3. Which of the following is a disadvantage of the command-and-control approach to the problem of pollution?

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1 Eco 333 Name Test 2 30 July 2010 Please write your answers in ink. You may use pencil to draw graphs. Part I: each question is worth 2.5 points. Part II: each question is worth 25 points, so allocate your time efficiently. Part I 1. Suppose that Company A's railroad cars pass through Farmer B's corn fields. The railroad causes an externality to the farmer because the railroad cars emit sparks that cause $1,500 in damage to the farmer's crops. There is a special soy-based grease that the railroad could purchase that would eliminate the damaging sparks. The grease costs $1,200. Suppose that the railroad is not liable for any damage caused to the crops. Assume that there are no transaction costs. Which of the following characterizes the efficient outcome? a. The railroad will continue to operate but will pay the farmer $1,500 in damages. b. The railroad will purchase the grease for $1,200 and pay the farmer nothing because no crop damage will occur. c. The farmer will incur $1,500 in damages to his crops. d. The farmer will pay the railroad $1,200 to purchase the grease so that no crop damage will occur. 2. A local laundry advertises that the clothes it washes smell "sunshine fresh" because it line dries everything outside. Then a steel factory moves in next door and emits black smoke which stains the clothes drying at the laundry. In a world of zero transaction costs, according to the Coase theorem, granting the a. steel factory the right to pollute would be efficient, but granting the laundry the right to clean air would be equitable. b. laundry the right to clean air would be efficient, but granting the steel factory the right to pollute would be equitable. c. steel factory the right to pollute has the same effect on equity as granting the laundry the right to clean air. d. steel factory the right to pollute has the same effect on efficiency as granting the laundry the right to clean air. 3. Which of the following is a disadvantage of the command-and-control approach to the problem of pollution? a. It creates licenses to pollute. b. It is undemocratic. c. It only works in societies where everyone (or almost everyone) has a high degree of environmental consciousness. d. It usually overlooks less costly ways to achieve given goals. e. It violates property rights.

2 4. In some cases, tradable pollution permits may be better than a corrective tax because a. pollution permits allow for a market solution while a corrective tax does not. b. pollution permits generate more revenue for the government than a corrective tax. c. pollution permits are never preferred over a corrective tax. d. the government can set a maximum level of pollution using permits. 5. Tradable pollution permits a. have prices that are set by the government. b. will be more valuable to firms that can reduce pollution only at high costs. c. are likely to create a higher level of total pollution. d. are less desirable than corrective taxes in reducing pollution. 6. In the economic way of thinking, a tax on pollutants a. unfairly places the burden of pollution reduction on the poor. b. is inefficient because it won't reduce pollution to zero. c. is cost effective because it equates marginal abatement costs across firms. d. cannot be labeled unfair as long as the tax revenues are used to fund public works projects that benefit the community as a whole. 7. A tax on emissions into the air that accurately reflects the social cost of an additional unit of the emissions a. amounts to no more than a license to pollute. b. encourages firms to reduce emissions as long as the cost of doing so is less than the cost of continuing the emissions. c. gives firms little incentive to search for less-polluting production processes. d. will not prevent large and profitable firms from polluting. 8. Corrective (pollution) taxes differ from most taxes in that corrective taxes a. enhance economic efficiency. b. do not raise revenue from the government. c. cause deadweight loss. d. cannot be divided between the buyer and seller. 9. When new technologies make cleaner production possible, a. emissions fees rise. b. emissions fees fall. c. the price of transferable permits rises. d. the price of transferable permits falls.

3 10. Protecting air quality by establishing identical low limits on noxious discharges for all firms is a questionable policy because a. a little pollution from many sources adds up to excessive pollution. b. by allowing firms to pollute at all it sacrifices the community's interest to private profit. c. it does not allow firms that can only prevent air pollution at a high cost to exceed the limits. d. it tolerates air pollution that could have been prevented. e. no one knows the possible side effects of the discharges. Part II 1. Able Company and Baker Company each emit 10 tons of waste into the atmosphere per year, for a total of 20 tons. The regional air quality control (AQC) board wishes to halve the emissions and is debating whether to require the two companies to cut their emissions to five tons a day each (command and control) or to tax the emissions. Because they manufacture different products, with different technologies, Able and Baker estimate the costs of reducing their emissions quite differently: Emissions Reduced (tons/year) Total Abatement Costs Source A Source B a. If the board decides to issue a regulation requiring each company to cut its emissions to five tons, what is the total clean-up (abatement) cost? b. Suppose the AQC board decides to tax emissions. What tax rate per ton of emissions emitted will cut emissions to a total of ten (10) tons? By how much will each firm cut its emissions? What is the total social cost of the pollution abatement? What will the emission tax policy cost each firm? Explain whether the emission tax could be designed so that both Able and Baker would prefer the tax to command and control regulation. c. Suppose the community prints ten (10) transferable discharge permits (TDPs), each of which entitles the holder to emit one ton of emissions. If the permits are distributed equally, what will the final emissions be for each source? Assume that permits are traded in a competitive market. What is the price of a TDP? d. What is the total social cost of the pollution abatement? What is the net cost (the cost of abatement plus, or minus, the cost of permits) to each firm?

4 2. Railway engines create sparks, which sometimes set fire to crops planted near the tracks. A large number of farmers are affected, and transactions costs prevent the farmers and the railroad from negotiating bribes or side payments. The price of railway service is $50 per train, and each train causes $10 of crop damage. The accompanying diagram shows the relevant market for railway service. a. Suppose a Pigovian tax of $10 per train is imposed on the railroad and given to farmers. By how much will social gain increase? Net Gain to Railroad Damage Suffered by Farmers With No Tax With Pigou Tax b. Suppose that the farmers can move their crops away from the tracks at a cost of $120 per month. If the goal is to achieve economic efficiency, which party should be made liable for the crop damage? What will be the resulting social gain? Net Gain to Railroad Cost to Farmers Railroad Liable Farmers Liable c. Suppose that farmers still have the option of moving their crops as described in part b. Also suppose that the railroad can install safety equipment that will prevent the engine sparks at a cost of $5 per train. If the goal is to achieve economic efficiency, which party should be made liable for the crop damage? What will be the resulting social gain?

5 Net Gain to Railroad Railroad Liable Farmers Liable Cost to Farmers 3. The following table shows the effects that varying numbers of flights will have on the net revenues of airlines using an airport and on the value of real estate in the neighborhood of the airport. Flights Airlines' Net Revenue 100 $10,000 $20, ,000 19, ,800 18, ,400 18, ,800 17, ,000 16, ,000 15, ,800 14, ,400 13, ,700 12, ,900 11, ,000 10, ,900 9,300 Rental Value of Real Estate a. How many flights will be scheduled each week if the airlines do not take into account the effects of their actions on the value of the surrounding real estate? b. What are the marginal potential gains from trade (or marginal cost of the externality) at the solution point in part (a)? c. What is the number of flights that maximizes society s welfare, and what are the total potential net benefits from reducing the number of flights to this number? d. If airlines are not liable for damage, but owners of rental property incur no costs in contracting with airlines, how much would the owners of rental property be willing to pay to airlines to reduce the number of flights per week to the number you found in part (c)? How low must transactions costs be for this negotiated settlement to occur? Explain.