1. It has been said that "Prices are like giant neon billboards that flash important information." Describe the types of information that market prices provide.

2. What is an "externality"? Why might it create a problem for market allocation? Why is it widely accepted that the government is responsible for dealing with externalities? Please give examples of externalities?

3. Suppose that an automobile race track is built several miles from a small town. After the construction is completed it is discovered that the heavy roar from the cars regularly disturbs the 2,500 local residents between the hours of 10:00 PM and 1:00 AM on summer nights. Each local resident places a value of $150 on having quiet evenings at home during the summer concert season. The amphitheater owners could install a retractable roof over the track that would eliminate the noise at a cost of $350,000. Local residents could install extra insulation in their homes to soundproof them at a cost of $125 per resident. Suppose that transaction costs are small and it is easy for the theater owner and the town residents to reach an agreement that makes them all better off. If the amphitheater must provide full monetary compensation for any noise damage imposed on the community, what will the outcome be? If the amphitheater is NOT required to pay any compensation for any noise damage done to the community, what will be the outcome? What will happen if the transactions costs of reaching an agreement are large?