Problem 1: Short Answer Questions
a) If the total benefits to society of achieving some specific level of pollution control are significantly greater than the total costs to society of doing so, will it necessarily be economically efficient (socially optimal) to do so? Explain your answer with words and a graph.
b) In March 2011, the US EPA issued a report that looked at the results of the Clean Air Act from 1990 to 2020 (see: http://www.epa.gov/air/sect812/prospective2.html). This review found that in the central estimate of the CAA’s impact, benefits exceeded costs by a ratio of 30 to 1. This leads some environmental policy commentators to conclude that the EPA had not gone far enough in reducing air pollution. Under what conditions would a benefit cost ratio of 30:1 imply that it would be economically efficient to further reduce air pollution under the CAA? Assuming the EPA’s benefit-cost estimate is correct, is it possible that it could actually be economically efficient to loosen, rather than strengthen, air pollution regulations? Explain your answer with words and a graph.
Problem 2: Maximizing Net Benefits
There are important trade-offs involved in granting “Wild and Scenic River Status” to portions of a river. How much of this public good, a free-flowing river, should be protected from further development? As an analyst in the Office of Policy Analysis of the U.S. Department of the Interior, you are called upon to make a recommendation. Each year, 1,000 people benefit from the river’s various services. A contingent valuation survey carried out by your office has estimated that each individual beneficiary has the same demand function for river preservation, Q = 75 – (0.25)(P) where P is the price-per-mile which persons are willing to pay (per year) for Q miles of river preserved. You find that the marginal (opportunity) cost of preservation is $60,000 per mile per year. [Hint: You need to derive the market (aggregate) demand curve for a public good.]
a) How many miles of the river would be preserved in an efficient allocation?
b) What is the magnitude of the total (gross), annual benefits associated with this (efficient allocation) policy?
c) What are the total, annual costs of the policy?
d) What is the magnitude of the total (annual) consumers’ surplus?
e) How large are net, annual benefits?
f) If it turns out that the marginal cost of preservation is only $20,000 per mile per year, how many miles of the river would be preserved in an efficient allocation?
g) Now assume substitute sites are available to beneficiaries, so their demands are substantially more elastic: their individual demand functions for river preservation are Q = 75 – (0.75)(P) In this case, with the original marginal costs of preservation of $60,000 per mile per year, how many miles of the river would be preserved in an efficient allocation?
Problem 3: Sensitivity of NPV to Discount Rates
A ski resort wants to expand by opening more trails and adding a new high-speed chair lift. The initial capital investment for the expansion is $60,000 in year 0 and the resort will not benefit financially until after the project is completed in year 1. After that the annual net benefits will be $20,000 at the end of each year. Assume that the expansion terminates at the end of year 5.
a) Is this investment NPV positive under a 5% discount rate? Under a 13% discount rate?
b) The resort invests in the expansion but ownership decides to sell three years later. Does this affect the NPV analysis? Why or why not? Please state your assumptions. Hint: You do not need to complete another quantitative analysis, and there is more than one right answer.
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