Natural Resource Economics Midterm Final Set 3

Front 1

The “law of one price” suggests that water prices should equalize across markets so that any remaining differences merely reflect things like treatment and transportation costs (i.e. marginal net benefits should be equalized). In the western U.S., water prices for urban use have tended to remain markedly higher than water prices for agricultural use, to an extent that cannot be accounted for by differences in treatment and transportation costs. Why is this so? What prevents efficient allocations of water? Explain.

Back 1

The system of property rights with respect to water resources has long interfered with the ability of water resources to be allocated efficiently across competing end uses. While water rights in the eastern U.S. are largely “riparian” rights, most western state use a system based upon “prior appropriation.” Whoever makes the first official legal claim to the water has the senior right, and can use water up to the amount that was claimed before the junior rights-holders can have any. There has also been the problem that the senior holder of water rights must put that water to beneficial use, or the right can be forfeited. If the senior rights holder wished to lease their right to the water to someone else, therefore, they would risk losing their rights to the water by selling or leasing these rights. This restriction has prevented the full and free development of water markets.

Other problems that have interfered with efficient allocation via free markets have included the problem of externalities associated with water use. Water put to agricultural use, in particular, often returns (via runoff) to instream flows that support subsequent users or ecosystem support. While the owner of the agricultural rights would be compensated for the sale of his/her water to an urban user outside the watershed, the constituency that relied upon return flows would not be compensated for the loss of those return flows. Thus free markets would not guarantee efficiency, because of externalities like these.

Front 2

Explain the concept of “marginal user cost” (MUC). Why it is relevant to planning a dynamically efficient extraction path for an exhaustible resource, and when do economists need to worry about measuring it? Use a carefully labeled simple two-period model to illustrate the concept, and specifically list the four main factors that determine the size of the marginal user cost.

Back 2

Marginal user cost is the additional opportunity cost associated with consumption of an exhaustible resource in the current period stemming from the foregone opportunity to consume that same unit in the future.

Private firms will automatically take their current period marginal extraction costs into account, but they may neglect the marginal user cost if they have no claim on future profits from the extraction and sale of a given unit of mineral in that future period. This can happen if they are merely temporarily leasing the rights to extract a mineral, and do not own those rights in perpetuity.

Economists worry about measuring marginal user cost when they need to help governments figure out what royalties might be appropriate as a substitute for firms’ attention to marginal user costs. The four main factors which determine marginal user costs are marginal benefits and marginal extraction costs from the use of the resource (combined into MNB in each period) as well as the discount rate and the size of the resource stock.

Front 3

We have illustrated the dynamically efficient extraction profile for an exhaustible resource, in continuous time, using a “four-quadrant diagram.” Sketch the simplest version of this diagram and label all features clearly. Make sure that the information depicted in all four quadrants is consistent. In the lectures and in the homework, we used this diagram to illustrate what might happen to marginal user costs under different conditions. Describe two of the questions we used the four-quadrant diagram to answer (NOTE: you do not need to reproduce the answers. Just explain how the issue was captured in the four-quadrant diagram—i.e. what key feature of the diagram changed in each case, and in what way.)

Back 3

Ideally, you would be able to reproduce this diagram, with all of the curves.

(a.) The starting point in the “extraction path” quadrant should line up with the initial period total marginal costs (marginal extraction costs plus marginal user costs) passed through the marginal benefit curve.

(b.)The ending point of the extraction path should line up with the time at which overall marginal cost reaches the choke price on the marginal benefits curve. You did not need to include the two intermediate time periods (t1 and t2) but the rest of the story should line up.

Some of the questions we addressed with this model were:

1. What happens to marginal user cost and the extraction path when the company fears expropriation and therefore acts as if it has a much higher discount rate? (the time profile for the marginal user cost component in the upper right quadrant gets much steeper)

2. What happens to marginal user cost if there is a backstop technology in the form of a renewable resource that is available in essentially infinite quantities at a price that is below the choke price for this resource? (The demand curve for this resource (i.e. the marginal benefits curve) becomes horizontal when price reaches the price of the substitute renewable resource, so demand for this exhaustible resource will go to zero at that point.)

3. What happens to the shape of the extraction path if the industry is a monopoly, rather than competitive? (Overall marginal cost is compared to the marginal revenue curve associated with the marginal benefit (demand) curve, rather than to the marginal benefit curve itself, so that the exhaustible resource is extracted more slowly.)

Front 4

How can the OPEC oil cartel, by restricting the overall oil output of its member nations, exercise monopoly power over the world price of oil, especially when there are many other smaller oil-producing countries which are not members of OPEC? Explain, using an appropriate diagram.

Back 4

This is the diagram I was looking for. The monopoly-like entity has much lower costs of production than the competitive fringe. The fringe is allowed to do its worst (supply as much demand as it can handle at each price). The residual demand belongs to the monopoly-like firm, which sets quantity based on MR=MC and dictates its profit-maximizing world price = Pm. The fringe takes this price as given and supplies as much as it wants to at that price. Thus monopoly pricesetting behavior on the part of OPEC co-exists with competitive price-taking behavior on the part of the fringe, where producers passively adjust their quantity of output in response to the world price. In contrast, OPEC dictates the world price via their output decisions, as long as they are successful in coordinating members’ behavior (i.e. sometimes the cartel breaks down and take a while to get organized again).

Front 5

The Hotelling Rule suggests that the net price of an exhaustible resource should rise over time at the rate of discount/interest. Do we tend to observe this pattern in the data? Why or why not? Explain.

Back 5

Reasons why the implications of the Hotelling Rule for net prices of exhaustible resources (i.e. they should rise over time at the rate of discount/interest) is typically not apparent in the data on gross prices:

• We usually observe gross prices, not prices net of marginal extraction costs

• Ceteris paribus is violated all the time

– Falling marginal costs of extraction when extraction rates decrease over time (upward sloping MEC curves)

– Technological progress = falling extraction costs at all current output levels

– Rising marginal extraction costs with cumulative extractions

– Shifting demand (technology providing better substitutes, cross-price elasticities of demand)

– Exploration = increasing reserves (more reserves, lower marginal user costs)

Front 6

Describe Eastern water rights

Back 6

East Coast: riparian (adj. Of, pertaining to, or situated on, the banks of a river; riverine)

-Right to use water allocated to the owner of the land adjacent to the water

-Increasing settlement amplified the inefficiency of no water rights without frontage on the water

Front 7

Describe Western water rights

Back 7

West of the Mississippi: "right of prior appropriation"

-Water relatively more scarce to start with, out west

-Allows rights holders to withdraw a certain amount of water from a natural water course for private beneficial purposes on land remote from the point of diversion

-First person to arrive and apply for right to use water has the "senior claim" on the water • In most cases, the water belongs, technically, to the state, but claimants establish a right to use the water (rather than an ownership right)

-Usufructory rights (usufruct, L. usus et fructus "use and enjoyment")

Front 8

Describe California water rights

Back 8

California exception
-California's water law is actually a hybrid system that combines the prior appropriation doctrine with riparianism

Front 9

What are some perverse incentives in the western rights for water?

Back 9

-Failure by rights holders to continue to use their water may result in these rights being lost through the "doctrines of abandonment or forfeiture"

• Creates incentive to use all of the water to which you hold a right

• Farmers who conserve water receive no benefit-motivated to devote large quantities of water to grow low-value crops

• CA: now has statute that provides that when use of water is reduced through conservation, conserved water may be sold, leased or transferred.

• Water markets are generally local or at most statewide. Little action across state lines (expensive to transport)

Front 10

Sources of inefficiency of The Faustmann mode?

Back 10

• The Faustmann model takes no account of the external benefits of forests

— Forests do more than provide revenue to harvesters (prevention of soil erosion, carbon sequestration, ecosystem support, etc.); many public goods aspects (e.g. a first analytical paper by Hartman, 1976)

— Private logging companies operating on timber concessions on public lands may employ a discount rate that is greater than the social discount rate (harvest timber too quickly)

— Threat of losing property rights (expropriation) will affect incentives to replant

Front 11

Dynamically efficient allocations are automatically “sustainable” allocations, especially where exhaustible resources are concerned. True, False, Uncertain? Explain.

Back 11

False. In the extreme, no use of exhaustible resources is consistent with a non-declining stock of the resource. However, use of an exhaustible resource in the current period can be sustainable if we interpret sustainability as “weak sustainability” in the sense of a non-declining value of the overall capital stock consisting of both natural capital and human-made capital. With this definition of sustainability, it is possible to preserve the level of well-being of successive generations if the larger share of exhaustible resources consumed in the earlier periods is converted into human-made capital that can be bequeathed to subsequent generations to substitute for their lesser consumption of natural capital. However, there is no requirement that early consumption of exhaustible resources be converted into bequests of human-made capital to substitute for lesser natural capital. We mention that if the current generation uses more of the exhaustible resource but just “has a big party” rather than investing in more human-made capital to pass along to future generations, then a dynamically efficient allocation will NOT result in sustainable levels of well-being.

Front 12

Hedonic property value models often use a measure of distance to a desirable natural resource (or an undesirable environmental problem) to produce dollar-denominated measures of the related non-market benefits enjoyed (or losses suffered) by homeowners. Why do econometricians typically use regression models that are not simply linear in distance? Explain.

Back 12

A model that is “linear in distance” could capture the fact that house prices increase with distance from an environmental problem, or decrease with distance from a desirable natural resource (controlling for differences in structural attributes and other local public goods). But this is likely to be the case only within the area near the site in question. As you look farther and farther from the site, increases in distance should have less and less of an effect until eventually, the distancve from the site is irrelevant to housing prices. Thus the slope of the function used should change as distance increases, and should eventually go to zero (perhaps asymptotically). If your regression model uses (1/distance) as the explanatory variable, rather than (distance), the model can accommodate a steeper slope with respect to distance near the site (either a steeper positive slope or a steeper negative slope, depending upon the sign of the estimated coefficient on this variable). It can also take on a slope that gets arbitrarily close to zero as you consider houses that are farther and farther from the site.

In the illustration in the lecture notes, the model reflects that house prices cease to have anything to do with distance from the site by about half way along the horizontal axis. We would use prices, from that point on, as our prediction of what prices might have been, closer to the site, had the site not been present.

Front 13

The “economic impact” of natural resources management policies can be measured by the resulting changes in consumer surplus as these policies shift people’s demand curves for access to these natural resources. True, False, Explain?

Back 13

False. Economic impact is measured in terms of changes in expenditures on market goods and services that are related to the (often) non-market consumption of natural resources. These expenditures (equal to travel cost per trip, for example, times the number of trips) represent the revenues of suppliers and outfitters. Expenditures represent that portion of willingness to pay that is actually paid for.

In contrast, consumer surplus is the remaining portion of willingness to pay that is in excess of what the consumer has to pay. It is the “something for nothing” that is enjoyed in the process of consumption. When environmental goods are provided by nature, so that there is no market-type supply function and therefore no producer surplus involved, economists consider the change in consumer surplus from a policy to be the appropriate measure of the “social benefits” (or costs, if consumer surplus decreases) of that policy.