# Consider a market with supply and demand curves.

November 24, 2016

1. Consider a market with supply and demand curves.

Qd = 180 – 2Pd, or Pd = 90 – ½ Qd

Qs =Ps, or Ps = Qs

Policy makers are considering adoption of a deficiency payment program. Find the optimal size of government subsidy G (where G = Ps – Pd), when the government objective, or policy objective, is to maximize:

a. Total surplus (TS) defined as TS = CS + PS – GE (where CS is consumer surplus, PS is producer surplus and GE is government expenditure).

b. A policy objective (PO1) defined as PO1 = CS + 1.5 PS – GE.

c. A policy objective (PO2) defined as PO2 = CS + PS – GE + EB where EB is a measure of external benefits resulting from farm output level, where (in this problem) the relationship of EB to quantity produced is EB = 10 Qs

2. If the government used an income tax to raise money to pay for the deficiency payment program (so that raising G above zero required an increase in the income tax rate), how might that change your answer to question 1. Would optimal G be larger or smaller? Explain your reasoning.

3. Using a simple mathematical model, we saw that the existence of external benefits can create a rationale for farm subsidies. Now suppose that these subsidies are financed by increasing the income tax rate. Explain the welfare cost associated with income taxation. What implication does that have for whether farm subsidies are justified whenever farm production creates an external benefit.

4. What is “rent seeking” and why might it be regarded as an element of government failure.

5. A question on stabilization that does not require mathematical calculations or drawing of supply-demand diagrams (unless using supply-demand diagrams helps you organize your thoughts for the question).

6. Briefly describe the theory of the second best, and give an example of how it might apply to agriculture.

7. In the paper by Joseph Stiglitz on “Government Failure and Market Failure,” the author identifies three general reasons why government intervention is needed in private markets.

a. One of the three reasons is “irrationality”. Explain what Stiglitz means, why it might create a reason for government intervention, and give an example of irrationality creating a rationale for government intervention in markets for food and/or agricultural commodities.

b. Name and briefly define the other two general reasons.

8. If farmers are risk averse, reducing price instability (price uncertainty) will have what effect on the market? (Describe using words.) Would this be beneficial or harmful to consumers?

9. The approach to price instability taken by Waugh, Oi, and Massell is fundamentally different from the approach taken by Van Kooten, Schmitz, and Furtan. Explain the fundamental difference.

10. In the lecture about the economics of stabilization, Prof. Leathers described the Waugh, Oi, Massell strain of literature as modeling a situation in which there was “instability, but no risk or uncertainty.” What does that mean?

11. How might Olsen’s Theory of Collective Action help explain the existence of farm subsidies in a country like the US, where only a small percentage of the population lives on farms.

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