Quiz+4+Econ+101+Winter+2010_suggested solution

# Quiz+4+Econ+101+Winter+2010_suggested solution - Economics...

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Unformatted text preview: Economics 101 Section 400 Winter 2010 Quiz 4 For discussion in section, March 18 and 19 Name:______________________________________ Section:________________ Consider the diagram below, depicting demand and supply for curves for bacon.  Values  on the horizontal axis are measured in thousands of pounds per week, and values on the  vertical axis are measured in dollars per pound.    To supply bacon to the market, bacon producers must farm pigs.  Unfortunately, pig  farming is a dirty and smelly business, and it generates significant costs for those who  live near to the farms.  Suppose the producers impose \$4 of external costs on those who  live nearby for every pound of bacon produced.  \$20 Supply  \$10 Demand  250  500  (a) If all bacon producers and bacon consumers are price takers, and are able to  transact freely with each other in the bacon market (but not with those who live  near the farms), what quantity of bacon will be sold in the market?  At this  quantity, what is the value of the marginal pound of bacon to consumers?  What  is the private cost to producers of producing the marginal pound of bacon?    ANSWER:    250,000 pounds of bacon will be sold in the market.  At this quantity, the value of  the marginal pound of bacon to consumers is \$10.   The private cost to producers of  producing the marginal pound of bacon is also \$10.    ANSWER:  The external cost imposed by production of the marginal pound of bacon is \$4.  Hence,  the social cost of producing the marginal pound of bacon is \$10 + \$4 = \$14.  This is  illustrated in the diagram below:    (b) If the quantity of bacon produced is as predicted in part (a), what external cost is  imposed by production of the marginal pound of bacon?  What is the social cost  of producing the marginal pound of bacon?  On the diagram above, sketch the  marginal social cost curve showing the social costs of producing each  incremental pound of bacon?        (c) The quantity of bacon identified in part (a) is not the efficient production  quantity. Is it possible to reallocate resources to make somebody better off  without hurting anybody else? If so, how? If not, why not? Then, identify on your  diagram the efficient quantity of bacon to be produced.     ANSWER:    Yes, it is possible to reallocate resources to make somebody better off without  hurting anybody else.  If we assign and enforce property rights over the right to  benefit from, or to impose, an externality, and if agents are free to trade these  rights, then Coasean (private) bargaining can lead to the efficient outcome.      For example, we can assign the right to pollute to the bacon producers.  The  producers can agree to reduce bacon production if the people living near pig farms  agree to compensate them in some way.  Because the producers impose an      externality cost of \$4 per pound of bacon produced, the people who live near pig  farms would then be willing to pay the producers exactly this amount.  In return, the  bacon producers would agree to reduce output to the efficient level, where the  social marginal benefit is just equal to the full social cost of producing bacon.  (See  diagram above for the efficient quantity.)    Alternatively, we can assign the right to clean environment and fresh air to the  people living near pig farms.  For bacon producers to be able to raise pigs, they then  need to compensate the people for the cost of externality that pig farms will create.   Therefore, the bacon producers will now bear not only the production cost but also  the externality cost, so that production will then ensue where the full social cost is  equal to the social marginal benefit.    It is possible to not make any Pareto improvements or for inefficiency to persist if  property rights are poorly assigned or poorly enforced or if there are transactions  and bargaining costs.  (d) Suppose you are elected to represent the people who live near pig farms in  negotiations with the farmers.  Since the production of bacon imposes costs  upon your group, you ask the farmers to reduce their output of bacon below the  output level derived in part (a).  What is the most you would pay the farmers  (per pound reduction in bacon output)?  How much would you have to pay the  farmers (per pound reduction in bacon output) to ensure farmers produce the  efficient output level?    ANSWER:    The most I would pay the farmers would be \$4 per pound reduction in bacon output.   Any payment higher than \$4 is not commensurate for the reduction in the cost of  damage to me.  Moreover, I would have to pay the farmers \$4 (per pound reduction  in bacon output), because a payment lower than \$4 is still not enough to compel the  pig farmers to fully internalize the social cost and produce the efficient output level.    ...
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