Q5. [9 Marks] a) Briefly explain each of the following with one practical example.

i) Adverse selection problem

ii) Moral hazard

iii) Costly to fake principle (3 marks)

b) You live in dairy country, surrounded by green fields and lots of cows. About 200 metres up the road from your house, a farmer has a dairy that milks cows. At various times during the day, the smell and noise from the cows waiting to be milked is very unpleasant. Having studied economics at university, you approach the farmer knowing:

the farmer is a price taker in a very competitive milk industry;

you can help the farmer determine the profit maximising amount of milk to produce for the current market price of milk;

the farmer's marginal cost curve is upward sloping when more milk is produced using the current milking equipment.

i) Using the above information, draw one diagram showing both the demand curve for this farmer's milk and the farmer's private marginal cost curve. Clearly indicate on the diagram how many litres of milk the farmer should produce to maximise profit when the selling price is $P/litre. (2 marks)

ii) The smells from the farm when the cows are being milked really annoy you. You convince the local council to impose a social cost on the farmer that reflects the costs associated with these smells. Redraw the diagram in part i) to now show the farmer's social marginal cost curve if the imposed social cost is $C/litre. Then mark the socially optimal number of litres of milk the farmer should produce if the selling price remains at $P/litre and the farmer maximises profit. (3 marks)

iii) Using your diagram from part ii), explain how you believe the farmer will react when the council decides to impose the social cost of $C/litre on the milk produced. (1 mark)