Q5 (10 marks) Fossil Fuels
Consider a simple two-period model of a nonrenewable resource, oil. The demand function and the marginal cost functions are assumed to be constant in the two periods, as shown below. Note that period 2 monetary values are expressed in present values (already discounted). Note that there are only 100 units of this resource available, to be consumed over the two periods.
5a. Draw a graph below to demonstrate the optimal (dynamically efficient) resource allocation.
(4 marks)
5b. According to a recent study, almost 60% of oil reserves must remain in the ground in order to keep global warming below 1.5˚C. Impose a policy instrument and modify the period 1 and period 2 graphs accordingly so that the resulting consumption of oil (Q1 + Q2) will be such that that 60% of the 100 units of the reserve available (i.e., 60 units) will remain under the ground, never to be consumed.
Then explain the reason behind your modification shown above. What is your policy proposal that can cause the change, as demonstrated above?
(4 marks)
