### Economics 359M

Peter J. Wilcoxen

Department of Economics

University of Texas at Austin

### Exam 1

*Fall 1992*

#### Section I, Essay (4 parts, 36 points total)

Answer each of the following questions. Explain your position as completely as possible in the time allowed. If you use graphs, be sure to explain what each one is intended to show.
- Give an example of a positive externality (an external benefit) and explain why it would cause a competitive market to reach an inefficient equilibrium.

- Economists often assume that the best way to allocate a resource over time is to maximize the net present value of social surplus. Why is a reasonable criterion?

- Give an example of a nonexclusive good. Would a competitive market produce the right amount of such a good? Explain why or why not.

- The state government has been trying to obtain legal jurisdiction over the Edwards aquifer. What economic features of the aquifer brought this about? Is it a good idea?

#### Section II, Problem 1 (4 parts, 28 points total)

From time to time the government imposes price controls on exhaustible resources like oil or natural gas. This problem asks you to examine the effect of price controls on the allocation of a resource over time. Consider the following model of the natural gas market:
- There are two periods, 1 and 2.

- Demand in period 1: P1 = 220 - 10Q1 (P1 and Q1 are P and Q in period 1).

- Demand in period 2: P2 = 220 - 10Q2.

- MEC is 20 in both periods.

- The total quantity of gas is 30.

- The interest rate is 0.

Please answer the following questions:
- Find the efficient allocation of gas between the two periods. What quantity should each period consume? What should the royalty be in each period? What should the price be?

- Suppose the gas market is competitive and gas reserves are not common property. Will the market arrive at the allocation in (1)? Explain why or why not.

- Now suppose the government imposes a price ceiling of $50 in period 1. The control will NOT apply in period 2. What will happen to the price of gas in each period? What will happen to the quantity of gas consumed by each period? Be sure to consider both supply and demand in answering this question.

- Is the outcome in part (3) efficient? Explain. Who gains and who loses from the policy? Is there any sense in which the policy is counterproductive?

#### Section III, Problem 2 (2 parts, 14 points total)

This problem asks you to consider the effect of a backstop on the use of an exhaustible resource. You are given the following information:
- There are 10 periods, 1 through 10.

- Each period's demand is: Pi = 100 - 10Qi. (Pi and Qi are P and Q in period i)

- Total demand over all periods is given by: P = 100 - Qt. (Qt is the total quantity)

- Marginal extraction costs are given by: MEC = 1Qt.

- The interest rate is 0.

Please answer the questions below:
- What is the efficient price for the resource? What total quantity will be consumed? How much will be consumed in each period?

- Now suppose a backstop is available a marginal cost of $30 per unit. What will be the new price and total quantity in the market? In what year will the backstop first be used? Why?