b. If price is between the minimum of AVC and AC, then the firm will shutdown.

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1 EEP1/ECON 3 November Professor Peter Berck SOLUTIONS (Quiz 2 Fall 2008) The exam totals to 20 points. Do all the questions. 1. True, False, Uncertain and Why. 1 point each. a. Technology standards always cost less than technology based effluent standards, for the same amount of pollution abated. FALSE. Technology standards can only cost more or the same as a TBES. A TBES sets a quantity of pollution according to what is possible with a certain technology and then firms can abate to that level however they choose. If the firms use the technology upon which the TBES was based, they will likely spend the same amount as if a technology standard had been used. If they find another, cheaper way to reduce pollution by the same amount as if they had used the technology, then the cost will be cheaper. (Note that this answer assumed that scientists/ engineers correctly assess the capabilities of a given technology if they over-estimate the technology s capabilities, then it is possible for a technology standard to be cheaper than a TBES.) General Grading Breakdown: (Note: total points possible is 1 ( )).7 for correctly describing the 2 policies.4 for correctly defining one of the two policies.2 for defining one policy correctly but calling it the wrong thing.1 for correctly stating which policy is more expensive.2 for explaining why technology standard is more expensive or equal to cost of TBES b. If price is between the minimum of AVC and AC, then the firm will shutdown. UNCERTAIN. In the short run, it will be more profitable to continue operating because the firm will be able to cover all of its variable costs and some of its fixed costs (if it does not produce, it will not be able to cover any of its VC). In the long run, the firm will shut down because profits are negative. Grading breakdown: (Total points are 1= ).3 for 1 correct shutdown answer (SR or LR).3 for 1 correct explanation of why (including something correct about covering variable/fixed costs).1 for second correct shutdown answer (i.e. LR case if already answered for SR).2 for explanation of this second scenario.1 for distinguishing between SR and LR

2 c. One reason to leave a river undammed is option value. TRUE. Krutilla explains that some benefits of natural resources are difficult to measure and capture by private markets. One of the types of benefits he argues difficult to measure/capture are option values potential future uses (like scientific discoveries) and armchair environmentalism (or non-use) values (though some may not classify this as an option value, Krutilla does in this paper). However, option value is only a reason to keep a river undimmed if the option value is sufficiently large. The social benefit of keeping the river undammed (equal to the sum of all other social benefits plus the option value of doing so) must be higher than the benefit from the benefit of damming. Grading Breakdown 1 for defining option value correctly, mentioning Krutilla and saying that it depends on benefit of damming (or opportunity cost of keeping the river undimmed).9 for defining option value fully and saying that it depends on benefit of damming (or opportunity cost of keeping the river undimmed) with no mention of Krutilla.8 for defining option value in some correct way and mentioning Krutilla.7 for defining option value fully.6 for defining option value in part.7 for saying it depends on opportunity cost of keeping river undammed.4 for just mentioning Krutilla d. Firms are likely to try and convince government officials to institute marketbased or polluter pays policies (like an effluent tax or cap and trade permits) rather than command-and-control policies (like quotas or effluent standards) (You may assume that the government will implement some pollution control policy for sure) FALSE. Command-and-control policies (like effluent standards) tend to be less costly for producers than market-based policies, thus firms will prefer command-and-control policies. Many people said that one type of policy would pass on cost to the consumers while the other would not. It is true that in the long run, in a competitive industry, firm profit will be zero and consumers will bear the full cost of increases in production costs. However, this is true for both policies, and command and control policies increase costs by less than market-based policies. Many people also said that firms can sell permits. This is true, but this also means that using permits (rather than selling them) means you cannot sell them. Thus, there is now an extra cost (an opportunity cost) to polluting. This effectively makes the cost of polluting go up, just as a tax would. Because both taxes and permits both change the price of pollution (ideally to reflect its true social cost) rather than simply telling firms not to pollute, they are called market-based policies.

3 Grading Breakdown 1 for answers similar to the above.6-.8 for correctly stating which policy is more expensive but having some part of the explanation incorrect.1-.2 for saying something correct in the answer e. Competitive firms choose their price so that price equals marginal cost. UNCERTAIN/FALSE. Competitive firms do not choose price they are price-takers. They choose how much quantity to produce given market prices. They do, however, choose quantity such that price is equal to MC (so long as price is above AVC curve in the short run, above ATC in the long run). General Breakdown 1 point for saying firms are price-takers (or something like that) and that they choose Q such that P=MC.8 points for just saying firms are price takers.7 for providing a full explanation for why firms choose the point P=MC but not saying that firms do not choose price/ are price-takers in a competitive market.3 points for saying firms maximize profits at P=MC Miscellaneous deviations for more correct/incorrect answers.

4 2. A pollution control agency decides to control the pollution per unit output of an industry. a. (3 pts) Use an isoquant and isocost diagram to show how much cost increases with a tax on clean air services versus how much cost increases with a limit on how much clean air services can be used. Tax and limit are set to consume the same amount of clean air. Solution: The isocost line under the tax policy hits the Other Stuff axis at a higher point than does the isocost line under the limit policy. Since the price of other stuff is the same under both policies (limit and tax), the cost represented by the isocost line under the tax policy must be higher. Using numbers from the graph above to say the same thing: We assume price of Other Stuff (P Oth )=$1 Expenditure under limit policy= $5 (seen from the y-intercept of the isocost line) Expenditure under tax policy=$8 (also seen from the y-intercept of the isocost line) $8>$5, so tax policy costs firms more for same level of output (and both cost more than no government intervention) Grading breakdown (total points=3): 1 point for correct drawing of limit policy +1 point for correct drawing of tax policy +1 for explaining/ showing how we know cost is higher under tax policy

5 b. (2pts) Using your diagram explain how the tax rate should be calculated so that the polluter consumes the same amount of clean air that she would under the limit system. Solution: Tax Rate=Price clean air services under tax policy- Price clean air services without tax policy 1) Find price clean air services without tax policy by using isocost line equation E= P Oth *Q Oth +P CA *Q CA. a. Using numbers from the graph above: i. Under limit, E=$5 & Isocost x-intercept (the maximum number of clean air units purchased with $5) is Q CA =10. Thus P CA =E/Max Q CA =$5/10=50 cents. 1. Note 1: you could also use the isocost line under no policy, as limit policy does not change input prices. 2. Note 2: you could also calculate P Oth using total expenditures=$5 and knowing P oth =$1 (assumed) and the input bundle is (2,4) (estimated/made up). ii. Alternatively you could use the fact that slope= rise/run = -P CA /P Oth. Rise/Run=-5/10=-1/2, so P CA /P oth =-1/2. P oth =$1 (assumed), and so P CA =slope*-p Oth =-1/2*-1=1/2 (or 50 cents). 2) Find the isocost line tangent to the isoquant curve at the pollution goal (2 units in this example). 3) Find the price of clean air consistent with the slope of this new isocost line. (Same basic idea as in step one, but isocost line has changed): a. Using nubers from graph above: i. Under tax, E=$8 & Isocost x-intercept (the maximum number of clean air units purchased with $8) is Q CA =4. Thus P CA =E/Max Q CA =$8/4=$2. 1. Note: you could also calculate P Oth using total expenditures=$8 and knowing P oth =$1 (assumed) and the input bundle is (2,4) (estimated/made up). ii. Alternatively you could use the fact that slope= rise/run = -P CA /P Oth. Rise/Run=-8/4=-2, so P CA /-P oth =2. P oth =$1 (assumed), and so P CA =slope*p Oth =2*1=$2. 4) Tax=P(with tax)-p(without tax)=$2- $.50=$1.50 Grading Breakdown (out of 2): 2 for fully correct answer 1.7 for saying everything correct but missing one piece of information/ 1 step 1 for saying tax=p(tax)-p(no tax).5 for saying you need to find the isocost line tangent to isoquant at the goal pollution level Additional points for other miscellaneous correct (& relevant) pieces of information

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