Consider the following scenario.

1. A farmer produces wheat and sells it at a constant price per kilogram.

Show, diagrammatically, the marginal cost of wheat production as an upward-sloping line and the price of wheat as a horizontal line [4 marks]

2. For the wheat farmer, the marginal private benefit of producing a kilo of wheat is equal to the price. However, imagine there is some negative external effect imposed by an external party (I.e. surrounding community), which increases in the quantity of wheat produced.

• a. Re-draw the diagram from 2.1 but with an additional line to represent the marginal social cost of wheat production. Show the quantity of wheat that would be Pareto efficient. How does it compare with the quantity chosen by the beekeeper? [2 marks]
• b. Show the area that illustrates the total external cost imposed from the farming practice? [2 marks]
• c. What is the reservation option of the wheat farmer? Be sure to explain what a reservation option means [3 marks]
• d. What is the minimum acceptable offer for the farmer and what does this signify? [3 marks]
• e. What is the fallback option for the external party? Explain. [3 marks]
• f. What is the external party's minimum acceptable payment? [2 marks]
• g. Assume that the external party has ample bargaining power and has rights to challenge the farming. How will this party bargain towards the pareto optimal outcome? [3 marks]

3. Consider the hypothetical example discussed above.

• a. Why might the external party and the farmer be unable to bargain successfully to achieve a Pareto-efficient outcome in practice? [4 marks]
• b. Imagine a tax could be imposed on wheat farming. Show the tax revenue that will be received on the diagram from 2.2. Re-draw if necessary. [2 marks]
• c. Describe the distributional effects of this tax and compare it to the Pareto-efficient bargaining outcome. [3 marks