ECNS 432. Redemption Quiz/Final Exam Review (Answers)

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1 ECNS 432 Redemption Quiz/Final Exam Review (Answers) Name Please note that this review is not exhaustive. That is, it does not cover all of the topics we discussed in lecture. For example, topics omitted from this review sheet include (but are not limited to) our discussion on prospect theory, when WTP and WTA diverge, and important concepts from student presentations. Make sure to study your class notes when preparing for the final. 1. Exercise #1 from Chapter 12 1.a. R: XO 2 R: O 4 1.b. O 1 XO 2 O 3 O 4 1.c. O 1 XO 2 2. Exercise #2 from Chapter 12 2.a. Trainee perspective: Since members of the control group received $9,000 in after tax earnings during the program year, on average, it is reasonable to presume that this was the amount of earnings forgone by an average trainee while undergoing training. However, this cost to trainees was partially offset by the $5,000 stipend they received. Thus, trainees incurred a net cost of $4,000 during the program year. During each of the next two years, trainees received after tax earnings of $18,000, while members of the control group received after tax earnings of only $13,500. Thus, the program's impact on the after tax earnings of trainees during each of the two post-training follow-up years was $4,500. However, during each of these years, members of the control group received $1,000 more in transfer benefits than members of the treatment group. Hence, the program's net impact on the average income of trainees was $3,500 during each of the two follow-up years. Using this information, the present value of the net benefits received by the trainees (PVNB T ) can be computed for the five year time horizon as follows: PVNB T = -$4,000/(1+.05) + $3,500/(1+.05) 2 + $3,500/(1+.05) 3 + $3,500/(1+.05) 4 + $3,500/(1+.05) 5 = $8,010 Non-Participant Perspective: During the program year, non-participant taxpayers incurred program operating and service costs of $3,000 and stipend costs of $5,000. Moreover, since members of the control group paid an average of $1,000 in taxes during the program year,

2 while trainees paid no taxes, we can infer that $1,000 in tax payments were forgone by nonparticipants. Thus, during the program year, non-participants incurred total costs of $9,000 ($3,000 + $5,000 + $1,000) for a typical trainee. During each of the two post-training follow-up years, however, trainees paid $500 more in taxes, on average, than members of the control group and received $1,000 less in transfer benefits. Hence, non-participants received net benefits totaling $1,500 during each of the two follow-up years. Using this information, the present value of the net benefits received by non-participants (PVNB NP ) can be computed for the five year time horizon as follows: PVNB NP = -$9,000/(1+.05) + $1,500/(1+.05) 2 + $1,500/(1+.05) 3 + $1,500/(1+.05) 4 + $1,500/(1+.05) 5 = -$3,504 Social Perspective: During the program year, the per trainee cost of the program to society was $13,000, the sum of the resources used to operate the program and provide services to those participating in it ($3,000) and the gross earnings that were forgone as a result of trainees participating in the program ($10,000). Note that the stipend received by the trainees was a transfer from taxpayers to trainees and, hence, is not counted as a cost to society. The per trainee benefits received by society during each of the two post-training follow-up years were $5,000, the program's impact on the average gross earnings of the trainees. Notice that the program's impact on transfer benefits is treated as a transfer from trainees to taxpayers, rather than as a benefit or cost to society. The present value of the net benefits received by society (PVNB S ) can be computed for the five year time horizon as follows: PVNB S = -$13,000/(1+.05) + $5,000/(1+.05) 2 + $5,000/(1+.05) 3 + $5,000/(1+.05) 4 + $5,000/(1+.05) 5 = $4,506 Alternatively, PVNB S can be computed by simply summing PVNB T and PVNB NP -- that is, $8,010 + (-$3,504) = $4, b. Since benefits and costs are directly observed during the program year and during the two post-training follow-up years, it is only necessary to take account in the decay of the program's impact on earnings and transfer benefits during the last two years of the five year time horizon. Since the decay rate is assumed to be 20 percent, but the decay process is assumed not to begin until year 4, the undiscounted benefits received by the trainees in year 4 equal $3,500/(1 +.2) = $2,917 and the undiscounted benefits received by the trainees in year 5 equal $2,917/(1 +.2) = $2,431. Similarly, the undiscounted benefits from the non-participant perspective for years 4 and 5 equal $1,500/(1 +.2) = $1,250 and $1,250/(1 +.2) = $1,042, respectively. And the undiscounted benefits from the social perspective for years 4 and 5 equal $5,000/(1 +.2) = $4,167 and $4,167/(1 +.2) = $3,473, respectively. After making these calculations, the formulas used in 2.a. are altered as follows: PVNB T = -$4,000/(1+.05) + $3,500/(1+.05) 2 + $3,500/(1+.05) 3 + $2,917/(1+.05) 4 + $2,431/(1+.05) 5 = $6,692 PVNB NP = -$9,000/(1+.05) + $1,500/(1+.05) 2 + $1,500/(1+.05) 3 + $1,250/(1+.05) 4 + $1,042/(1+.05) 5 = -$4,070

3 PVNB S = -$13,000/(1+.05) + $5,000/(1+.05) 2 + $5,000/(1+.05) + $4,167/(1+.05) 4 + $3,473/(1+.05) 5 = $2,622 As can be seen, the estimated present values of net benefits are not very sensitive to assuming that benefits decay over time, even though a rather large decay rate is used. The major reason for this is the very short time horizon used in the analysis; benefits were allowed to decay for only two years. 3. Exercise #2 from Chapter 14 The workers require $6,000 to accept a death risk of.001. The value of life implied by this is $6,000/.001 = $6,000, Exercise #1 from Chapter 15 1.a. As noted in the chapter, CV studies of use goods appear to give answers generally consistent with methods based on observed behaviors. CV studies of non-use goods have not been validated through comparisons with behavioral methods because the latter are not available. Furthermore, they are especially prone to the many of the CV biases discussed in the text. Consequently, one would likely place more confidence in valuations of use than non-use. In this context, one would likely be more confident in the CV estimate of the value of sport fishing on the first stream than CV estimates of the existence value of either of the two streams. 1.b. If either WTA or WTP could be estimated by CV methods with the same degree of confidence, then the first approach would be the most appropriate because it corresponds exactly to the project under consideration. However, most experts believe that WTP estimates are so much more reliable than WTA estimates that the former should always be used, even in a case like this where WTA is conceptually more appropriate. See, for example, National Oceanic and Atmospheric Administration, "Report of the NOAA Panel on Contingent Valuation," Federal Register, 58, no. 10, (1993), pp Exercise #3 from Chapter 15 The mean WTP for the sample is approximately the price increment times the sum of the fractions of acceptance: ($5)[ ] = ($5)(4.61) = $23.05.

4 Price (in tens of thousands of dollars) 6.) Suppose you are considering the market for scenic views. Furthermore, suppose you want to estimate the benefits of improving the (quality) level of a scenic view in an area. Using the housing market and the hedonic price method you can accomplish this task. We know that the price of a house is a function of many attributes (including scenic views) and can be illustrated as follows: P = F(view, X) where view denotes the level of scenic view and X is a vector containing other relevant attributes (e.g. lot size, number of bedrooms, distance from nuclear power plant, etc.). Assuming the hedonic price function is additively separable, we can write P = F(view, X) = f(view) + g(x). Let s also assume f(view) takes the following functional form f(view) =. a.) On a graph, plot the hedonic price function for the following values of scenic view, given a level of other attributes X: view = 1, view = 2, view = 10. Your vertical axis will be price (say, in tens of thousands of dollars) and your horizontal axis will be level of scenic view Hedonic Price Function for Scenic Views Hedonic Price Function Level of scenic view

5 b.) What important property does the hedonic price as a function of scenic views exhibit? Diminishing marginal returns to scenic views. c.) What is the hedonic price of a marginally better scenic view given an initial level of scenic view of view = 2? What about for an initial level of scenic view of view = 4 and for an initial level of scenic view of view = 6? Illustrate these hedonic prices in your graph from part a.). For view = 2: = 0.5(view) -0.5 Plugging in view = 2, we have 0.5(2) -0.5 = That is, the WTP for a one unit increase in view, given an initial level of view = 2, is $3,536. For view = 4: = 0.5(view) -0.5 Plugging in view = 4, we have 0.5(4) -0.5 = 0.25 That is, the WTP for a one unit increase in view, given an initial level of view = 4, is $2,500. For view = 6: = 0.5(view) -0.5 Plugging in view = 6, we have 0.5(6) -0.5 = That is, the WTP for a one unit increase in view, given an initial level of view = 6, is $2,041. Graphically, these values represent the slope of the hedonic price function at view = 2, view = 4, and view = 6.

6 7.) Consider modeling the demand for recreation visits to Glacier National Park. Assume the park has a level of quality, q. A typical consumer maximizes utility with respect to visits to the park (v) and a basket of market goods (x): U(x, v, q) a.) The consumer maximizes utility subject to what type of constraints? (hint: there are two constraints). Write the formulas for these constraints and describe the variables included. The consumer maximizes utility subject to a budget constraint wl = x + p 0 v where w is the wage rate, L is the number of hours the consumer works, p 0 is the out-of-pocket expenses associated with a single trip, and the price of x is assumed to be unity (i.e. = 1). The consumer also maximizes subject to a time constraint T = L + (t t + t v )v where t t and t v are the travel time associated with a single round trip visit and on-site time associated with a single visit. b.) Upon solving the utility maximization problem (don t worry about actually solving it), one obtains the demand function for visits to Glacier: v = f(p v, q, y) where y is income and p v is the price of a single visit. Suppose the Glacier National Park Service hires additional trail crews for the summer to fix and maintain all of the trails in the park. Upon doing so, the level of quality of the park increases from q 1 to q 1 + q. Graphically illustrate what happens to the change in consumer surplus. Simply graph a demand curve for trips that shows the demand function shift out from there, illustrating the increase in CS is straightforward.