HCI_H2_ECONS_Essays_Answers

2018 HCI C2H2 Economics – Suggested Answers to Prelim Essays 1 1. The world has spent an estimated $2 trillion on dams in recent decades. Many nations built dams to control floods, improve irrigation, alleviate water shortages and generate low- carbon hydroelectricity. But recent studies have shown that mostly people living upstream are benefiting from the capture of river flows at the expense of those downstream. Dams also cause decay to the surrounding areas leading to large emissions of greenhouse gases such as methane that contributes more to global warming than carbon dioxide. (a) Use the concepts of public goods and imperfect information to explain why the price mechanism fails to allocate resources efficiently in the provision of dams. [10] Why may dams be considered as public goods? • Non-excludable: Once a dam is built and operat ed, you cannot prevent people who stay near the dam from enjoying flood control even if they have not paid for its construction or operation • Non-rival: The extent of the flood control does not diminish even if more firms or households move into the area surrounding the dam How does the existence of public goods lead to market failure? • Non-excludable: As people who stay near the dam can enjoy flood control without paying, most will be unwilling to pay as they can always free ride on others who do. It is thus not profitable for a firm to build and operate the dam as it will be unable to earn enough revenue to cover its cost. The dam will therefore not be provided in the free market, which means that there is total market failure. • Non-rival: As the marginal cost of allowing an additional person to consume flood control is zero, the socially efficient price should be zero so that as many people as possible can enjoy the flood control. However, as a profit maximizing dam operator will definitely charge a positive price so that it can make profits, the free market outcome will never be socially efficient. Why are the forms of imperfect information that may exist in the provision of dams? • Merit goods: the community staying near the dam may underestimate the extent of the benefits (e.g. improvement in irrigation, alleviation of water shortages and cheaper and less polluting electricity) that they may arises from the provision of the dam • Demerit goods: the community staying near the dam may underestimate the extent of the cost arising from environmental damage (e.g. emission of greenhouse gasses arising from the decay in the surrounding regions) due to the construction and operation of the dam How does such forms of imperfect information lead to market failure? • In a free market, it is possible for a private firm to finance the building and operation of a damn if the revenue that it expects to earn from selling electricity and water exceeds the expected costs of building, operating and maintaining the dam. • However, to for the dam to be built, the firm would