ECON3004 Public Economics Hamad Kataria

QUESTION 1
International emissions regulation Individuals in two countries (c and −c) consume a
good x. The exogenous world market price of the good is p. Consumption of 𝑥𝑐 units
generates emissions (𝑒𝑐) equivalent to its level of consumption, so 𝑒𝑐 = 𝑥𝑐. The
representative agent in each country derives utility from consumption and disutility
from being exposed to aggregate emissions 𝑒𝑐 +𝑒−𝑐:

𝑈𝑐 = 𝑥𝑐 − 𝑝𝑥𝑐 − 𝑏(𝑥𝑐 + 𝑥−𝑐)

(a) Suppose each country chooses production to maximise their representative agent’s
𝑁 𝑁
utility. Derive best replies and the Nash equilibrium (𝑥𝑐 , 𝑥−𝑐 ), and aggregate
emissions.

Country C Maximisation

𝑀𝑎𝑥 𝑥𝑐 {𝑈𝑐} = 𝑀𝑎𝑥 𝑥𝑐 { 𝑥𝑐 − 𝑝𝑥𝑐 − 𝑏(𝑥𝑐 + 𝑥−𝑐)}

0.5
= 𝑀𝑎𝑥 𝑥𝑐 {𝑥𝑐 − 𝑝𝑥𝑐 − 𝑏(𝑥𝑐 + 𝑥−𝑐)}
FOC:
𝑑𝑈𝑐 −0.5
𝑑𝑥𝑐
=0. 5𝑥𝑐 − 𝑝 − 𝑏 = 0
−0.5 0.5 1
→ 𝑥𝑐 = 2(𝑝 + 𝑏) → 𝑥𝑐 = 2 ( 𝑝 +𝑏 )
Country C best response:
1
𝑥𝑐 = 2
4(𝑝+𝑏)

Country -C Maximisation

𝑀𝑎𝑥 𝑥−𝑐 {𝑈−𝑐} = 𝑀𝑎𝑥 𝑥−𝑐 { 𝑥−𝑐 − 𝑝𝑥−𝑐 − 𝑏(𝑥−𝑐 + 𝑥𝑐)}

0.5
= 𝑀𝑎𝑥 𝑥−𝑐 {𝑥−𝑐 − 𝑝𝑥−𝑐 − 𝑏(𝑥−𝑐 + 𝑥𝑐)}
𝑑𝑈−𝑐 −0.5
𝑑𝑥−𝑐
=0. 5𝑥−𝑐 − 𝑝 − 𝑏 = 0
−0.5 0.5 1
→ 𝑥−𝑐 = 2(𝑝 + 𝑏) → 𝑥−𝑐 = 2 ( 𝑝 +𝑏 )
ECON3004 Public Economics Hamad Kataria

Country -C best response:

1
𝑥− 𝑐 = 2
4(𝑝+𝑏)

Simultaneous best responses for Nash Equilibrium:

𝑁 1
𝑥 −𝑐
= 2
4 ( 𝑝 +𝑏 )
𝑁 1
𝑥 𝑐
= 2
4 ( 𝑝 +𝑏 )
𝑁 𝑁
So 𝑥 𝑐= 𝑥 −𝑐
𝑁 𝑁 1 1
(𝑥 𝑐, 𝑥 −𝑐
)=( 2 , 2 )
4 ( 𝑝 +𝑏 ) 4 ( 𝑝 +𝑏 )

Aggregate emissions:

𝑁 𝑁 1 1
𝑒 = 𝑒𝑐 + 𝑒−𝑐 =𝑥 𝑐+𝑥 −𝑐
= 2 + 2
4(𝑝+𝑏) 4(𝑝+𝑏)
1
𝑒 = 2
2(𝑝+𝑏)
ECON3004 Public Economics Hamad Kataria

(b) Suppose a supra-national agency (think of the European Union) requires individual
member countries to set emissions standards to regulate emissions from the
consumption of good x. The new utility function now includes the level of emissions
standards sc for each respective country where 0 < 𝑠𝑐 < 1.

𝑈𝑐 = 𝑥𝑐 − 𝑝𝑥𝑐 − 𝑏(1 − 𝑠𝑐)𝑥𝑐 − 𝑏(1 − 𝑠−𝑐)𝑥−𝑐

𝑁 𝑁
Derive the best replies and the Nash equilibrium (𝑥𝑐 , 𝑥−𝑐), and aggregate emissions
with these new emissions standards in place.

Country C Maximisation

𝑀𝑎𝑥 𝑥𝑐 {𝑈𝑐}

= 𝑀𝑎𝑥 𝑥𝑐 { 𝑥𝑐 − 𝑝𝑥𝑐 − 𝑏(1 − 𝑠𝑐)𝑥𝑐 − 𝑏(1 − 𝑠−𝑐)𝑥−𝑐}

0.5
= 𝑀𝑎𝑥 𝑥𝑐 {𝑥𝑐 − 𝑝𝑥𝑐 − 𝑏(1 − 𝑠𝑐)𝑥𝑐 − 𝑏(1 − 𝑠−𝑐)𝑥−𝑐}
FOC:
𝑑𝑈𝑐 −0.5
𝑑𝑥𝑐
=0. 5𝑥𝑐 − 𝑝 − 𝑏(1 − 𝑠𝑐) = 0
−0.5 0.5 1
→ 𝑥𝑐 = 2𝑝 + 2𝑏(1 − 𝑠𝑐) → 𝑥𝑐 = 2𝑝+2𝑏(1−𝑠𝑐)
Country C best response:
1
𝑥𝑐 = 2 2 2
4𝑝 +4𝑏 (1−𝑠𝑐)

Country -C Maximisation
𝑀𝑎𝑥 𝑥−𝑐 {𝑈−𝑐}

= 𝑀𝑎𝑥 𝑥−𝑐 { 𝑥−𝑐 − 𝑝𝑥−𝑐 − 𝑏(1 − 𝑠−𝑐)𝑥−𝑐 − 𝑏(1 − 𝑠𝑐)𝑥𝑐}

0.5
= 𝑀𝑎𝑥 𝑥−𝑐 {𝑥−𝑐 − 𝑝𝑥−𝑐 − 𝑏(1 − 𝑠−𝑐)𝑥−𝑐 − 𝑏(1 − 𝑠𝑐)𝑥𝑐}
ECON3004 Public Economics Hamad Kataria

FOC:
𝑑𝑈−𝑐 −0.5
𝑑𝑥−𝑐
=0. 5𝑥−𝑐 − 𝑝 − 𝑏(1 − 𝑠−𝑐) = 0
−0.5 0.5 1
→ 𝑥−𝑐 = 2𝑝 + 2𝑏(1 − 𝑠−𝑐) → 𝑥−𝑐 = 2𝑝+2𝑏(1−𝑠−𝑐)
Country -C best response:
1
𝑥− 𝑐 = 2 2 2
4𝑝 +4𝑏 (1−𝑠−𝑐)

Simultaneous best responses for Nash Equilibrium:

𝑁 1 1
𝑥 −𝑐
= 2 2 2 > 2
4𝑝 +4𝑏 (1−𝑠𝑐) 4 ( 𝑝 +𝑏 )
𝑁 1 1
𝑥 𝑐
= 2 2 2 > 2
4𝑝 +4𝑏 (1−𝑠−𝑐) 4 ( 𝑝 +𝑏 )
𝑁 𝑁 1 1
(𝑥 𝑐, 𝑥 −𝑐
)=( 2 2 2 , 2 2 2 )
4𝑝 +4𝑏 (1−𝑠𝑐) 4𝑝 +4𝑏 (1−𝑠− 𝑐)

Aggregate emissions:

𝑁 𝑁 1 1
𝑒 = 𝑒𝑐 + 𝑒−𝑐 =𝑥 𝑐+𝑥 −𝑐
= 2 2 2 + 2 2 2
4𝑝 +4𝑏 (1−𝑠𝑐) 4𝑝 +4𝑏 (1−𝑠−𝑐)
1 1
𝑒 = 2 2 2 > 2
2𝑝 +2𝑏 (1−𝑠𝑐) 2(𝑝+𝑏)

- When 𝑝 and 𝑏 increase, emissions and consumption fall.

- When 𝑠 increases, then emissions and consumption rise
𝑐
- Surprisingly, with the emission standards in place, consumption and
emissions are higher. Perhaps this is due to green technology being
utilised to supply more goods as its more efficient, thus naturally people
can consume more.
ECON3004 Public Economics Hamad Kataria

(c) Derive the allocation of production (𝑥𝑐 , 𝑥−𝑐 ) that maximises utilitarian welfare,
i.e. the sum of utilities of the representative agents. Compare emissions in the Nash
equilibrium outcome to the utilitarian optimum and explain. Is the utilitarian optimum
a Pareto optimum?

𝑀𝑎𝑥 𝑥𝑐𝑥−𝑐 {𝑈𝑐 + 𝑈−𝑐}

= 𝑀𝑎𝑥 𝑥𝑐𝑥−𝑐 { 𝑥𝑐 + 𝑥−𝑐 − 𝑝𝑥𝑐 − 𝑝𝑥−𝑐 − 2𝑏(1 − 𝑠𝑐)𝑥𝑐 − 2𝑏(1 − 𝑠−𝑐)𝑥−𝑐}

0.5 0.5
= 𝑀𝑎𝑥 𝑥𝑐𝑥−𝑐 {𝑥𝑐 + 𝑥−𝑐 − 𝑝𝑥𝑐 − 𝑝𝑥−𝑐 − 2𝑏(1 − 𝑠𝑐)𝑥𝑐 − 2𝑏(1 − 𝑠−𝑐)𝑥−𝑐}

FOC:
𝑑(𝑈𝑐+𝑈−𝑐) −0.5
𝑑𝑥𝑐
=0. 5𝑥𝑐 − 𝑝 − 2𝑏(1 − 𝑠𝑐) = 0
0.5 1
→ 𝑥𝑐 = 2𝑝+4𝑏(1−𝑠𝑐)
1
𝑥𝑐 = 2 2 2
4𝑝 +16𝑏 (1−𝑠𝑐)
Therefore due to symmetric preferences:
1
𝑥−𝑐 = 2 2 2
4𝑝 +16𝑏 (1−𝑠− 𝑐)
Utilitarian Allocation:
1 1
(𝑥𝑐,𝑥−𝑐)=( 2 2 2 , 2 2 2 )
4𝑝 +16𝑏 (1−𝑠𝑐) 4𝑝 +16𝑏 (1−𝑠− 𝑐)
ECON3004 Public Economics Hamad Kataria

Aggregate emissions:
1 1
e= 𝑒𝑐 + 𝑒−𝑐= 𝑥𝑐 + 𝑥−𝑐 = 2 2 2 + 2 2 2
4𝑝 +16𝑏 (1−𝑠𝑐) 4𝑝 +16𝑏 (1−𝑠− 𝑐)
1 1
= 2 2 2 < 2 2 2
2𝑝 +8𝑏 (1−𝑠𝑐) 2𝑝 +2𝑏 (1−𝑠𝑐)

- Emissions and consumption in utilitarian approach is less than in Nash

Outcome.
- This is due to the utilitarian approach enabling an allocation that maximises
welfare on society as a whole, by reducing emissions, even if it means
sacrificing some individual gains. Whereas in a Nash outcome, decisions are
made based on individual self-interest, meaning everyone consumes more,
even if there are now more emissions that decrease others' utility.

Is this Pareto?

Pareto Optimum occurs when no allocation is available that makes one

individual better off without making another worse

So let's compare Utilitarian outcomes utility to Nash Outcomes utility. If the

Utilitarian outcome derives higher utility than Nash, then the Utilitarian might
be Pareto optimal. But if Nash derives higher utility than Utilitarian, then
Utilitarian certainly is not Pareto optimal.

𝑈𝑐 = 𝑥𝑐 − 𝑝𝑥𝑐 − 𝑏(𝑥𝑐 + 𝑥−𝑐)

Utility of Utilitarian
1 𝑝 1
𝑈𝑐 = 2 2 2 − 2 2 2 − 𝑏( 2 2 2 )
4𝑝 +16𝑏 (1−𝑠𝑐) 4𝑝 +16𝑏 (1−𝑠𝑐) 2𝑝 +8𝑏 (1−𝑠𝑐)
1 𝑝 2𝑏
𝑈𝑐 = − 2 2 2 − 2 2 2
2𝑝 +4𝑏 (1−𝑠𝑐) 4𝑝 +16𝑏 (1−𝑠𝑐) 4𝑝 +16𝑏 (1−𝑠𝑐)
2𝑝+4𝑏(1−𝑠𝑐) 𝑝+2𝑏
𝑈𝑐 = 2 2 2
− 2 2 2
4𝑝 +16𝑏 (1−𝑠𝑐) 4𝑝 +16𝑏 (1−𝑠𝑐)

𝑈𝑡𝑖𝑙𝑖𝑡𝑎𝑟𝑖𝑎𝑛 𝑝+4𝑏(1−𝑠𝑐)−2𝑏
𝑈𝑐 = 2 2 2
4𝑝 +16𝑏 (1−𝑠𝑐)
ECON3004 Public Economics Hamad Kataria

Utility of Nash

1 1 1
𝑈𝑐 = 2 2 2 − 𝑝 2 2 2 − 𝑏( 2 2 2 )
4𝑝 +4𝑏 (1−𝑠𝑐) 4𝑝 +4𝑏 (1−𝑠𝑐) 2𝑝 +2𝑏 (1−𝑠𝑐)
1 𝑝 2𝑏
𝑈𝑐 = − 2 2 2 − 2 2 2
2𝑝 +2𝑏 (1−𝑠𝑐) 4𝑝 +4𝑏 (1−𝑠𝑐) 4𝑝 +4𝑏 (1−𝑠𝑐)

2𝑝 +2𝑏 (1−𝑠𝑐) 𝑝 2𝑏
𝑈𝑐 = 2 2 2
− 2 2 2 − 2 2 2
4𝑝 +4𝑏 (1−𝑠𝑐) 4𝑝 +4𝑏 (1−𝑠𝑐) 4𝑝 +4𝑏 (1−𝑠𝑐)

𝑁𝑎𝑠ℎ 𝑝+2𝑏(1−𝑠𝑐)−2𝑏
𝑈 𝑐
= 2 2 2
4𝑝 +4𝑏 (1−𝑠𝑐)
Assuming 𝑠𝑐 = 0. 9, b=0.5, p=2:
𝑈𝑡𝑖𝑙𝑖𝑡𝑎𝑟𝑖𝑎𝑛 𝑝+4𝑏(1−𝑠𝑐)−2𝑏
𝑈𝑐 = 2 2 2
4𝑝 +16𝑏 (1−𝑠𝑐)
𝑈𝑡𝑖𝑙𝑖𝑡𝑎𝑟𝑖𝑎𝑛 1. 2
𝑈𝑐 = 16.04

𝑁𝑎𝑠ℎ 𝑝+2𝑏(1−𝑠𝑐)−2𝑏
𝑈 𝑐
= 2 2 2
4𝑝 +4𝑏 (1−𝑠𝑐)
𝑁𝑎𝑠ℎ 1. 1
𝑈 𝑐
= 16.01

𝑈𝑡𝑖𝑙𝑖𝑡𝑎𝑟𝑖𝑎𝑛 𝑁𝑎𝑠ℎ
𝑈𝑐 >𝑈 𝑐

Utilitarian allocation derives more utility than Nash equilibrium. There is a

Pareto improvement by using a utilitarian allocation from nash allocation.
But using the first welfare theorem, competitive equilibriums and nash
equilibriums are Pareto efficient, so the Utilitarian outcome must be Pareto
optimal.
ECON3004 Public Economics Hamad Kataria

(d) What is the role of the emissions standards sc in the utility function above? The
setting of standards typically comes at a technological cost to producers. What are the
likely problems that countries will face when trying to set higher environmental
standards? What is the potential role of supra-national agencies in the setting of
emissions standards?

1
𝑒 = 2 2 2
2𝑝 +8𝑏 (1−𝑠𝑐)
The emissions standards in the function increase total emissions if standards rise.

A potential issue that countries may face when establishing higher environmental
standards is that higher standards will be at the expense of economic growth. The
issue for a country is that when they raise emissions standards, other countries may
not. These countries will enjoy an economic advantage, while the country that
increases emissions standards will pay for all the costs. This will exacerbate their
competitive position, and only they will suffer as a result. Countries are hesitant to
sign agreements to reduce emissions because they are afraid of this scenario. This
scenario is comparable to the prisoner's dilemma. The Prisoner's Dilemma
demonstrates that people make decisions based on their own self-interest, which
ultimately works against everyone.

Using this matrix, the overall best Utilitarian outcome would be for both countries to
increase standards. However, individuals may make different decisions.

Following both countries' best responses, the Nash Equilibrium is to do nothing:

Supra-national agencies should put incentives in place so that the nash equilibrium in
both countries' increasing standards occurs. Which could be done via the agencies
intermediating between countries to negotiate deals to ensure that both countries
collude to increase standards.
ECON3004 Public Economics Hamad Kataria

QUESTION 2
Suppose now that the two countries exist for two periods, 1 and 2, and the
consequence of emissions in period 1 are not felt until period 2 (much as with climate
change). The representative agent in country i = A, B maximises now present and
future utility discounted by a discount factor δ < 1 according to the new utility
function:

2 2 2
𝑈𝑖 = 𝑥𝑖 − 0. 5𝑥 𝑖 + δ(𝑦𝑖 − 0. 5𝑦 𝑖 − 𝑠𝑖(𝑥𝐴 + 𝑥𝐵) )
where 𝑥 denotes consumption in period 1, 𝑦 consumption in period 2, and 𝑠 the
𝑖 𝑖 𝑖
susceptibility to climate change of each country.

𝑁
(a) Derive the Nash equilibrium of the game of countries' consumption choices (𝑥𝐴 ,
𝑁 𝑁 𝑁 𝑁 𝑁
𝑥𝐵 , 𝑦𝐴 , 𝑦𝐵 ). Compute aggregate emissions in period 1 (𝑥𝐴 + 𝑥𝐵 ) and describe how
they vary in δ.

Period 1 Country A Maximisation

2 2 2 2
𝑀𝑎𝑥 𝑥𝐴, 𝑦𝐴 {𝑥𝐴 − 0. 5𝑥 𝐴
+ δ(𝑦𝐴 − 0. 5𝑦 𝐴
− 𝑠𝐴(𝑥 𝐴
+ 2𝑥𝑎𝑥𝑏 + 𝑥 𝐵)}

FOC:
𝑑𝑈𝐴
𝑑𝑥𝐴
=1 − 𝑥𝐴 − 2δ𝑠𝐴𝑥𝐴 − 2δ𝑠𝐴𝑥𝐵 = 0

𝑥𝐴(1 + 2δ𝑠𝐴) = 1 − 2δ𝑠𝐴𝑥𝐵

Country A best response:
1−2δ𝑠𝐴𝑥𝐵
→ 𝑥𝐴(𝑥𝐵) = (1+2δ𝑠𝐴)

Country B best response:

1−2δ𝑠𝐵𝑥𝐴
→ 𝑥𝐵(𝑥𝐴) = (1+2δ𝑠𝐵)
ECON3004 Public Economics Hamad Kataria

Period 2 Country A Maximisation

2 2 2 2
𝑀𝑎𝑥 𝑥𝐴, 𝑦𝐴 {𝑥𝐴 − 0. 5𝑥 𝐴
+ δ(𝑦𝐴 − 0. 5𝑦 𝐴
− 𝑠𝐴(𝑥 𝐴
+ 2𝑥𝑎𝑥𝑏 + 𝑥 𝐵)}

FOC:
𝑑𝑈𝐴
𝑑𝑦𝐴
= δ − δ𝑦𝐴= 0
𝑁𝐴𝑆𝐻
→𝑦 𝐴
= 1
𝑁𝐴𝑆𝐻
→𝑦 𝐵
= 1
Simultaneous best responses for Nash Equilibrium:
1−2δ𝑠𝐵𝑥𝐴
1−2δ𝑠𝐴
𝑁𝐴𝑆𝐻 (1+2δ𝑠𝐵)
𝑥 𝐴
= (1+2δ𝑠𝐴)
2
2δ𝑠𝐴−4δ 𝑠𝐴𝑠𝐵𝑥𝐴
1−
𝑁𝐴𝑆𝐻 (1+2δ𝑠𝐵)
𝑥 𝐴
= (1+2δ𝑠𝐴)
2
𝑁𝐴𝑆𝐻 2δ𝑠𝐴−4δ 𝑠𝐴𝑠𝐵 𝑥𝐴
𝑥 𝐴
(1 + 2δ𝑠𝐴) = 1 − (1+2δ𝑠𝐵 )

𝑁𝐴𝑆𝐻 2
𝑥 𝐴
(1 + 2δ𝑠𝐴)(1 + 2δ𝑠𝐵) = (1 + 2δ𝑠𝐵) − 2δ𝑠𝐴 + 4δ 𝑠𝐴𝑠𝐵𝑥𝐴
2
𝑥𝐴(1 + 2δ𝑠𝐴)(1 + 2δ𝑠𝐵) = (1 + 2δ𝑠𝐵) − 2δ𝑠𝐴 + 4δ 𝑠𝐴𝑠𝐵𝑥𝐴
2
𝑥𝐴(1 + 2δ𝑠𝐴)(1 + 2δ𝑠𝐵) − 4δ 𝑠𝐴𝑠𝐵𝑥𝐴 = (1 + 2δ𝑠𝐵) − 2δ𝑠𝐴
2
𝑥𝐴((1 + 2δ𝑠𝐴)(1 + 2δ𝑠𝐵) − 4δ 𝑠𝐴𝑠𝐵) = 1 + 2δ𝑠𝐵 − 2δ𝑠𝐴
1+2δ 𝑠𝐵−2δ 𝑠𝐴
𝑥𝐴 = 2
(1+2δ 𝑠𝐴)(1+2δ 𝑠𝐵)−4δ 𝑠𝐴𝑠𝐵

𝑁𝐴𝑆𝐻 1+2δ 𝑠𝐵−2δ 𝑠𝐴

𝑥 𝐴
= 1+2δ 𝑠𝐵+2δ 𝑠𝐴
ECON3004 Public Economics Hamad Kataria

𝑁𝐴𝑆𝐻 1+2δ𝑠𝐴−2δ𝑠𝐵
→𝑥 𝐵
= 1+2δ𝑠𝐴+2δ𝑠𝐵

So Nash Equilibrium allocations are:

𝑁𝐴𝑆𝐻 1+2δ𝑠𝐵−2δ𝑠𝐴
𝑥 𝐴
= 1+2δ𝑠𝐵+2δ𝑠𝐴

𝑁𝐴𝑆𝐻 1+2δ𝑠𝐴−2δ𝑠𝐵
→𝑥 𝐵
= 1+2δ𝑠𝐴+2δ𝑠𝐵

𝑁𝐴𝑆𝐻
→𝑦 𝐴
= 1
𝑁𝐴𝑆𝐻
→𝑦 𝐵
= 1

Aggregate emissions in period 1

𝑁𝐴𝑆𝐻 𝑁𝐴𝑆𝐻
𝑥 + 𝑥
𝐴 𝐵

1+2δ𝑠𝐵−2δ𝑠𝐴 1+2δ𝑠𝐴−2δ𝑠𝐵
1+2δ𝑠𝐵+2δ𝑠𝐴
+ 1+2δ𝑠 +2δ𝑠
𝐴 𝐵

2
e = 1+2δ𝑠 +2δ𝑠𝐵
𝐴

- When δ increases, then the denominator of the fraction increases, but for
the fraction as a whole, it decreases.
- Aggregate emissions and δ have an inverse relationship.
- So when δ increases, emissions fall.
ECON3004 Public Economics Hamad Kataria

(b) Set up the utilitarian social planner’s optimisation problem and compute the
optimal allocation (x ∗ A, x∗ B, y∗ A, y∗ B). Compare allocation and emissions to (a)
and explain any differences.

Period 1 Country A Maximisation

𝑀𝑎𝑥 𝑥𝐴𝑥𝐵𝑦𝐴𝑦𝐵 {𝑈𝐴 + 𝑈𝐵}
2 2 2 2
= 𝑀𝑎𝑥 {𝑥𝐴 − 0. 5𝑥 𝐴
+ δ(𝑦𝐴 − 0. 5𝑦 𝐴
− 𝑠𝐴(𝑥 𝐴
+ 2𝑥𝐴𝑥𝐵 + 𝑥 𝐵))
2 2 2 2
+ 𝑥 𝐵 − 0. 5𝑥 𝐵
+ δ(𝑦𝐵 − 0. 5𝑦 𝐵
− 𝑠𝐵(𝑥 𝐵
+ 2𝑥𝐴𝑥𝐵 + 𝑥 𝐴))}
FOC:
𝑑(𝑈𝐴+𝑈𝐵)
𝑑𝑥𝐴
=1 − 𝑥𝐴 − 2δ𝑠𝐴𝑥𝐴 − 2δ𝑠𝐴𝑥𝐵 − 2δ𝑠𝐵𝑥𝐵 − 2δ𝑠𝐵𝑥𝐴 = 0
1 − 2δ𝑠𝐴𝑥𝐵 − 2δ𝑠𝐵𝑥𝐵 = 2δ𝑠𝐵𝑥𝐴 + 2δ𝑠𝐴𝑥𝐴 + 𝑥𝐴
1 − 2δ𝑠𝐴𝑥𝐵 − 2δ𝑠𝐵𝑥𝐵 = 𝑥𝐴(2δ𝑠𝐵 + 2δ𝑠𝐴 + 1)
1−2δ𝑠𝐴𝑥𝐵−2δ𝑠𝐵𝑥𝐵
𝑥𝐴 = (2δ𝑠𝐵+2δ𝑠𝐴+1)
Therefore:
1−2δ𝑠𝐵𝑥𝐴−2δ𝑠𝐴𝑥𝐴
𝑥𝐵 = (2δ𝑠𝐴+2δ𝑠𝐵+1)

Substitute 𝑥𝐵 into 𝑥𝐴 equation:

1−2δ𝑠𝐴𝑥𝐵−2δ𝑠𝐵𝑥𝐵
𝑥𝐴 = (2δ𝑠𝐵+2δ𝑠𝐴+1)
1+𝑥𝐵(−2δ𝑠𝐴−2δ𝑠𝐵)
𝑥𝐴 = (2δ𝑠𝐵+2δ𝑠𝐴+1)
1−2δ𝑠𝐵𝑥𝐴−2δ𝑠𝐴𝑥𝐴
1+ (2δ𝑠𝐴+2δ𝑠𝐵+1)
(−2δ𝑠𝐴−2δ𝑠𝐵)
𝑥𝐴 = (2δ𝑠𝐵+2δ𝑠𝐴+1)
1−2δ𝑠𝐵𝑥𝐴−2δ𝑠𝐴𝑥𝐴
𝑥𝐴(2δ𝑠𝐵 + 2δ𝑠𝐴 + 1) = 1 + (2δ𝑠𝐴+2δ𝑠𝐵+1)
(− 2δ𝑠𝐴 − 2δ𝑠𝐵)
ECON3004 Public Economics Hamad Kataria

𝑥𝐴(2δ𝑠𝐵 + 2δ𝑠𝐴 + 1) = (2δ𝑠𝐴 + 2δ𝑠𝐵 + 1) + (1 − 2δ𝑠𝐵𝑥𝐴 − 2δ𝑠𝐴𝑥𝐴)(− 2δ𝑠𝐴 − 2δ𝑠𝐵)

2
𝑥𝐴(2δ𝑠𝐵 + 2δ𝑠𝐴 + 1) = (2δ𝑠𝐴 + 2δ𝑠𝐵 + 1) + (1 − 2δ𝑠𝐵𝑥𝐴 − 2δ𝑠𝐴𝑥𝐴)(− 2δ𝑠𝐴 − 2δ𝑠𝐵)

2 2 2 2 2 2
= 2δ𝑠𝐴 + 2δ𝑠𝐵 + 1− 2δ𝑠𝐴− 2δ𝑠𝐵+4δ 𝑠𝐴𝑠𝐵𝑥𝐴+ 4δ 𝑠 𝐵𝑥𝐴+ 4δ 𝑠𝐴 𝑥𝐴+ 4δ 𝑠𝐴𝑠𝐵𝑥𝐴
2 2 2 2 2 2
= 1 +4δ 𝑠𝐴𝑠𝐵𝑥𝐴+ 4δ 𝑠 𝐵𝑥𝐴+ 4δ 𝑠𝐴 𝑥𝐴+ 4δ 𝑠𝐴𝑠𝐵𝑥𝐴
2 2 2 2 2 2
𝑥𝐴(2δ𝑠𝐵 + 2δ𝑠𝐴 + 1) = 1 +8δ 𝑠𝐴𝑠𝐵𝑥𝐴+ 4δ 𝑠 𝐵𝑥𝐴+ 4δ 𝑠𝐴 𝑥𝐴
2 2 2 2 2 2
𝑥𝐴(2δ𝑠𝐵 + 2δ𝑠𝐴 + 1) − 8δ 𝑠𝐴𝑠𝐵𝑥𝐴 − 4δ 𝑠 𝐵𝑥𝐴 − 4δ 𝑠𝐴 𝑥𝐴= 1
2 2 2 2 2 2
𝑥𝐴((2δ𝑠𝐵 + 2δ𝑠𝐴 + 1) − 8δ 𝑠𝐴𝑠𝐵 − 4δ 𝑠 𝐵
− 4δ 𝑠𝐴 )=1
1
𝑥 *𝐴= 2 2 2 2 2 2
(2δ𝑠𝐵+2δ𝑠𝐴+1) −8δ 𝑠𝐴𝑠𝐵−4δ 𝑠 𝐵−4δ 𝑠𝐴
1
𝑥 *𝐴= 4δ𝑠𝐵+4δ𝑠𝐴+1

Therefore:
1
𝑥 *𝐵 = 4δ𝑠𝐵+4δ𝑠𝐴+1

𝑠𝑜 𝑥*𝐴 = 𝑥*𝐵
ECON3004 Public Economics Hamad Kataria

Period 2 Country A Maximisation

2 2 2 2
𝑀𝑎𝑥 {𝑥𝐴 − 0. 5𝑥 𝐴
+ δ(𝑦𝐴 − 0. 5𝑦 𝐴
− 𝑠𝐴(𝑥 𝐴
+ 2𝑥𝐴𝑥𝐵 + 𝑥 𝐵))
2 2 2 2
+ 𝑥 𝐵 − 0. 5𝑥 𝐵
+ δ(𝑦𝐵 − 0. 5𝑦 𝐵
− 𝑠𝐵(𝑥 𝐵
+ 2𝑥𝐴𝑥𝐵 + 𝑥 𝐴))}
FOC:
𝑑(𝑈𝐴+𝑈𝐵)
𝑑𝑦𝐴
=δ − δ𝑦𝐴 = 0

*
→𝑦 𝐴
= 1
*
→𝑦 𝐵
= 1

Utilitarian Allocation
* * 1 1
(𝑥 *𝐴, 𝑥 *𝐵, 𝑦 𝐴, 𝑦 𝐵)=( , ,1,1)
4δ𝑠𝐵+4δ𝑠𝐴+1 4δ𝑠𝐵+4δ𝑠𝐴+1

Period 1 Allocation Comparison

𝑁𝐴𝑆𝐻 1+2δ 𝑠𝐵−2δ 𝑠𝐴
𝑥 𝐴
= 1+2δ 𝑠𝐵+2δ 𝑠𝐴
1
𝑥 *𝐴= 4δ𝑠 +4δ𝑠𝐴+1
𝐵
Assuming δ = 𝑠𝐴 = 𝑠𝐵 = 0. 5
1 𝑁𝐴𝑆𝐻
𝑥 *𝐴= 3 < 𝑥 𝐴
=
1
2
- The Utilitarian outcome has less consumption than Nash outcome.

Period 2 Allocation Comparison

* 𝑁𝐴𝑆𝐻
→𝑦 𝐴
= 1 = 𝑦𝐴
* 𝑁𝐴𝑆𝐻
→𝑦 𝐵
= 1 = 𝑦𝐵
- Utilitarian and nash outcomes have the same amount of period 2
consumption as each other.
ECON3004 Public Economics Hamad Kataria

Aggregate Emissions Comparison

1 1
e= 𝑒𝐴 + 𝑒𝐵= 𝑥𝐴 + 𝑥𝐵 = 4δ𝑠𝐵+4δ𝑠𝐴+1
+ 4δ𝑠𝐵+4δ𝑠𝐴+1

2 𝑁𝐴𝑆𝐻 2
e*=
4δ𝑠𝐵+4δ𝑠𝐴+1
< 𝑒 = 1+2δ𝑠 +2δ𝑠𝐵
𝐴
- The Utilitarian outcome has less aggregate emmissions than Nash
outcome. Shown via denominator of Nash being smaller, thus fraction as
a whole is bigger.
- Emissions and consumption in utilitarian approach is less than in Nash
Outcome.
- This is due to the utilitarian approach enabling an allocation that maximises
sum of societies utilities as a whole, by reducing emissions, even if it means
sacrificing some individual gains. Whereas in a Nash outcome, decisions are
made based on individual self-interest, meaning everyone consumes more,
even if there are now more emissions that decrease others' utility
ECON3004 Public Economics Hamad Kataria

(c) Now a cap and trade scheme is introduced. Producing (and consuming) one unit of
the good requires one licence. A total of q licences are available in the two countries.
Denote the price for one licence by p. Will the equilibrium (price p and allocation xA,
xB), given that a licence price p has to be added per unit, maximise utilitarian welfare
given the fixed supply q? Will the countries agree on a preferred supply q of licences?

To determine whether the equilibrium under a cap and trade scheme maximizes
utilitarian welfare given the fixed supply q, we need to compare the welfare under the
Utilitarian outcome to the equilibrium.

Maximisation
2 2 2
𝑀𝑎𝑥 {{𝑥𝐴 − 0. 5𝑥 𝐴
+ δ(1 − 0. 5 − 𝑠𝐴(𝑥 𝐴
+ 2𝑥𝐴𝑥𝐵 + 𝑥 𝐵))
2 2 2
+ 𝑥 𝐵 − 0. 5𝑥 𝐵
+ δ(𝑦𝐵 − 0. 5 − 𝑠𝐵(𝑥 𝐵
+ 2𝑥𝐴𝑥𝐵 + 𝑥 𝐴))
𝑠. 𝑡. 𝑥𝐴 + 𝑥𝐵 = 𝑞
2 2
𝑀𝑎𝑥 {{𝑥𝐴 − 0. 5𝑥 𝐴
+ δ(0. 5 − 𝑠𝐴(𝑞 ))
2 2
+ 𝑥 𝐵 − 0. 5𝑥 𝐵
+ δ(0. 5 − 𝑠𝐵(𝑞 )) }
2 2
𝑀𝑎𝑥 {{𝑞 − 𝑥𝐵 − 0. 5(𝑞 − 𝑥𝐵) + δ(0. 5 − 𝑠𝐴(𝑞 ))
2 2
+ 𝑞 − 𝑥𝐴 − 0. 5(𝑞 − 𝑥𝐴) + δ(0. 5 − 𝑠𝐵(𝑞 )) }
2 2 2
𝑀𝑎𝑥 {{𝑞 − 𝑥𝐵 − 0. 5(𝑞 − 𝑞𝑥𝐵 − 𝑞𝑥𝐵 + 𝑥 𝐵) + δ(0. 5 − 𝑠𝐴(𝑞 ))
2 2 2
+ 𝑞 − 𝑥𝐴 − 0. 5(𝑞 − 𝑞𝑥𝐴 − 𝑞𝑥𝐴 + 𝑥 𝐴) + δ(0. 5 − 𝑠𝐵(𝑞 )) }
𝑑(𝑈𝐴+𝑈𝐵)
𝑑𝑥𝐴
=− 1 + 𝑞 − 2𝑥𝐴 = 0

𝑥𝐴 = 0. 5𝑞 − 0. 5 = 𝑥𝐵
𝑞 *= 2𝑥𝐴 + 1
1
We know 𝑥 *𝑎 = 3
So 𝑞 *= 1/3
ECON3004 Public Economics Hamad Kataria

Uilitarian welfare is maximised when q the number of licensces is equal to ⅓

Welfare with Cap and Trade(Utilitarian outcome)
2 2
Welafre = {𝑞 − 𝑥𝐵 − 0. 5(𝑞 − 𝑞𝑥𝐵 − 𝑞𝑥𝐵 + 𝑥 𝐵) + δ(0. 5 − 𝑠𝐴(𝑞))
2 2
+ 𝑞 − 𝑥𝐴 − 0. 5(𝑞 − 𝑞𝑥𝐴 − 𝑞𝑥𝐴 + 𝑥 𝐴) + δ(0. 5 − 𝑠𝐵(𝑞))
Welafre = 2*{2/3 + 0. 5(0. 5 − 0. 5(1/3)) = 5/3

Welfare with Cap and Trade(Equilibrium)

𝑁𝐴𝑆𝐻 1
We know 𝑥 𝐴
= 2
q=0
2 2
Welfare = {𝑞 − 𝑥𝐵 − 0. 5(𝑞 − 𝑞𝑥𝐵 − 𝑞𝑥𝐵 + 𝑥 𝐵) + δ(0. 5 − 𝑠𝐴(𝑞))
2 2
+ 𝑞 − 𝑥𝐴 − 0. 5(𝑞 − 𝑞𝑥𝐴 − 𝑞𝑥𝐴 + 𝑥 𝐴) + δ(0. 5 − 𝑠𝐵(𝑞))
Welfare = 2*{− 0. 5 − 0. 5(0. 25) + 0. 5(0. 5) =− 0. 75

The welfare in equilibrium is lower than what should be the case in utilitarian maxing
welfare. Thus the equilibrium does not maximise utilitarian welfare given fixed
quantity q.

As for whether the countries will agree on a preferred supply q of licences, they would
but the amount of q will depend on their preferences and susceptibility to climate
change.
ECON3004 Public Economics Hamad Kataria

(d) Consider the real-world problem of climate change. In what way does this model
succeed in capturing the issues around this inter-generational problem? In what ways
does the model fail?

2 2 2
𝑈𝑖 = 𝑥𝑖 − 0. 5𝑥 𝑖 + δ(𝑦𝑖 − 0. 5𝑦 𝑖 − 𝑠𝑖(𝑥𝐴 + 𝑥𝐵) )
The simple model presented above offers interesting insights into the issue of climate
change. One of its key strengths is its incorporation of a discount factor(δ). By setting
the discount rate to a value less than one, the model then weights a high proportion of
utility from present consumption compared to the future. This captures the human
tendency to prioritize present consumption over future consumption due to the higher
utility derived from the former.

Another vital feature of the model is its inclusion of the susceptibility to climate
change of each country (𝑠𝑖). This is an important consideration since some countries
are more vulnerable to the impacts of climate change than others. Within the utility
function, as 𝑠𝑖 increases, then the utility of the country falls. This illustrates that
countries with higher susceptibility would want policies in place to reduce emissions.

Furthermore, the model implicitly accounts for the delayed consequences of emissions
in period 1 that may not be felt until period 2. This is a key aspect of the problem as it
recognizes the long-term nature of climate change and the impact it will have on
future generations. By incorporating these delays, the model acknowledges that the
costs of emissions today will be felt by future generations. This is an essential
consideration for policymakers as they explore potential solutions.

However, the model does have some limitations. One such limitation is that it assumes
only two countries are competing. Expanding the model to include n amount of
countries could provide more insights into how countries may behave and interact in
the context of climate change.

To extend from that, this model assumes the utility function of the country, which
would be really hard to compute as everyone has different preferences, then to
aggregate these preferences would be strenous. Thus the utility function wouldnt be
the most accurate, thus we cant determine a true optimal allocation.

Finally, the model assumes that the representative agent in each country acts in a
perfectly rational and self-interested manner., with no consideration for other
regarding preferences. The model could be improved if the utility function had
included an altruism component, where the utility function includes a binary term ie 0
or 1 that multiplies consumption from other countries as follows: 𝑈𝑖 + γ(), where
γ 𝑖𝑠 1 if country is altruistic, 0 if not.