End of Chapter Exercises: Solutions

End of Chapter Exercises: Solutions

Chapter 12

1. Manufacturers in an urban environment are currently producing 25,000 widgets per annum. Their gross revenue is $300 per widget and their variable costs are $125 per widget. Air quality in the city has fallen to a level of 20 points measured on a 0 to 100 point indicator. Three proposals are being considered to improve the city’s air quality. Option 1 involves annual direct costs of $100,000 which raises the index of air quality to 32; option 2 costs $130,000 per annum which raises the air quality index to 42; and option 3 costs $150,000 per annum and raises the air quality index to 50. In addition, producers are required to reduce their output of widgets by: 5% under option 1, 10% under option 2, and 15% under option 3. Three questions are posed:

(i) Which option has the lowest total opportunity cost?

(ii) Which option has lowest cost per unit of air quality improvement?

(iii)Why might neither of these represent the most efficient option?

Answer:

(i)Option 1 has lowest total opportunity cost of $150,000

(ii)Option 2 results in the lowest cost per unit of water quality improvement ($9,200)

(iii)We do not know how the value of ecosystem services and other benefitsrespond to changes in water quality. Without that information we cannot say whichoption maximizes net benefit.Adopting the precautionary principle we would probably choose option 3.

1. Individuals A and B have the same money income, have the same tastes, and face the same set of prices of all goods and services except that of access to a National Park. Individual A lives further away from the Park than Individual B and hence incurs a higher travel cost per visit. There is no admission charge to enter the Park. The following data summarize their annual use of the Park:

IndividualTravel Cost per Visit Number of Visits p.a.

A$205

B$1010

(i)approximately how much consumer surplus does Individual A receive per annum from her use of the Park?

(ii)approximately how much consumer surplus does Individual B receive per annum from his use of the Park?

(iii)what is the approximate measure of the annual benefits to A and B from their use of the Park?

(iv)why are the measures in (i), (ii) and (iii) “approximate”?

Answer:

(i)$25

(ii)$100

(iii)$125

(iv)assumption of a linear demand curve

1. A contingent valuation study was used to value improvements to a coral reef, where, at present, the reef quality, measured in terms of percentage of reef cover, is so poor that the local residents can no longer rely on the reef for their supply of fish. The study sample, which included users (one-third) and non-users, found the following estimates of average WTP.

Mean WTP ($ per annum)*
Scenario / Whole sample / Local users / Others
1. Increase reef cover to 50% / $25 / $45 / $15
2. increase reef cover to 75% / $40 / $70 / $25
3. increase reef cover to 100% / $53.5 / $95 / $33

* NOTE: In the textbook the column headings for this table are misaligned, one column to the left.

(i)construct a demand curve for reef quality for: users; others; and the whole sample and discuss the forms of these curves;

(ii)explain how this information could be used in a BCA to compare management options to improve the quality of the reef.

Answer:

(i)

$50
$40 /

$30 / `
$20 /
$10 /
25% / 50% / 75% / 100%
Percentage Cover

(ii) Alternative management options (projects) to increase reef cover could be costed, and, when assembled in ascending order in terms of marginal cost,and resulting improvement in reef cover, a corresponding supply curve could be constructed, showing the marginal cost of improvements to reef cover. The optimal management option would then be identified as that combination of projects at which marginal cost and marginal benefit are equal; ie. where the supply curve intersects the demand curve for the whole sample. If its assumed that ‘others’ are non-users, the difference between the users and non-users WTP could be used as a basis for setting a users’ entrance fee for the marine park.

1. Using the data provided in Example 12.4, calculate the net benefits of an alternative road proposal that results in increased noise levels in Areas A and B of 5 and 10 decibels respectively, and decreased noise levels in Areas C and D of 2 and 8 decibels respectively.

Answer:

Change in / % price
Area / Mean Price / No. houses / Noise level / per unit / Cost ($ thous)
A / $250,000 / 76 / 5 / 0.45 / 427.5
B / $125,000 / 124 / 10 / 0.18 / 279.0
C / $400,000 / 64 / -2 / 0.92 / -471.0
D / $100,000 / 60 / -8 / 0.08 / -38.4
Net cost of change in noise levels / $197.1

Note that under this scenario there is a net increase in the cost of noise to the community in comparison with the original example where there was a decrease in noise cost of $18.4 thousand. To calculate the net benefits of the project, the benefits/costs of changed noise levels would need to be added to other project benefits and then compared with the cost of constructing the ring road, within a BCA framework. That additional information has not been provided.