WS 2022/23, Prof. Dr. K.

Pittel

Exercise Set 2

Environmental and Resource Economics

Exercise 1:

Consider an economy with three coal-fired power plants (Plant 1, Plant 2 and Plant 3). The three
plants can reduce their annual CO2 emissions at different marginal costs. The fixed costs of the
reduction are zero. The marginal abatement costs (𝑀𝑀𝑀𝑀𝑀𝑀) of the power plants for the reduction of
their CO2 emissions by 𝑥𝑥 tonnes and the annual emissions before regulation (𝐸𝐸 in tonnes) are
given by:

Plant 1 Plant 2 Plant 3

The government wants to reduce the annual CO2 emissions of the three power plants by a total
of 70 tonnes.

a) A commission proposes a distribution of the 70 tonnes reduction to the three plants propor-
tional to their marginal costs. What is the total cost to be incurred if the reduction is made in
accordance with the commission’s proposal?

b) The government finds the commission's proposal absurd and decides to implement the 70
tonnes reduction with the aid of an emissions tax. How high must the tax rate be chosen so
that the reduction target can be achieved at minimum cost? What is the total cost of reduction
and by how many tonnes of CO2 will Plant 1, Plant 2 and Plant 3 reduce their respective CO2
emissions?

c) One interest group disagrees with the government's decision and proposes a solution via trad-
able allowances. Plant 1 and 2 each receive 20 allowances and Plant 3 receives the remaining
allowances. Each allowance represents the right to emit one tonne of CO2. After the allocation,
the power plants will be free to trade their allowances on a market.

c1. How many allowances will be issued given the 70-tonne abatement target and how many
allowances will each company receive?

c2. Calculate how many allowances each power plant buys or sells in the course of the allow-
ance trade. How high is the price of an allowance in equilibrium?

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 WS 2022/23, Prof. Dr. K. Pittel

Exercise 2:

The graph below shows the marginal costs, MC, and marginal utility, MU, associated with the
emission of a pollutant 𝐸𝐸 as presumed by the regulator. Please mark the equilibrium and the
respective welfare losses in the case of internalisation through…

… an emission tax … emission allowances

MU, MU(alleged) MU, MU(alleged)

MC(actual) MC(actual)
MC(alleged) MC(alleged)

E E

Exercise 3:

Suppose two households, 𝐴𝐴 und 𝐵𝐵, each live by a lake and discharge their wastewater directly
into the lakes. The lake on which 𝐴𝐴 lives is much larger than the lake on which 𝐵𝐵 lives. As a result,
a unit of wastewater from 𝐴𝐴 causes less damage than a unit of wastewater of 𝐵𝐵. The correspond-
ing damage coefficients are 𝑘𝑘𝐴𝐴 and 𝑘𝑘𝐵𝐵 with 𝑘𝑘𝐵𝐵 > 𝑘𝑘𝐴𝐴 > 0. The regulator aims to reduce aggregate
damages by 𝑉𝑉�.

How should an environmental tax on wastewater be designed to achieve a cost-effective reduc-

𝐶𝐶(𝑣𝑣𝑖𝑖 ) with 𝐶𝐶𝑣𝑣𝑖𝑖 𝑣𝑣𝑖𝑖 (𝑣𝑣𝑖𝑖 ) > 0, 𝐶𝐶𝑣𝑣𝑖𝑖 (𝑣𝑣𝑖𝑖 ) > 0, 𝑖𝑖 = 𝐴𝐴, 𝐵𝐵

where 𝑣𝑣𝑖𝑖 is the reduction of wastewater from household 𝑖𝑖.

Exercise 4:

a) The marginal benefit of a firm from producing commodity 𝑥𝑥 is given by

𝑈𝑈𝑥𝑥 (𝑥𝑥) = 𝑎𝑎 − 𝑏𝑏𝑏𝑏, 𝑎𝑎, 𝑏𝑏 > 0.

The external marginal costs of production are:

𝐶𝐶𝑥𝑥𝑒𝑒 (𝑥𝑥) = 𝑐𝑐𝑐𝑐, 𝑐𝑐 > 0.

(1) How much of 𝑥𝑥 is produced in the market equilibrium and how much is produced in the
welfare optimum? What is the level of the corresponding Pigouvian tax rate 𝜏𝜏?

(2) Can Pigouvian taxation result in a suboptimal level of production given the optimization
problem above?

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 WS 2022/23, Prof. Dr. K. Pittel

(3) Present your results from (1) graphically and explain your result from (2).

(4) Assume that the marginal damage does not increase in 𝑥𝑥 but is constant. How does this
affect your result in (2)?

b) Now consider the market for a commodity 𝑦𝑦 produced under perfect competition. The world
market price for the good is

𝑝𝑝(𝑦𝑦) = 𝛼𝛼, 𝛼𝛼 > 0 .

The market supply curve is determined by the marginal private costs of the firms and corre-
sponds to
𝑝𝑝
𝐶𝐶𝑦𝑦 (𝑦𝑦) = 𝛽𝛽𝛽𝛽, 𝛽𝛽 > 0.

The external marginal damage of production is:

𝐶𝐶𝑦𝑦𝑒𝑒 (𝑦𝑦) = 𝛾𝛾𝛾𝛾, 𝛾𝛾 > 0.

b1. What is the optimal environmental tax rate if the environmental tax is levied 1) on the
customers and 2) on the suppliers? How is the tax burden distributed between demand
and supply in these two cases?

b2. How would the distribution of tax burden change if demand were completely price ine-
lastic?

Exercise 5:

A monopolist produces a good 𝑥𝑥. During production, the company incurs marginal costs of 𝑐𝑐 > 0.
Production causes emissions of 𝑒𝑒(𝑥𝑥) = 𝑥𝑥, which causes societal damages 𝑑𝑑 > 0. The demand
function is given by 𝑝𝑝(𝑥𝑥), 𝑝𝑝𝑥𝑥 (𝑥𝑥) < 0.

a) Calculate the production in the profit maximum of the monopolist? Show your profit maxi-
mum in the graph below and compare it to the market solution with perfect competition.
(The graph can be supplemented by further results in the course of the rest of the exer-
cise.)

b) The regulator plans to introduce an environmental tax on production whose rate is equal
to the marginal damage. Show the welfare effect of the tax graphically.

c) If you were asked to support the regulator in designing the tax, what tax rate would you
propose? Explain the economic intuition behind your proposal, focusing on its welfare ef-
fects.

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 WS 2022/23, Prof. Dr. K. Pittel

𝑝𝑝(𝑥𝑥) + 𝑑𝑑

𝑐𝑐 + 𝑑𝑑

𝑝𝑝(𝑥𝑥)

𝑐𝑐

𝑥𝑥

Exercise 6:

a) A large family is considering investing in a used car. The Family-Carriage model consumes
10 Litre gasoline/100km, while the Clan-on-Wheels model consumes just 6 Litre/100km. The
purchase cost of the Family-Carriage model is 14.000€ and the Clan-on-Wheels model is
22.000€. The price of gasoline is 0,85€/Litre before tax. The eco-tax amounts to 0,65€/Litre,
which corresponds to the marginal damage of emissions. The benefit of the family in each
year depends on each 100 kilometres travelled 𝑥𝑥:

1
𝑈𝑈(𝑥𝑥) = 𝑥𝑥 �40 − 𝑥𝑥� .
20
The family’s discount rate is 10%.

a1) If the family plans to drive their new car for 3 years and then sell it at a residual value of
half the purchase price, which model will it choose and how many kilometres per year
will it drive?

a2) Suppose that the family has to pay a tax per car in addition to the eco-tax. This will be
charged upon purchase depending on the vehicle-specific amount of CO2 emissions/km
(but regardless of the actual kilometres driven!) and amounts to 300€ (or 350€) for the
Family-Carriage and 200€ (or 250€) for the Clan-on-Wheels. To what extent does this
additional tax influence the family's decision? Comment.