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There are four problems, and several of you will be chosen at random for grading. You are allowed (even encouraged!) to discuss this with friends, but your write-up must represent your own understanding and ideas. Be clear and concise, and show your work.

1. A Neighborhood Externality Erica grows garlic in her backyard organic garden and sells it at the Madison

Farmer's Market. Her supply curve is given by MC = P = QS, where QS is the quantity supplied (in bushels) and P is the price. The market price is \$24 per bushel. Unbeknownst to Erica, her neighborhood reeks of garlic due to her garden. Her neighbors are pleasant Madisonians and don't complain, though they suffer as a result of her garden. The marginal external costs are constant: MEC = 4.

a) How much does Erica harvest in equilibrium?

b) What is the Marginal Cost curve for society? (Hint: “vertical” summation of the private marginal cost and marginal external costs)

c) What is the socially-optimal amount of garlic produced by Erica?

d) Suppose Erica has the right to grow as much garlic as she'd like, and she produces at the privately-optimal amount. Her neighbor considers a “bribe” to persuade her to cut production to the socially-optimal level. What is the minimum amount she would need to be compensated to cut

production to the socially optimal level?

2. Roommates Adam and Bill each rent a studio apartment for \$300 per month. They are

considering renting a two-bedroom apartment, where the total monthly rent is \$500. If the rental costs were the same, they would be indifferent between living together or separately, except for one problem: Adam likes to practice his accordian late at night and this will disturb Bill's sleep. Adam would pay up to \$150/month rather than reschedule his playing. Bill would pay up to \$80 per month not to have his sleep disturbed.

a) Will they live together or separately?

b) What is the largest rent Bill would be willing to pay if the two were to live

together? Explain.

c) How should Adam and Bill split the \$500/month rent if they agree that each

should benefit equally from living together?

3. A Common Pool Resource

Consider two Scandinavian settlers who encounter a buffalo herd when settling in the American West. If both decide to kill 5 buffalos each per day, then they earn profits of \$500 each. If they both decide to kill 1 buffalo each per day, then they earn profits of

\$700 each (because the herd is so much more productive). However, if one decides to kill 1 and the other decides to kill 5, the first earns \$200 in profits and the latter earns \$1000 in profits.

a) If the settlers behave competitively, what is the equilibrium outcome?

b) Why is the market equilibrium of a common resource inefficient?

4. Pollution Problem There are two firms, A and B. Each firm is currently emitting 50 units of pollution.

Firm A’s marginal abatement costs are given by MAC A =X A /2, where X A is firm A’s reduction in pollution. Firm B’s marginal abatement costs are given by MAC B =X B /4, where X B is firm B’s reduction in pollution.

a. Suppose the regulator wants to reduce emissions to 80 total units. If the

regulator requires each firm to reduce 10 units of pollution, what are the total costs of abatement?

b. Suppose the regulator wants to reduce emissions to 80 total units. What is the

most cost-effective allocation of emissions across the two firms?