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Market efficiency and moral hazards

1. 35% Turkey growers operate in a competitive, constant cost industry. This industry has reached a long run equilibrium at a price of $1 per pound of turkey
a. Illustrate the situation for a typical grower and the market. Show price, farm and market quantity, and farm profits.
It is known that unregulated waste products from turkey production degrade water quality in nearly lakes and streams.
b. Explain why this pollution creates inefficiency in the turkey market this pollution and illustrate the inefficiency on a graph.
The Environmental Protection Agency proposes stringent waste control requirements on all turkey growers. Growers argue against the proposal by pointing out that the regulations will increase the cost of producing a pound of turkey by 10 cents and the extra cost will be passed along to consumers. However, EPA implements the regulations, which are expected to be permanent.
c. Under what conditions in the turkey market would it be true that the price would rise by the full 10 cents in the short run?
d. Are those conditions likely to exist in this market? If so, explain why. If not, discuss the likely short run effect of the regulations under market conditions that you think are more realistic.
e. Explain the short run effects of the regulations on the quantity of turkey sold by each grower and in the entire market, the number of growers in business, and profits of a typical grower.
f. Explain what will happen in the long run to the price, quantity sold by each grower and in the market, the number of growers in business, and profits of a typical grower.
g. What information would you need to determine whether the new long run price and quantity are at the efficient level? Assume that the pollution is the only externality of turkey production.

2. 30% The Scottsdale Park Zoo is expanding its exhibits to present more species and have them live in more natural enclosures. The directors are deciding how to set the admission price for the improved zoo. Assume SPZ will set one price for all visitors and has some control over the price. The directors all agree that no matter what price they set, SPZ will not be able to cover all its costs from admissions revenue and will run a deficit each year. The SPZ financial staff reports that the expanded zoo will have fixed costs of $10,000 per day and that each visitor will add $1.25 in maintenance costs.
The county council member who serves as a director argues that SAM should set an admission price that minimizes the deficit and seek private donations to help cover the annual deficit. If it does this, she promises that the County will provide public funds to cover any deficit that remains after private donations are counted.
A spokesperson for "Friends of SPZ" suggests that the Zoo should 1) admit anyone who wants to visit, as long as each person pays for the extra cost that his/her visit creates, and 2) rely on private donations and tax revenues to cover the deficit.
a. Graph and properly label a set of demand, marginal revenue, marginal cost and average cost curves that could represent the expected situation at SPZ.
b. Use the graph to show the price that the council member and "Friends of SPZ" would set and explain the reasoning that produces each price.
c. Which price is economically more efficient? Why?
d. Show the extent of the inefficiency created by the other pricing option.
e. A third director does not say which pricing plan he supports. He proposes running a publicity campaign to increase public awareness of the expanded SPZ and raise attendance. He argues that a successful campaign will reduce the deficit. When you hear his proposal and argument, you whisper to your friend that you know which plan he supports. Which plan does he support and how do you know?

3. 15% A high school senior receives $25/week from her parents to spend as she wishes. She wants more income, and has found a job that pays $6/hour. She is currently working 15 hours/week.
a. Draw the student's budget constraint and show her equilibrium. Assume her parents will not allow her to work more than 25 hours/week. Ignore any possible taxes on her earnings.
Her parents raise her allowance to $40/week.
b. Draw the new budget constraint. Discuss the likely effect of this raise on the student's labor supply, assuming non-work is a normal good.
Instead, suppose her employer raises her wage to $7/hour, but the allowance remains at $25/week.
c. Draw the budget constraint for this situation. (Feel free to create a new graph.) Discuss its likely effect on the student's labor supply, assuming non-work is a normal good.

4. 15% Sea turtles are valued for their eggs, meat and shells, and as tourist attractions. Yet most species of sea turtle are endangered.
a. Analyze the economic factors that lead to this situation.
b. What policy (or policies) would you recommend to increase and sustain the population of sea turtles? Explain why you think it (they) would work.
c. Is sea turtle conservation a public good? Why or why not?

5. 5% Give an example of a public policy that is likely to create a "moral hazard" problem. Briefly explain why the moral hazard is likely to exist.

Solution Preview

1. See the attached file "externality." The marginal cost of production (MPC) is the supply curve for turkey. The demand curve meets the supply curve at equilibrium, a price $1 and output level A. However, the true cost to society is represented by the combination of the MPC and the marginal social cost (MSC). Thus the economically efficient equilbrium point is at a higher price, P2, and lower quantity, B. The increased cost of production is essentially a tax, which can be represented as moving the supply curve up and to the left. Note that the amount of the tax, represented by the green line, is shorter than the distance between the old price and the new price. This tells you that it is the slope of the demand and supply curves that are determining how much of the tax is being passed on to the consumer. The entire tax would be passed on to the consumer if the demand curve was vertical. This is occurs when the elasticity of demand is zero?quantity does not change as price goes up or down. This is the case for individual firms in a perfectly competitive market. However the entire market faces a downward sloping supply curve, as shown in the attached file. Individual firms are "price takers." Think in terms of a vendor selling wares just like what's available at the vendor right next to him. If he raises his price, everyone will just go to the next vendor. He must sell at the going rate.

The full cost of the tax will also be passed onto the consumer ...

Solution Summary

Determining the economic and socially efficient market outcomes. Description and example of moral hazards.