ECO Exam2 – Consider a market with supply and demand curves.

| November 24, 2016

Question
1. Consider a market with supply and demand curves.
Qd = 180 – 2Pd,
Qs = Ps,

or Pd = 90 – ½ Qd
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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