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 probably need to gain the support and approval of the government, which in turn depends on the support and approval of the people staying near the damn as they will be directly affected by its construction and existence. • So if the people staying near the damn underestimates the private benefits, than the dam might not be built even when it should. • Conversely if the people staying near the dam under estimates the private costs, then the dam might be built when it should not have been.

2018 HCI C2H2 Economics – Suggested Answers to Prelim Essays 2 (To score L3, the analysis of public goods and EITHER merit OR demerit goods will be sufficient) Level Descriptors Marks L3 • Explains why dams could be public goods AND how imperfect information may exist in the provision of damns • Explains how public goods AND such forms of imperfection information lead to market failure • Explanations are rigorous and detailed • Illustrates understanding using examples from the preamble OR other plausible examples related to the provision of damns 8-10 L2 • Lacking in any one of the L3 criterions 5-7 L1 • Largely irrelevant response • Descriptive response which lack application of economic concepts or theory • Serious and pervasive conceptual errors 1-4 (b) Assess the determinants that a rational decision-making government should consider in allocating resources to build a new dam. [15] What is rational decision making from the perspective of the government? • A rational decision is one where the expected benefits of the decision outweighs the expected costs • In general, the main economic aim of a government is to maximize society’s welfare and for that to occur, the expected social benefits and costs needs to be considered • Social benefits and costs include both the private as well as external benefits and costs What determinants should a rational government consider in deciding to build a new dam? • Private benefits o This refers to the benefits enjoyed by econom ic agents that are directly derived from the operation of the dam o For example, the dam may result in improved irrigation thus benefitting the famers in the surrounding region o Such costs can be estimated based on the expected increase in agricultural output and subsequently the expected increase in farmers’ incomes • External benefits o This refers to benefits enjoyed by 3 rd parties i.e. people who indirectly benefit from the construction or operation of the dam o For example, when electricity is generat ed by the dam, the demand and hence production of electricity from other more polluting carbon sources is lowered, thus reducing global warming so that everyone else in the country benefits from less extreme weather conditions o Such costs can be estimated based on the expected power generation capacity of the dam, the carbon intensity of the alternative power generation methods, the reduction in carbon emissions, the reduced probability of adverse weather conditions and the expected damage caused by such adverse weather conditions • Private costs o This refers to costs involved in the construction, operation and maintenance of the dam o Construction costs can be estimated by having construction firms to bid for the project while operation and maintenance costs can be estimated by looking at such costs that have been incurred by existing dams

2018 HCI C2H2 Economics – Suggested Answers to Prelim Essays 3 • External costs o External costs refer to cost suffered by 3 rd parties i.e. people who ar e indirectly harmed from the construction or operation of the dam o For example, damming the river upstream ma y cause fishermen living downstream to suffer from lower water levels, reduced catch of fishes and hence lowered incomes o Estimates of such costs can be obtained by studying similar effects in other countries to calculate the reduction in the fish caught and hence the fall in fishermen income. How important are these determinants in the context of dam provision? • The easiest cost to estimate is arguably private costs as the cost of building, running and maintenance have already been incurred by many other existing local or foreign dam projects • While the potential benefits enjoyed by farmers from improved irrigation and potential costs borne by fishermen from reduced catch can be highly variable depending on how and how much water is redirected, the effects are nevertheless specific and thus a range of estimates can be accurately calculated if high quality studies are commissioned • The most difficult and thus most important determinant is the external costs incurred as the extent to which the reduction in carbon emissions affects the probability and severity of adverse weather conditions and the resulting damage done in a particular country are largely unpredictable as the global weather system is probably still too complex for