The British government's only interest is to maximize tax revenue net of costs for maintaining law and order from region A in its former colony India. The British government receives 10 million in tax revenue per year irrespective whether it governs the region directly or indirectly. If it governs the region directly, it incurs an annual cost of 2 million for successfully quelling a rebellion. If the British government controls the region indirectly, it has two options. The first one entails providing autonomy to the local elites who are authorized to collect revenue on behalf of the British government, for which they are compensated by 1 million paid to them by the British government. The third option is transferring the ownership rights to the British East India Company, which in return commits to pay the British government an annual fee of 8.5 million.

1. Calculate the opportunity cost of directly governing region A. Show all steps.
2. Briefly explain whether your answer in part a) conforms with Step 1 of the argument developed by Banerjee and Iyer (2005) with respect to:

a) the nature of the optimization problem faced by the British government;

b) the trade-offs involved in choosing a fiscal institution