ECO 324: Environmental Economics
Review Sheet (Exam 1; Chapters 1-5)
Chapter 1 The Role of Economics in Environmental Management
Circular Flow Model
Materials Balance Model
Natural Resource Economics (Flow of resources from the environment to
the economy)
Environmental Economics (Flow of residuals from the economy to the
environment)
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Sources of Pollution: Stationary source; mobile source; point source;
nonpoint source (examples: ……)
Scope of Environmental Damage: local, regional, global
Environmental Objectives: Environmental Quality, Sustainable
Development, Biodiversity
Chapter 2 Modeling the Market Process: A Review of the Basics
Market: the interaction between consumers & producers to exchange a
well-defined commodity
Sellers’ decisions are modeled through a supply function and buyers’
decisions are modeled through a demand function
The willingness to pay (WTP), or demand price, measures the marginal
benefit (MB) from consuming another unit of the good
The willingness to sell (WTS), or supply price, measures the marginal
cost (MC) from producing another unit of the good
Supply and demand together determine a unique equilibrium price (PE)
and equilibrium quantity (QE); PE occurs where QS = QD
Model for bottled water:
D: P = –0.01QD + 11.5
S: P = 0.0025QS + 0.25
Equilibrium found where
–0.01QD + 11.5 = 0.0025QS + 0.25, or
where QE = 900 and PE = $2.50
At the market level, allocative efficiency requires that resources be
appropriated such that additional benefits to society are equal to
additional costs incurred, i.e., MB = MC
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Consumer surplus (CS)—the net benefit to buyers estimated by the
excess of marginal benefit (MB) of consumption over market price (P),
aggregated over all units purchased; graphically measured as the
triangular area above the price and below the demand curve up to the
quantity sold
Producer surplus (PS)—the net gain to sellers of a good estimated by the
excess of the market price (P) over marginal cost (MC), aggregated over
all units sold; graphically measured as the triangular area above the MC
curve up to the price level over all units sold
Deadweight loss (DWL)
Chapter 3 Modeling Market Failure
A public good is a commodity that is nonrival in consumption and yields
nonexcludable benefits (examples: ……)
Market demand: In theory, market demand for a public good is found by
vertically summing individual demands; vertical sum because we must
ask consumers “What price would you be willing to pay for each quantity
of the public good?”
Market supply and market demand determine equilibrium; efficient level
of abatement is not necessarily 100% (which means zero pollution)
Modeling public goods (slide 10)
An externality is a spillover effect associated with production or
consumption that extends to a third party outside the market
Negative externality—an external effect that generates costs to a third
party
Positive externality—an external effect that generates benefits to a third
party
Modeling a Negative Environmental Externality:
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--Assume the market is competitive
--Supply is the marginal private cost (MPC)
--Demand is the marginal private benefit (MPB)
--Production generates pollution, modeled as a marginal external cost
(MEC)
--Problem: Producers (refineries) have no incentive to consider the
externality
--Result: Competitive solution is inefficient
Competitive Solution: set MPB = MPC, solve for QC and PC
Socially Efficient Solution: set MSB (which is MPB + MEB) = MSC
(which is MPC + MEC), solve for QE and PE
--QC (160) is higher than QE (128), since the firm does not bear the full
cost of its production, and so will produce more than the socially efficient
quantity
Property rights and the Coase Theorem—Proper assignment of property
rights, even if externalities are present, will allow bargaining between
parties such that efficient solution results, regardless of who holds rights
Transaction cost
Chapter 4 Conventional Solutions to Environmental Problems:
Command-and-Control Approach
Ambient standard—a standard that designates the quality of the
environment to be achieved, expressed as a maximum allowable pollutant
concentration
Technology-based standard—a standard that designates the equipment or
method to be used to achieve some abatement level (an example: ……)
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Performance-based standard—a standard that specifies a pollution (or
emissions) limit to be achieved but does not stipulate the technology
MSC = MACMKT + MCE
MSC is the sum of all polluters’ marginal abatement costs (MACMKT)
plus government’s marginal cost of enforcement (MCE)
Technology-based standards specify the type of abatement equipment or
method to be used; by definition, these standards potentially prevent
firms from selecting and using the least-cost abatement method
Uniform standards waste economic resources as long as abatement costs
differ among polluting sources; cost savings can be obtained if low-cost
abaters do more cleaning up than high-cost abaters
Slides 20-25: uniform standard is not cost-effective; the cost-effective
abatement is found at MAC1=MAC2
Chapter 5 Economic Solutions to Environmental Problems: The
Market Approach
Market approach refers to incentive-based policy that encourages
conservative practices or pollution reduction strategies
Types of pollution charges: product charge; emission/effluent charge
If the tax equals the marginal external cost (MEC) at QE, it is called a
Pigouvian tax
Modeling a Pigouvian tax
Two major types of subsidies: abatement equipment subsidies; pollution
reduction subsidies
If the subsidy equals the marginal external benefit (MEB) at QE, it
achieves an efficient equilibrium and is called a Pigouvian subsidy
Deposit/Refund Systems
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Pollution permit trading system:
1. Definition
2. How does permit trading work?
--There is an incentive to trade as long as polluters face different MAC
levels.
--Low-cost abaters will clean up pollution and sell excess permits to
other firms; they will sell at any P higher than their MAC.
--High-cost abaters will buy permits rather than abate; they will buy at
any P lower than their MAC.
--Trading will continue until the incentive to do so no longer exists, at
which point, the cost-effective solution is obtained, i.e., the MACs across
firms are equal.
3. Example: round 1, round 2, final round
4. Assessing the model
--advantages
--disadvantages
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Sample Questions (Exam 1; Chapters 1-5)
Fill in the blanks:
1. The focus of environmental economics is the flow of residuals from the economy
to the environment.
2. Environmental objectives are environmental quality, sustainable development,
and biodiversity.
3. “The only amount of acceptable pollution is no pollution at all.” True or false?
False
Multiple-choice questions:
__3)___1. What statement below best describes how the environment is incorporated
into the standard circular flow model?
1) The long-term availability of natural resources is considered
2) The pollution generated by firms and households is considered
3) Natural resources are considered as inputs into the production process
4) The build-up of waste heat is considered
Explain the concepts:
1. nonpoint source
2. Public good
a commodity that is nonrival in consumption (your
consumption does not diminish its value) and yields
nonexcludable benefits (do not need to pay). An example:
environmental quality
3. externality
4. ambient standard
5. property rights
6. Pigouvian tax
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Essay questions:
How do you assess pollution permit trading system? (definition; how it works;
advantages; disadvantages)
Calculations:
1. A model for bottled water:
D: P = –1/3QD + 40
S: P = 1/2QS + 25
Find equilibrium quantity and price.
Answer: –1/3QD + 40 = 1/2QS + 25
40-25 = 1/2Q + 1/3Q
15 = 5/6 Q
Q = 18
P = –1/3QD + 40
P = –1/3 * 18 + 40
P = $ 34
2. What is the value of consumer surplus (CS) and producer surplus (CS) at
equilibrium?
Answer: CS = ½ * 80 * (28-16) = $480
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PS = ½ * 80 * (16-0) = $640
3. Question 5 on Page 77: I will give you different numbers. Do calculations and
compare competitive and efficient equilibria.
4. Consider the environmental problem created by two paint companies that release
chromium wastes into a nearby stream. The state authorities set a standard for the
waterway that requires a combined abatement level for chromium of 30 units.
Suppose that the two firms, firm 1 and firm 2, face the following marginal
abatement cost equations: MAC1 = 3.2A1, and MAC2 = 0.8A2, where costs are
measured in thousands of dollars.
(1) If the state uses a uniform standard, show that such a ruling would not be costeffective. Which firm should be abating more, and which firm should be
abating less?
Answer: A1 =A2 = 15
MAC1 = 3.2A1 = 3.2 * 15 = $48 thousand
MAC2 = 0.8A2 = 0.8 * 15 = $12 thousand
Such a ruling would not be cost-effective since MAC1 does not equal MAC2.
Firm 1 should abate less and buy permits since it has higher MAC; firm 2
should abate more and sell permits since it has lower MAC.
(2) Now find the cost-effective solution.
Cost-effectiveness requires:
MAC1 = MAC2
3.2A1 = 0.8A2
Abatement standard requires:
Solving simultaneously:
Therefore:
A1 + A2 = 30
3.2(30 – A2) = 0.8A2
96 – 3.2A2 = 0.8A2, so A2 = 24, and
A1 = 30-24, A1 = 6
To check the solution, make sure that the MACs for each firm are equal:
MAC1 = 3.2 * 6 = $19.2 thousand
MAC2 = 0.8 * 24 = $19.2 thousand
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