Consider a scenario where an oil company is operating a refinery in a developing
ID: 1140390 • Letter: C
Question
Consider a scenario where an oil company is operating a refinery in a developing country.
For simplicity’s sake assume that the refinery’s output is consumed entirely within the country.
a.
Assuming decreasing marginal benefit MB to consumers for consumption of refined oil,
increasing private cost MC to the oil company, and constant marginal health damages to
society MD, draw the graph showing the privately and socially optimal equilibria. Will
the firm over or underproduce oil relative to the social optimum?
b.
Suggest at least two mechanisms the developing country government might try to use to
correct for this externality. What might be practical barriers to implementation for either
mechanism in the real world?
c.
Suppose that ateam of young environmental and development economists announces that
they believe that marginal damages due to oil refinery effluent are much larger than
estimated, increasing, and highly nonlinear above a threshold value somewhere in the
vicinity of the current and old market equilibria. Draw what this graph might look like.
Which of the policy mechanisms we’ve discussed might you suggest as the preferred
means of dealing with this uncertainty, and why?
d.
Suppose that a rival group of development economists counters that the environmental
economists’ damage estimates are unrealistically high and the constant MD curve is more
realistic. Moreover, when one considers the positive external long-term effect that the oil
refinery has on local industry, marginal benefit accruing to society from the refinery’s
benefit may be far in excess of current estimates at all levels of production.Draw what
this graph might look like. If such is the case, what policy mechanism might you suggest
the country use to control pollution emissions, and why?
e.
Assume instead that there is a coup and the oil refinery is nationalized. Oil output is now
directly determined by the populace that is subject to the marginal damages. Graph how
the equilibrium quantity of oil produced might change. What has happened from an
economic point of view? Would the country still want to impose an externality-correcting
policy?
f.
Was the movement from privately held firm to nationalized firm Pareto improving? Did
it satisfy the Kaldor-Hicks criterion? Explain
Explanation / Answer
Marginal analysis involves a cost-versus-benefits comparison of various business activities. In marginal analysis, the cost of an activity is measured against incremental changes in volume to determine how the overall change in cost will affect the bottom line of a business. Marginal analysis can show the cost of additional production by a business all the way up to the break-even point. This is generally the maximum cost that a business can sustain without losing money.