Page 1 of 3Second Quiz Econ. 4/5535 -Natural Resource Economics Fall 1999I. An Introduction to NR Economics 1. (6 points) Define the following three concepts: state of technical knowledge, isoquants,and indifference curves. Use these three concepts in a discussion of the market’s ability orinability to partially offset the impacts of increased scarcity. The state of technical knowledge describes all the different ways products can be produced giventhe current state of knowledge. As economists, we often describe the state of technology forproducing a particular product with a production function. A production function for product xidentifies the maximum amount of x than can be produced by every possible combination ofinputs. The isoquant for output level x is all those combination of inputs that are just capable ofproducing x units of output. “Iso” quant as in “equal” “quantity”. As compared to isocost, whichis equal cost. An individual’s indifference curve for bundle identifies all those bundles of goods the individualxoranks indifferent with bundle . That is, the indifference curve for identifies all those bundlesxoxoof goods the individual considers no better or worse than bundle . Sometimes indifferencexocurves are referred to as “isoutility” curves. If the price of a natural resource increases how much the market will be able to mitigate thatincreased scarcity through changes in production processes that use that natural resource willdepend on the state of technical knowledge (the currently available techniques for producingproducts), and the ability of society to increases the set of available techniques (technicalprogress). The state of technical knowledge determines the shape and position of isoquants. Technicalprogress makes them shifts inward. When the price of a NR increases there is an increased profit incentive to find new ways to useless of that input. Technical progress has saved us from decreasing stocks and increasing demandfor goods and services. Isoquants tell us how easy it is to substitute one input for another. Specifically the slope anisoquant at a particular point (the marginal rate of technical substitution) identifies how much theproducer has to increase the quantity of one input when the quantity of another input decreases,holding constant output. The more easily inputs substitute for one another in production the morePage 2 of 3the use of a NR will decrease when its price increases. The market’s ability to mitigate increasedscarcity through substitution in production will be maximized when the NR whose price hasincreased has a perfect substitute in production. The market’s ability to mitigate increasedscarcity through substitution in production will be minimized when the NR whose price hasincreased is essential and has no substitutes. An individual’s indifference curves tell us the individual’s willingness to substitute one good foranother. Specifically the slope an indifference curve at a point (the marginal rate of substitution)identifies how much the consumption of one good has to increase when the consumption of theother good decreases by one unit to keep the individual indifferent. The more easily other goodssubstitute for natural resource intensive goods the more the consumption of NRIGs will decreasewhen their price increases. The market’s ability to mitigate increased scarcity through substitutionin consumption will be maximized when the NRIGs whose price have increased have perfectsubstitutes in consumption. The market’s ability to mitigate increased scarcity throughsubstitution in consumption will be minimized when the NRIGs whose prices have increased arenecessary for life and have no substitutes. Some comments:Some of you in your discussion jumbled together substitution in production (input substitution)with substitution in consumption (the substitution of one good for another by the consumer). Goods and inputs are not the same thing, and isoquants have nothing to do with preferences.We also need to distinguish between movements along an isoquant and shifts in the isoquant map. When you draw graphs make sure to label the axis. 2. (4 points) Define the term rent (resource royalty) within the context of nonrenewablenatural resources. In principles of microeconomics you learned that when a competitivefirm is in competitive equilibrium its marginal cost of production equals the market priceof the good it produces. For a competitive firm that extracts oil from a pool that it owns,in equilibrium will the marginal cost of extracting a barrel equal the market price of oil. Yes or No and explain. Rent is the price at which a unit of the extracted ore would sell for above the ground minus thecost of extracting it. That is, it is the value of a unit of the resource insitu (in the ground). Forthe typical competitive firm, like the ones you learned about in principles and intermediate microtheory, how much they produce this year does not affect the amount they can produce in futureyears, so longrun and shortun profits are maximized in each year by producing up to the pointwhere price equals the marginal cost of production. This is not the case for an extraction firmthat owns the stock of ore they are mining. Every unit that is extracted is one less unit that can beextracted in the future. Therefore, for the extractive firm there is a cost of production in thecurrent period above and beyond the cost of extraction; it is the lost value because one less unit isin the ground to extract or sell in the future. For the competitive extraction firm, profits arePage 3 of 3maximized when price equals the marginal cost of extraction plus the value of the marginal unit ofthe resource in the ground (the rent).Thinking about it in another way, imagine that you own the mineral rights to the reserves. Wouldyou let someone extract them for free or would you charge them some amount for each unitextracted? Running a bit with this second thought, what would happen if the minerals were acommon property