Exam 1 Fall 1996

Economics 359M

Peter J. Wilcoxen
Department of Economics
University of Texas at Austin

Exam 1

Fall 1996

Question 1 (2 parts, 16 points total)

San Antonio is currently being sued by the Sierra Club and other groups for pumping too much water out of the Edwards aquifer. The Sierra Club argues that San Antonio's use of the aquifer leaves too little water in it to support several natural springs that are home to various endangered species. This question asks you to think about that problem a bit. Suppose you were given the following facts:

Annual flow through the aquifer is 400 units;
San Antonio gets to extract water first and whatever is left over flows out the springs;
San Antonio's willingness to pay for drinking water is given by P = 4000 - 10Qd, where Qd is the number of units of drinking water;
Water can be extracted from the aquifer at zero cost;
There are 800 environmentalists concerned about the endangered species;
Each environmentalist receives the following marginal benefit when there are Qs units of water flowing out of the aquifer: MB = 5 - Qs/20.
The environmentalists do not actually use the water, they just like knowing it is there.

Please answer the following questions:

Find the efficient allocation of water between San Antonio (Qd) and the springs (Qs).
Suppose the water is allocated by a market. How much will end up coming out of the springs? Explain as thoroughly as you can why the situation turns out this way. Be sure to discuss any key aspects of the problem. Why does the market get this wrong?

Question 2 (2 parts, 16 points total)

The Internet is a prime example of one type of good that is not handled well by an unaided market. Suppose you were given the following information:

Two types of people use the Internet: business users and home users;
There are 1 million users of each type;
Each business user has a willingness to pay for hours of use given by P = 100 - 10Qb, where Qb is the number of hours she spends on line;
Each home user has a willingness to pay for hours given by P = 4 - Qh/5, where Qh is the number of hours he spends on line;
At low levels of traffic, when total user-hours is less than 10 million, the marginal cost of using the network is zero;
After network traffic reaches 10 million user-hours, each additional user-hour causes $2 worth of external costs to other people. (That is, MC=2!).

Please answer the following questions:

If there is no charge for using the Internet, how many total user-hours will business users spend on line? How many total user-hours for home users? Is the efficient? If not, explain in non-technical terms what is wrong with the situation and what features of the Internet create the problem.
Suppose a fee were charged per user-hour for access to the Internet. What should the fee be? Why? How many user-hours will each type of user spend on line now? How much revenue will the fee generate from each group? How much, in dollar terms, will it reduce the problem from (1)? How will different groups feel about the policy?

Question 3 (1 part, 8 points)

Suppose that you must decide whether to allow a particularly beautiful wilderness area to be strip mined. Strip mining would permanently destroy the scenic value of the site. If the area is left as a wilderness, it would generate recreational benefits thought to equal to $25,000 per year. If mined, it would produce an immediate, one-time payment of $300,000.

Explain in detail why it would be best to strip mine the area if the interest rate were 10%. Is this because we don't care as much about the future as we do about the present generation? Explain. Would your decision change if there was a 60% chance that the recreational value was $25,000 and a 40% chance that the value would actually turn out to be $40,000? Explain why or why not.

Question 4 (1 part, 8 points)

Pollution that originates in one country but ends up in another is known as "transboundary pollution". Examples include sulfur dioxide originating in the US and ending up in Canada as acid rain, and air pollution originating in Poland and ending up in Sweden. In general, there is no international government with authority to force one country to stop polluting another. There isn't even an agency that could impose pollution taxes (the UN would probably love to, but it can't!). Does this necessarily mean that there will be an inefficiently high amount of pollution? Discuss.