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 a team 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.