Practice

Free response question

Microeconomics · Hard · 30 marks

IEO past paper: 2025 International Economics Olympiad, open questions

Open Question 2. The Problem of Noisy Factory A factory producing car parts is located next to a care home for the elderly. The production process is noisy, which disturbs the sleep and daily activities of the care home residents. The factory is a price-taking firm that sells its car parts at the market price of £320. The original figure shows how marginal private cost (MPC) and marginal social cost (MSC) vary with the number of units produced (Q). It plots costs (£) on the vertical axis and output Q on the horizontal axis, with a horizontal line at Price = £320. The values marked on the figure are (costs in £): $\begin{array}{rrr} Q & \text{MPC} & \text{MSC} \\ \hline 0 & 100 & 100 \\ 80 & 270 & 320 \\ 120 & 320 & 430 \end{array}$ Both curves rise steadily between these points; treat them as straight lines between the marked values.

(a)Explain why the firm's profit-maximising choice of output is not Pareto efficient. Calculate the deadweight loss associated with this decision.[6](b)Explain why producing Q = 80 units is socially optimal.[2](c)Suppose the government assigns property rights to the care home residents, meaning they have the right to enjoy a peaceful environment. Assuming negligible transaction costs and that the socially optimal quantity will be produced, calculate: (i) the maximum amount that the car part factory is willing to pay to produce that quantity. Explain your answer. (ii) the minimum amount that the care home residents are willing to accept to tolerate the noise. Explain your answer.[6](d)Now suppose the government assigns property rights to the factory, meaning it has the right to make as much noise as it wants and the care home residents must compensate the firm for each unit not produced (compared to the profit-maximising quantity). Explain how they could reach an agreement to produce the socially optimal output and how much the firm would receive as compensation.[8](e)Thinking about situations of noise pollution in the real world, explain two reasons (aside from transaction costs) why the bargaining process in parts (c) and (d) may fail to produce a Pareto efficient outcome.[8]

Up to 5 AI marks a day. The mark scheme is shown after marking.

Report a mistake