Environmental Economics Homework 5

1. Consider a situation where the state of Wisconsin is trying to determine whether, due to budget issues, it should close down a state park. The cost of "decommissioning" the park -removing the campsite, restroom facilities, etc. -is $2.2 million incurred in the current year (year 0). On the other hand, the budgetary savings would be $100,000 every year (including year 0), forever.

a. From a purely budgetary perspective, should the park be closed down if the discount rate is 3%? What about 5%?

b. Now suppose the annual benefit of the park to park visitors is $40,000 (starting in year 0). In this case, what is the social net benefit of closing the park if the discount rate is 3%? What is the appropriate thing to do from a benefit-cost perspective -shut down the park or keep it open?

Q2. Suppose a small hydro dam is planned for the Trinity River in northern California. Up front construction costs (initial costs in year 0) are $20 million. After that (beginning in year 1), electricity benefits of $2 million/yr, and operating costs of $0.2 million/yr, are expected into perpetuity (the dam is very durable). Also, construction of the dam implies the loss of wilderness and recreation values known to be $1 million/yr, (starting in year 1) into perpetuity. At what interest rate are we - as economists - indifferent between constructing the dam and leaving the river wild? (You see, I hope, the effect of the discount rate in economic analysis).

Q3. Suppose 200 farmers are using a reservoir that holds 1000 units of water each year. The farms are identical, and the marginal benefit of water for each farm is MB=20-W.

The dam holding the water in the reservoir needs immediate repair at a cost of $300,000. After that (starting next year) it will last forever. If the dam is not repaired, the reservoir system must be shut down. There is no other source of water.

a. If the dam is repaired, the water will be allocated efficiently among the farmers, starting next year. In this case, how much water should each farmer receive each year?

b. What is the annual benefit of the water? Clearly show your work and box your answer.

c. From the perspective of economic efficiency, should the dam be repaired if the discount rate is 5%?

Q4. Suppose the government is being offered the chance to buy 100 acres of land for a park. The park would be developed in the current year, and the annual net benefit of the park for recreation would be $10,000 per year, starting next year. This net benefit reflects the annual benefit of the park to recreational users, minus the annual costs of maintaining the park.

The price of the land for the park is $800 per acre. The discount rate is 10%.

a. If the government were to choose between no park and a 100-acre park, and base its decision on benefit-cost analysis using the data above, what would it do? Show your work, including the difference between benefits and costs of the park, and indicate whether the government would create the park or not. Clearly show your work and box your answer.

Now suppose that the annual net benefit of the park for recreation depends on how large it is. In particular, the annual marginal net benefit of park acreage is given by MNB=200-2A, where A is the park acreage. The annual net benefit of the park would be received every year forever, starting next year. As before, the price of land for the park is $800 per acre and the discount rate is 10%.

b. Again assuming the government makes its decision based only on the information above, and that net benefits from recreational use of the park start next year, would the government construct a park? If so, how large would it be if the objective is to maximize the social net benefit of the park?

At a public hearing on whether or not to create the park, you represent the government. You first explain that the benefit cost analysis conducted by the government takes account of all costs and benefits from the perspective of society. Then you open the floor to questions about the analysis. The following comments are made. Indicate your best response to each comment.

c. Comment: "The calculation of net benefits from the park is low, because it ignores the jobs created by the park"

Possible Responses (circle the best response):

i. "We have not ignored the creation of jobs in the analysis. Jobs are counted as a cost in the analysis, as they should be."

ii. "You're right, we've made a mistake in our analysis."

d. Comment: "The analysis fails to consider the effect of the park on the value of neighboring land. This should be included in your analysis".

Possible Responses (circle the best response):

i. "In a benefit cost analysis of the park, the only benefits and costs that matter are those associated with the land actually used for the park. The effect on the value of neighboring land is not relevant to the analysis."

ii. "You're right, we should measure and account for this effect in our analysis."

e. Comment: "The calculation of net benefits from the park is too high, because it ignores the fact that the land could have been used in agricultural production. This is the opportunity cost of the land used for the park"

Possible Responses (circle the best response):

i. "We have properly accounted for the opportunity cost of the land used for the park".

ii. "You're right, we should measure and account for this effect in our analysis."