results from part b). What is
special about your result? Explain in less than 60 words. (6 pts)

10
10 - Q0 9
.
(10 - Q1)/1.1

Q0 10 Q
10
20 1

The scarcity rent in both the periods = 0. Given S = 20, this could be due to
lower demand or higher MC of extraction.

5. If the nonrenewable resource market from Q.4 is owned or monopolized by a

single firm, how much will this monopoly extract in each period? You may use
Hotelling rule directly (hint: note your result from 4(c) under competitive
market) (2 bonus pts)

Since in the competitive market scarcity rent = 0, it should be zero in the

monopoly market as well. Thus,

MR0 - MC0 = 0
14 - 2Q0 - 4= 0
Q0 = 5

Similarly, (MR0 - MC0)/1.1 = 0

14 - 2Q1 - 4= 0
Q1 = 5.

(Under the Monopoly situation as well, the resource will not be exhausted)