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Market Failure versus Government Failure

Market Failure versus Government Failure

Chapter 21

Market Failure versus Government Failure


True / False Questions

1. Externalities can be either positive or negative.
True False

2. Economists generally prefer direct regulation to incentive-based programs because explicit regulation tends to be more efficient.
True False

3. Direct regulation means that government sets specific limits on the use of scarce resources.
True False

4. Economists are likely to oppose direct regulation because they do not believe there is any need for government to take action when negative externalities exist.
True False

5. Economists tend to believe that market incentive plans are generally more efficient than direct regulation.
True False

6. An optimal policy is one in which the marginal cost of undertaking the policy is less than the marginal benefit of that policy.
True False


7. If a program requires people to pay a price that reflects the cost of an externality associated with their actions for which previously they did not pay, it will be in their best interest to change their behavior.
True False

8. Government provides secondary education because of its private good aspects.
True False

9. Economists believe that free riders can often undermine the social commitment of many in the society, causing voluntary policies to fail.
True False

10. Adverse selection problems can occur when buyers and sellers have different amounts of information about the good for sale.
True False

11. Government attempts to offset market failures can prevent the market from dealing with the problem more effectively.
True False

12. If government action is likely to do some good, then it is always best for government to intervene in the marketplace.
True False


Multiple Choice Questions


13. What do economists mean when they say there is "market failure"?
A. Business has introduced a product that consumers did not want.
B. Free markets have led to excessive profits.
C. Markets have surpluses or shortages so that government rationing is necessary.
D. Free markets yield results that economists do not consider socially optimal.

14. Some economists believe that the market will not solve all problems. They are referring to:
A. market failure.
B. market incentive plans.
C. optional policy.
D. the need to balance the good of the individual with the good of society as a whole.

15. All of the following are considered sources of market failure except:
A. public goods.
B. imperfect information.
C. profit-maximizing behavior.
D. externalities.

16. The criterion that no person can be made better off without another being made worse off is known as the:
A. normative criterion.
B. Pareto criterion.
C. Nirvana criticism.
D. second-best criticism.

17. John has ten apples and six bananas. Jane has 2 bananas and 2 apples. If this situation is Pareto optimal, what mutually beneficial exchange could be made?
A. None; there is no exchange that can help one without hurting the other.
B. Fruit should be taken from John and given to Jane to equalize their holdings.
C. Jane should give up apples to get bananas.
D. Jane should give up bananas to get apples.


18. The perfectly competitive output level is Pareto-optimal because at this output level:
A. the total cost to society equals the total benefit.
B. the marginal cost to society equals the marginal benefit.
C. the marginal cost to society is minimized.
D. the marginal benefit to society is maximized.

19. The economist who mathematically proved that a complete set of competitive markets could yield a socially (or Pareto) optimal result was:
A. Adam Smith.
B. Kenneth Arrow.
C. Milton Friedman.
D. Ronald Coase.

20. If there is a complete set of markets that are perfectly competitive:
A. the marginal cost of producing goods will exceed their marginal benefit.
B. the marginal cost of producing goods will be less than their marginal benefit.
C. every person's utility function is at a maximum.
D. the invisible hand guides the economy to a Pareto optimal position.

21. If a system has multiple defects but those defects in effect offset each other, then curing one defect may make the system perform more poorly. This possibility is known as:
A. the Hume Dictum.
B. the normative criticism of Pareto optimality.
C. the second-best criticism of Pareto optimality.
D. the Nirvana criticism of Pareto optimality.

22. Can outcomes that are not Pareto optimal be considered better than outcomes that are Pareto optimal?
A. No; Pareto optimal is defined as the best possible outcome.
B. Yes, if the non-Pareto-optimal outcome is more efficient than the Pareto-Optimal outcome.
C. Yes, if the distribution of wealth in the Pareto-optimal outcome is considered undesirable.
D. Yes, if there are too many market failures in the Pareto-optimal outcome.


23. If a market has no externalities, then marginal private costs:
A. exceed marginal social costs.
B. equal marginal social costs.
C. are below marginal social costs.
D. intersect marginal social costs.

24. Economists generally call the effect of an agreement on others which is not taken into account by the parties making the agreement:
A. excess burden.
B. welfare loss.
C. Pareto optimality.
D. an externality.

25. The best example of a positive externality is:
A. roller coaster rides.
B. pollution.
C. alcoholic beverages.
D. education.

26. Alex is playing his music at full volume in his dorm room. The other people living on his floor find this to be nuisance, but Alex does not care. Alex's music playing is an example of a:
A. negative externality.
B. positive externality.
C. normative externality.
D. Pareto externality.

27. Alex is playing his music at full volume in his dorm room. The other people living on his floor are enjoying his music, but Alex does not know or care. Alex's music playing is an example of a:
A. negative externality.
B. positive externality.
C. normative externality.
D. Pareto externality.


28. James enjoys gardening in the nude because he says it puts him in touch with nature. His neighbors find his gardening routine very offensive, but James replies that they should mind their own business and not watch him. To an economist this situation illustrates the concept of:
A. tragedy of the commons.
B. negative externality.
C. positive externality.
D. adverse selection.

29. Carbon dioxide emissions are thought to contribute to global warming, and there is concern that changes in climate will be costly. Emitting carbon dioxide is an example of:
A. a public good.
B. a negative externality.
C. an adverse selection problem.
D. an effluent fee.

30. In the Flint Hills Area of Kansas, proposals to build wind turbines to generate electricity have pitted environmentalist against environmentalist. Members of the Kansas Sierra Club support the turbines as a way to reduce use of fossil fuel, while local chapters of the Nature Conservancy say they will befoul the landscape. The Sierra Club argues that wind turbines:
A. are a source of negative externalities.
B. reduce negative externalities elsewhere in the economy.
C. create a free-rider problem.
D. are a way of solving a free-rider problem.

31. Proposals in Flint Hills, KS to build wind turbines to generate electricity have pitted environmentalist against environmentalist. Members of the Kansas Sierra Club support the turbines as being a way to reduce use of fossil fuel, while local chapters of the Nature Conservancy say they will befoul the landscape. The chapters of the Nature Conservancy argue that wind turbines:
A. are a source of negative externalities.
B. reduce negative externalities elsewhere in the economy.
C. create a free-rider problem.
D. are a way of solving a free-rider problem.


32. College education provides higher income for the individual, but also a more productive and more educated person who will contribute to society in many ways. Higher education is an example of
A. a positive externality.
B. a negative externality.
C. a non-excludable service.
D. adverse selection.

33. Richard Vedder argues that the states that have spent the most on higher education in the past 25 years have experienced the least economic growth. One might conclude that higher education:
A. does not have important positive externalities.
B. does not have important negative externalities.
C. is a non-excludable service.
D. has problems of adverse selection.

34. Under the Texas law known as "rule of capture," land owners "get to pump as much of the water under it as they want.... 'This means whoever sucks it out first, it's their water'--even if that means there isn't enough left for others." Under this law, pumping large amounts of water:
A. imposes a negative externality on others.
B. imposes a positive externality on others.
C. imposes the free-rider effect on others.
D. is a private decision with no effects on others.

35. Which of the following is not an example of an externality?
A. Carbon dioxide from energy generation that adds to the worldwide, long-term greenhouse effect.
B. Heat from a factory that makes the neighboring tomato patches more productive.
C. A defective part that causes an automobile to break down three months after purchase.
D. Acidic by-products of fossil fuel combustion that produce acid rain.


36. An externality is present in a free market whenever:
A. a monopolist spends funds to keep potential competitors out of the market.
B. an activity generates costs or benefits that are not reflected in market prices.
C. firms hire employees from outside the firm to fill positions normally filled by promotion from within the firm.
D. a tax is imposed on the supplier of a good.

37. When negative externalities are present, market failure often occurs because:
A. the marginal external cost resulting from the activity is not reflected in the market price.
B. the marginal external cost resulting from the activity is reflected in the market price.
C. the existence of imports from foreign countries takes jobs (and income) away from U.S. citizens.
D. consumers will consume the good at a level where their individual marginal benefits exceed the marginal costs borne by the firm producing the good.

38. The existence of negative externalities:
A. prevents the market from working efficiently.
B. prevents government from intervening in the marketplace.
C. causes the market to work more effectively.
D. necessarily means that government must intervene in the marketplace.

39. An example of a negative externality is the:
A. decrease in your real income that results when photographic equipment you purchase increases in price because of increased demand by others for these items.
B. cost you bear when your neighbor has a noisy party and does not compensate you for your discomfort.
C. benefit you receive without paying when your neighbor installs a smoke detector.
D. decrease in income to farmers that results from a drought.

40. If a negative externality is associated with burning firewood:
A. the marginal social cost of burning firewood falls short of its price.
B. the marginal social cost of burning firewood is exactly equal to its price.
C. less than the efficient amount of firewood for burning will be used each year.
D. the marginal social cost of burning firewood exceeds the price of burning firewood.


41. When negative externalities exist in the production of a good, the marginal social cost of producing the good:
A. is equal to the marginal benefit received by consumers if competitive markets exist and there is no government intervention.
B. equals the marginal cost borne by the firm minus the marginal external cost resulting from the production and consumption of the good.
C. is less than the marginal cost borne by the firm.
D. equals the marginal cost borne by the firm plus the marginal cost borne by third parties from the production and consumption of the good.

42. The cost of running an electrical utility includes costs for fuel, labor, and capital. In addition, there are sometimes costs associated with pollution from the utility, such an increased health-care costs for people living near the utility. To an economist, the costs associated with the pollution resulting from additional electricity are:
A. marginal private costs.
B. marginal social costs.
C. the difference between marginal social costs and marginal private costs.
D. the sum of marginal social costs and marginal private costs.

43. If a positive externality is associated with the purchase of smoke detectors:
A. the marginal social benefit of smoke detectors exceeds their price.
B. the marginal social benefit of smoke detectors is zero.
C. the marginal social benefit of smoke detectors equals their price.
D. more than the efficient quantity of smoke detectors will be sold.

44. When positive externalities exist in the consumption of a good, the marginal social benefit:
A. equals the marginal benefit received by consumers of the good minus the marginal benefit to third parties.
B. equals the marginal cost of producing the good plus the marginal cost to third parties.
C. equals the marginal benefit received by consumers of the good plus the marginal benefit to third parties.
D. could be either greater than or less than the marginal benefit received by consumers of the good depending on the equilibrium price determined in competitive markets.


45. If a negative externality exists in the production of paper and paper is sold in a perfectly competitive market, then at the equilibrium output:
A. additional net gains to society are possible by reducing the output of paper.
B. additional net gains to society are possible by increasing the output of paper.
C. the marginal social benefit of paper equals its marginal social cost.
D. additional net gains to society are not possible from either increasing or decreasing the output of paper.

46. If a positive externality exists in the provision of education when education is provided in a perfectly competitive market without government intervention, then at the market equilibrium level of education:
A. additional net gains to society are possible by reducing the level of education.
B. additional net gains to society are possible by raising the level of education.
C. the marginal social benefit of education equals the marginal social cost.
D. additional net gains to society are not possible by either increasing or decreasing the level of education.

47. If a negative externality exists in the market for dirt bikes and that market is perfectly competitive:
A. less than the efficient output of dirt bikes will be produced.
B. the price of dirt bikes exceeds the marginal social cost.
C. the price of dirt bikes equals the marginal social cost.
D. the price of dirt bikes is less than the marginal social cost.


48. Refer to the graph above. There is a 10-cent-per-gallon marginal external cost associated with the use of gasoline. Assuming that gasoline is sold in perfectly competitive markets, the market equilibrium price will be:
A. $0.95.
B. $1.00.
C. $1.05.
D. $1.10.

49. Refer to the graph above. If the marginal external cost associated with the use of gasoline is 10-cents-per-gallon, the point on the graph corresponding to the efficient quantity and price is:
A. G.
B. H.
C. K.
D. L.


50. Refer to the graph above. Assuming a 10-cent-per-gallon marginal external cost associated with gasoline, the market price of gasoline necessary to induce consumers to purchase the efficient quantity each year is:
A. $1.10.
B. $1.00.
C. $1.05.
D. 95 cents.

51. Refer to the graph below.

Assuming a marginal external cost equal to the tax shown in the above graph, the market price necessary to induce consumers to purchase the efficient quantity each year is:
A. P1.
B. P2.
C. P3.
D. P4.

52. Once vaccinated, a person cannot catch a cold nor give a cold to someone else. As a result the marginal social benefit resulting from consumption of the vaccine:
A. exceeds the marginal benefit received by consumers of the vaccine.
B. equals the marginal social cost of producing the vaccine in a competitive equilibrium.
C. equals the marginal benefit received by consumers of the vaccine in a competitive equilibrium.
D. is less than the marginal benefit received by consumers of the vaccine.

53. Refer to the graph above, which shows the demand and supply for a new vaccine against the common cold. Once vaccinated, a person cannot catch a cold or give a cold to someone else. As a result, the marginal social benefit curve will:
A. coincide with the market demand curve.
B. lie strictly below the market supply curve.
C. lie below the market demand curve.
D. lie above the market demand curve.

54. Refer to the graph above, which shows the demand and supply for a new vaccine against the common cold. Once vaccinated, a person cannot catch a cold or give a cold to someone else. At the competitively determined output level, the marginal social benefit will be:
A. equal to P0.
B. less than P0.
C. greater than or less than P0 depending on the income elasticity of demand and the effectiveness of the vaccine.
D. greater than P0.


55. Refer to the graph above, which shows the demand and supply for a new vaccine against the common cold. Once vaccinated, a person cannot catch a cold or give a cold to someone else. The socially efficient level of output is:
A. less than Q0.
B. greater than or less than Q0 depending on the income elasticity of demand and the effectiveness of the vaccine.
C. greater than Q0.
D. equal to Q0.

56. Refer to the graph above, which shows the demand and supply for a new vaccine against the common cold. Once vaccinated, a person cannot catch a cold or give a cold to someone else. If government does not subsidize the production of this vaccine:
A. the number of workers hired to produce the vaccine will be less than the socially efficient level.
B. the firm producing the vaccine will use too much capital in producing the vaccine.
C. the vaccine will be overproduced because consumers will not take into account the fact that many of their neighbors and coworkers will consume the vaccine.
D. No positive externality can be created.


57. Refer to the graph below.

The point on the graph corresponding to the socially optimal output per year and the price sellers must receive to make that amount available is shown by point:
A. G.
B. H.
C. I.
D. K.

58. If a negative externality is to be internalized to the decision maker, the:
A. producers' marginal costs should be increased by an amount equal to the marginal external cost resulting from production of the good.
B. producers' marginal costs should be reduced by an amount equal to the marginal external cost resulting from production of the good.
C. consumer of the good should receive a subsidy equal to the marginal external cost resulting from production of the good.
D. consumer of the good should pay a tax equal to the marginal external benefit resulting from consuming the good.


59. If a positive externality is to be taken full advantage of, the:
A. consumer of the good should receive a subsidy equal to the marginal external cost resulting from production (or consumption) of the good.
B. producers' marginal costs should be increased by an amount equal to the marginal external benefit resulting from production of the good.
C. consumer of the good should pay a tax equal to the marginal external benefit resulting from production (or consumption) of the good.
D. producers' marginal costs should be decreased by an amount equal to the marginal external cost resulting from production of the good.

60. If a corrective tax on gasoline results in the efficient output of gasoline by internalizing negative externalities associated with pollution:
A. pollution from gasoline will increase because people are also harmed by the tax.
B. there will be no effect on pollution from gasoline because the tax is paid by the supplier.
C. pollution from gasoline will be zero because environmental cleanliness is priceless.
D. the tax will generate enough revenue to compensate society for the damages resulting from the pollution that still occurs.

61. Refer to the graph above. Say that there is a negative externality associated with the production of the good depicted. The marginal social benefit from consuming this good at the competitive equilibrium output level is:
A. greater than P0.
B. equal to P0.
C. either greater than or less than P0, depending on the elasticities of supply and demand.
D. less than P0.


62. Refer to the graph above. Say that there is a negative externality associated with the production of the good depicted. The marginal social cost from consuming this good at the competitive equilibrium output level is:
A. either greater than or less than P0, depending on the elasticities of supply and demand.
B. greater than P0.
C. less than P0.
D. equal to P0.

63. Refer to the graph above. There is a negative externality associated with the production of the good depicted. The socially efficient level of output is:
A. either greater than or less than Q0, depending on the elasticities of supply and demand.
B. less than Q0.
C. equal to Q0.
D. greater than Q0.

64. The rule for making optimal decisions is that an activity should be increased until:
A. average costs are minimized.
B. total costs are minimized.
C. total benefits are maximized.
D. marginal benefits equal marginal costs.

65. A strategy that achieves a goal at the lowest cost in total resources without consideration as to who pays those costs is:
A. efficient.
B. inefficient.
C. impossible.
D. always the most profitable to the firm.


66. Direct regulation is inefficient because:
A. affected firms ignore regulations; for example, by dumping toxic waste illegally.
B. it does not take into account that the costs of reducing consumption are the same for all individuals.
C. it does not take into account the fact that the costs of reducing consumption may differ among individuals.
D. it does not take negative externalities into account.

67. Suppose that government wants a policy that will encourage people to use less oil. For this policy to be efficient, it must:
A. induce those with the highest cost of conserving to reduce their oil consumption the most.
B. induce those with the lowest cost of conserving to reduce their oil consumption the most.
C. force everyone to reduce oil consumption equally.
D. force rich people to reduce oil consumption proportionally more than poor people.

68. Economists generally oppose direct regulation because:
A. it is unlikely to achieve the desired end as efficiently as possible.
B. it assumes that people behave rationally.
C. it is generally unfair.
D. it does not assume that people behave rationally.

69. A market incentive plan:
A. regulates the amount of a resource a person can consume through direct limits.
B. requires that people choose to consume until the marginal costs exceed the marginal benefits.
C. makes the price of a resource reflect not only the marginal private costs but also the marginal social costs of consuming that resource.
D. makes the price of a resource reflect the marginal private costs of consuming that resource.


70. To address the problems created by negative externalities, economists prefer programs that:
A. require government to conserve, using general tax revenues to pay for the program.
B. require all people to reduce consumption equally.
C. make people who have the lowest benefit of reducing consumption choose to undertake the most reduction.
D. make people who have the lowest cost of reducing consumption choose to undertake the most reduction.

The table below shows four firms, the amount each pollutes, the marginal cost for each firm to clean up pollution, and the total cost to each firm of eliminating all pollution.

The total discharge of these four companies is 300 tons. Assume there is no one else who pollutes.

71. Refer to the table above. If the goal of the government is to reduce pollution by 50%, the cheapest way would be to have:
A. all four firms cut their discharge by 50%.
B. each firm reduce discharge by 37.5 tons.
C. firms A and D stop discharging and allow B and C to continue.
D. firms B and C stop discharging and allow A and D to continue.

72. Refer to the table above. Assume that these firms want to maximize profits. If the government wishes to cut discharge by 50%, it could do so by establishing an effluent fee of:
A. $3.00
B. $4.50
C. $5.50
D. $10.00


73. Refer to the table above. If the government establishes an effluent fee of $7.00, how much tax would firms pay to the government?
A. $660
B. $1,050
C. $1,820
D. $2,100

74. Refer to the table above. If the government establishes an effluent fee of $7.00, how much would the firms spend on reducing pollution?
A. $660
B. $1,710
C. $1,820
D. $2,100

75. Refer to the table above. If the government establishes a regulation requiring each company to reduce pollution by 50%, what would be spent on reducing pollution?
A. $660
B. $910
C. $1,050
D. $1,710

76. Refer to the table above. Suppose that the government gives each company a pollution permit equal to 50% of its present discharge. However, companies are allowed to reduce pollution more than 50% and sell their permit or reduce less than 50% and buy a permit from another company. If firms maximize profits, what would happen?
A. Each firm would reduce pollution by 50%.
B. Firms A and D would eliminate pollution and sell their permits to B and C, who would continue to pollute as before.
C. Firms B and C would eliminate pollution and sell their permits to A and D, who would continue to pollute as before.
D. There is not enough information to answer this question.


77. An effluent fee is an example of:
A. voluntary approach to pollution.
B. direct regulation of pollution.
C. a tax incentive policy.
D. a market incentive policy.

78. Based on economic theory, most economists believe market incentive plans are:
A. equitable.
B. efficient.
C. inefficient.
D. unfair.

79. In a tax incentive program, the person who conserves the most pays:
A. relatively less tax.
B. relatively more tax.
C. no tax.
D. no penalties.

80. Which of the following methods of reducing the amount of trash society generates is most likely to be efficient?
A. A mandatory recycling program
B. A completely voluntary recycling program
C. A "trash tax"
D. Landfills and incinerators

81. Which policy is likely to be the most efficient in dealing with automobile emission pollution?
A. A mandatory requirement to reduce pollution
B. Voluntary emission control guidelines
C. Subsidizing research and development for alternative forms of transportation
D. An emission tax


82. A policy that requires everyone to certify that they have reduced total consumption, not necessarily their own individual consumption, by a specified amount, is a:
A. external incentive plan.
B. internal incentive plan.
C. tax incentive plan.
D. market incentive plan.

83. Suppose Mary finds it easier to conserve than Jim. The difference between a tax incentive program and a marketable certificate plan in this case is that:
A. Mary undertakes most of the conservation in the case of a tax incentive program and least in the marketable certificate program.
B. Mary undertakes least of the conservation in the case of a tax incentive program and most in the marketable certificate program.
C. Mary takes on most of the conservation in both cases, but is paid by Jim in the marketable certificate program.
D. Jim takes on most of the conservation in both cases, but is paid by Mary in the marketable certificate program.

84. If markets are perfectly competitive and production of a good results in water pollution, the imposition of a tax on that good will:
A. increase the price of that good and increase pollution.
B. reduce the price of that good and increase pollution.
C. reduce the price of that good and decrease pollution.
D. increase the price of that good and reduce pollution.

85. If markets are perfectly competitive and production of a good results in water pollution, the imposition of a tax on the good will:
A. reduce the number of firms producing that good in the long run.
B. increase the number of firms producing that good in the long run.
C. reduce the number of firms producing that good in the short run.
D. increase the number of firms producing that good in the short run.


86. An individual with a highly elastic demand for gasoline will:
A. cut consumption more than an individual with a highly inelastic demand when price goes up.
B. cut consumption less than an individual with a highly inelastic demand when price goes up.
C. refuse to cut consumption for any reason.
D. stop using gasoline entirely if a tax is imposed.

87. A firm with a highly inelastic demand for coal will:
A. cut consumption more than a firm with a highly elastic demand when price goes up.
B. cut consumption less than a firm with a highly elastic demand when price goes up.
C. refuse to cut consumption for any reason.
D. stop using gasoline entirely if a tax is imposed.

88. A policy is considered optimal if it:
A. is supported by a majority of voters.
B. equates total costs with total benefits.
C. equates marginal costs with marginal benefits.
D. forces people to conserve on scarce resources.

89. An optimal corrective tax levied on polluters will:
A. be equal to the marginal external cost of their actions.
B. not generate enough revenue to pay for the cost of the damage resulting from pollution that occurs at the efficient output of the good.
C. decrease pollution to zero.
D. increase the supply of polluting goods.

90. A policy in which the marginal costs of undertaking the policy equal the marginal benefits of that policy is best called an:
A. equality policy.
B. incentive policy.
C. optimal policy.
D. opportunity policy.


91. An efficient policy to reduce pollution would reduce pollution to the point where:
A. the marginal costs of reducing pollution equals the marginal benefits of reducing pollution.
B. it is eliminated.
C. the marginal costs of reducing pollution are greater than the marginal benefits of reducing pollution.
D. the marginal costs of reducing pollution are less than the marginal benefits of reducing pollution.

92. The efficient amount of pollution control is:
A. the amount for which the total social benefit equals the total social cost of pollution.
B. the amount for which the marginal social benefit equals the marginal social cost of pollution.
C. always zero.
D. always 100% abatement.

93. The optimal quantity of pollution control occurs at the point where the:
A. level of pollution is reduced to zero.
B. marginal social benefit is at its maximum.
C. marginal social cost equals the marginal social benefit of pollution.
D. total benefit equals the total cost of pollution.

94. Economists' attitude toward voluntary programs causes them to:
A. actively oppose them on the grounds that they will do more harm than good.
B. actively oppose them on the grounds that they are unfair.
C. be skeptical of the potential success of such programs.
D. favor these programs over alternative solutions.


95. Economists tend to distrust voluntary approaches as a way to deal with externalities. What is their most common concern?
A. Voluntary approaches do not make people develop an awareness of the problem that would lead them to make good life-style changes.
B. Voluntary approaches are often perceived as unfair, imposing a heavy burden on the poor.
C. Voluntary approaches usually require people to ignore their self interest, and economists do not think people do that well.
D. Voluntary approaches are often too effective, and lead to excessive reduction in the externality.

96. Public television periodically runs pledge drives to raise money. Only a small percentage of the people who benefit from public television are willing to pay. What do economists call the people who do not pay?
A. Free riders
B. The excludables
C. Adverse selectors
D. Thieves

97. Public television periodically runs pledge drives to raise money. Only a small percentage of the people who benefit from public television are willing to pay. This low percentage of people willing to contribute illustrates a difficulty with:
A. government regulation.
B. voluntary programs.
C. tax-incentive policies.
D. market-incentive programs.

98. Economists are most likely to suggest that societies address the inefficiencies created by negative externalities by:
A. direct regulation.
B. voluntary conservation.
C. making the price people pay reflect the cost of the externality.
D. leaving environmental problems alone so that the market can effectively deal with them.


99. In 1990, the Clean Air Act was amended to place a national cap on sulfur dioxide emissions, giving electric utilities an allowance of a set amount of emissions, and allowing the utilities to trade their allowances. This type of plan is:
A. more efficient than direct regulation because utilities that receive a high marginal benefit from emissions can gain additional allowances through trade.
B. more efficient than direct regulation because it forces each utility company to reduce sulfur dioxide emissions by the same amount.
C. less efficient than direct regulation because utilities that receive a high marginal benefit from emissions can gain additional allowances through trade.
D. less efficient than direct regulation because it forces each utility company to reduce sulfur dioxide emissions by the same amount.

100. If government undertakes to reduce water usage using a market incentive plan, then:
A. each consumer will have to reduce their water usage by an equal amount.
B. consumers who reduce water usage by more than the required amount can sell marketable certificates to consumers who seek to reduce usage by less than the required amount.
C. consumers who do not reduce usage by the required amount will have to pay taxes on the extra water usage.
D. consumers will be asked to reduce water usage voluntarily.

101. Since trash generation involves an externality, the way economists might address the problem of trash generation that is most likely to be optimal is by:
A. integrating the cost of the externality into the initial price of the good.
B. having the government require mandatory sorting and recycling of trash.
C. having the cost of the externality be paid by the government.
D. not allowing persons to throw away more trash than acceptable as a maximum.

102. An economist is most likely to support all of the following methods to address the negative externalities created by the waste from newspapers except:
A. requiring publishers to cut the volume of newspapers generated, but allowing them to sell certificates so that others can meet those requirements for them.
B. taxing the suppliers of newspaper by the pound.
C. having the cost of the externality be paid by the government.
D. ensuring that the social cost of buying a newspaper is reflected in its price.


103. The inefficiency associated with negative externalities is most likely the result of:
A. special interest groups.
B. the fallacy of composition.
C. government intervention.
D. poorly specified property rights.

104. A per unit tax designed to internalize the external costs of production is called:
A. an excise taxes.
B. an effluent fee.
C. a sin tax.
D. a tariff.

105. The Environment Ministry in Japan proposed a new carbon tax in order to meet Japan's obligations to reduce carbon dioxide emissions under the Kyoto Treaty. The tax would be levied on producers and importers of fossil fuels, and the expectation is that it would be largely passed on to consumers. This proposal is an example of a:
A. progressive tax.
B. voluntary program.
C. tax-incentive policy.
D. free rider problem.

106. The Environment Ministry in Japan proposed a new carbon tax in order to meet Japan's obligations to reduce carbon dioxide emissions under the Kyoto Treaty. The tax would be levied on producers and importers of fossil fuels, and the expectation is that it would be largely passed on to consumers. The rationale for this tax is that it will:
A. reduce a negative externality.
B. reduce a positive externality.
C. turn a private good into a public good.
D. turn a public good into a private good.


107. The Environment Ministry in Japan proposed a new carbon tax in order to meet Japan's obligations to reduce carbon dioxide emissions under the Kyoto Treaty. The tax would be levied on producers and importers of fossil fuels and raise the cost of using fossil fuels. How do most economists view a tax such as this?
A. They prefer direct regulation to taxes because taxes create deadweight loss.
B. They prefer voluntary programs to taxes because they reduce the role of compulsion.
C. They do not believe any government intervention is necessary because the invisible hand of the market will correct the problem.
D. They support taxes on pollution as a way of making decision makers consider all costs.

108. Refer to the graph above. The price and quantity that would prevail if all social costs and benefits were taken into account is:
A. $5 and 2,600 units.
B. $3.50 and 2,000 units.
C. $3.95 and 6,800 units.
D. $1.80 and 2,000 units.


109. Refer to the graph above. The amount of a tax sufficient to reduce quantity supplied to the level that individuals would have supplied had they included the external cost in their decision is:
A. $2.50
B. $1.70
C. $1.00
D. $0.80

110. Refer to the graph above. The free-market equilibrium in the above graph is at a price and quantity of:
A. $5 and 2,600 units.
B. $3.50 and 2,000 units.
C. $2.50 and 2,600 units.
D. $3.50 and 3,100 units.

111. A good which, if supplied to one person is supplied to all, and whose consumption by one individual does not prevent its consumption by another individual, is known as:
A. a private good.
B. a public good.
C. an external good.
D. an internal good.

112. Public television periodically runs pledge drives to raise money. Only a small percentage of the people who benefit from public television are willing to pay. Why does public television have a problem in collecting money from its viewers?
A. Broadcast television has public good aspects.
B. Public television has problems of adverse selection.
C. Public television is an example of government failure.
D. Broadcast television has problems of asymmetric information.


113. When you purchase and eat a hamburger, no one else can eat the same hamburger. When you download a file on the internet, the file is still available for others to download. Economists explain this difference between hamburgers and computer files by saying that the hamburger is:
A. excludable while the computer file is not.
B. non-excludable while the computer file is not.
C. rival in consumption, while the computer file is not.
D. non-rival in consumption, while the computer file is not.

114. Television broadcasts are often given as examples of a public good. However, it is possible to code a broadcast so that only people who pay for the decoder box can view it. The use of a coded signal does what to a television broadcast?
A. Makes it rival.
B. Makes it nonrival.
C. Makes it excludable.
D. Makes it nonexcludable.

115. A meeting of the United Nations Convention on International Trade in Endangered Species ended with greater protection given to great white sharks. Why should sharks need special protection?
A. There is an informational problem in the market; people do not understand the full consequences of their actions.
B. Sharks are not privately owned and can be subject to a tragedy-of-the-commons problem.
C. Sharks are what economists call a public good, and hence there are no incentives to produce or protect them.
D. Sharks are subject to adverse selection problems.

116. A system whereby power plants buy and sell the right to pollute in the form of emission credits is known as:
A. a voluntary program.
B. direct regulation.
C. a tax incentive program.
D. a market incentive program.


117. Do economists tend to favor a system where power plants buy and sell the right to pollute in the form of emission credits?
A. No; these programs are ineffective because they encourage major polluters to free ride on the efforts of others.
B. No; it is possible for some firms to do nothing if they simply buy enough credits.
C. Yes; they encourage all firms to cut pollution by the same percentage.
D. Yes; they believe that such a proposal would achieve a level of pollution reduction with the lowest cost to society.

118. Suppose that there are only two firms that pollute, A and B, and each emits 10 tons of waste into the air. Firm A can reduce its pollution at a cost of $100 per ton and Firm B can reduce its pollution at a cost of $500 per ton. Each has been given an emission credit allowing it to pollute 6 tons. If firms maximize profits, what will happen?
A. Each firm will clean up four tons and pollute six tons.
B. Firm B will buy four credits from A; B will emit ten tons and A two tons.
C. Firm A will buy four credits from B; A will emit ten tons and B two tons.
D. Firm B will buy one credit from A; it will cut pollution to seven tons and firm A will cut to 5.

119. Which of the following does not illustrate the free rider problem?
A. Amy does not contribute to public television, but she watches it every day.
B. Roger refuses to help pay for the private security officer who patrols his neighborhood.
C. Amanda, a taxpayer, prefers to check out books from her local library rather than purchasing them herself.
D. Frank enjoys the fireworks from his lawn and does not purchase a ticket to view the display from the stadium.

120. The unwillingness of individuals to share in the cost of a public good is called the:
A. free rider problem.
B. social conscience problem.
C. volunteer problem.
D. public choice problem.


121. Which of the following is not a characteristic of a public good?
A. Nonexclusivity.
B. Available to non-buyers.
C. Nonrivalry in consumption.
D. Can only be consumed once.

122. Since consumption of a public good by one does not preclude consumption by others, public goods are said to be:
A. nonexclusive.
B. nonrival.
C. exclusive.
D. rival.

123. Once a public good is provided, those who do not pay cannot be denied the benefits. For this reason, public goods are said to be:
A. nonexclusive.
B. nonrival.
C. exclusive.
D. rival.

124. If air pollution control is a public good, it follows that:
A. the efficient output of air pollution control is zero.
B. additional persons can benefit from a given amount of air pollution control without reducing the benefits enjoyed by others.
C. the efficient output of air pollution control can be attained by selling it by the unit in a market.
D. the more air pollution control enjoyed by any one person, the less is available to others.

125. The free rider problem:
A. can never prevent pure public goods from being supplied.
B. results because people act unselfishly.
C. results because people behave irrationally.
D. prevents voluntary cost-sharing from achieving the efficient output of a public good.


126. The best example of a public good is:
A. competition.
B. government-subsidized lunches.
C. pollution.
D. national defense.

127. In economic terminology, a free rider is someone who:
A. does not pay for their own consumption of a public good.
B. chooses not to consume a public good.
C. is earning economic profit.
D. raises his or her prices because all other prices are rising.

128. In the case of public goods, a demand curve that shows the marginal benefit of the good is:
A. nonexistent.
B. the horizontal sum of individual demand curves.
C. the vertical sum of individual demand curves.
D. perfectly inelastic.

129. Suppose the marginal benefit (MB) of national defense is MB = 1,000 - 10Q, where Q measures units of national defense, for Charlie and MB = 400 - 4Q for Sally. Combining Charlie's and Sally's marginal benefits yields the social MB equation:
A. MB = 1,000 - 6Q.
B. MB = 1,000 - 14Q.
C. MB = 1,400 - 6Q.
D. MB = 1,400 - 14Q.


130. Suppose the marginal benefit (MB) of national defense is MB = 1,000 - 10Q, where Q measures units of national defense, for Charlie and MB = 400 - 4Q for Sally. Combining Charlie's and Sally's marginal benefits yields social MB = 1,400 - 14Q. If the marginal cost of providing national defense is constant and equal to 840 (measured in the same units as marginal benefit), the efficient level of national defense is:
A. 16 units.
B. 24 units.
C. 40 units.
D. 100 units.

131. Suppose the marginal benefit (MB) of national defense is MB = 1,000 - 10Q, where Q measures units of national defense, for Charlie and MB = 400 - 4Q for Sally. Combining Charlie's and Sally's marginal benefits yields social MB = 1,400 - 14Q. If the marginal cost of providing national defense is 840 and the efficient level of national defense is provided at a cost of 420 per unit of national defense each for Charlie and Sally, then:
A. Sally would be paying more for national defense than she thinks it is worth.
B. Charlie would be paying more for national defense than he thinks it is worth.
C. the benefits of national defense would exceed the cost for both Charlie and Sally.
D. the cost of national defense would exceed the benefits for both Charlie and Sally.

132. If the marginal benefit of one more unit of a public good is $500 for Sam and $800 for Alex, the social benefit of one more unit of a public good is:
A. $500 since the benefit will go to the person who values it least.
B. $800 since the benefit will go to the person who values it most.
C. $1,300 since the benefit of one more unit goes to both individuals.
D. more than $1,300 since the benefits to society exceed the sum of individual benefits.

This table shows the marginal benefits from widgets obtained by the only three people who value them.

133. Refer to the table above. Suppose widgets cost $8.50 to produce. If widgets are a private good, how many will be produced by market incentives and is it the right (efficient) number?
A. Zero will be produced and this is below the socially optimal amount.
B. One will be produced and this is the socially optimal amount.
C. One will be produced and this is below the socially optimal amount.
D. Two will be produced and this is the socially optimal amount.

134. Refer to the table above. Suppose widgets cost $8.50 to produce. If widgets are a public good, how many will be produced by market incentives and is it the right (efficient) number?
A. Zero will be produced, and this is below the socially optimal amount.
B. One will be produced, and this is the socially optimal amount.
C. One will be produced, and this is below the socially optimal amount.
D. Two will be produced, and this is the socially optimal amount.

135. Basic research is more likely to be funded by the federal rather than state and local government because basic research:
A. is usually conducted by oligopoly, the market structure that is most conducive to preliminary research.
B. has negative externalities that are passed on to those who live outside the state.
C. is largely a public good; benefits flow to the whole world, not just the state.
D. has information problems that cause adverse selection.

136. Music spreads easily and cheaply on computer networks. As a result, music has become more like:
A. a private good.
B. a public good.
C. a merit good.
D. an inferior good.


137. The Apple iPod is able to play digital music that has a special encoding that makes pirating music more difficult. In economic terms, this encoding is an attempt to:
A. make digital music more like a private good and less like a public good.
B. reduce the negative externalities of digital music.
C. reduce the adverse selection problem of digital music.
D. increase the marginal social benefit of digital music.

138. If the benefit of a public good is small to each individual in a society of millions of individuals:
A. it will never be efficient for government to provide the public good.
B. the total benefit will be large since social benefit is the sum of all individual benefits.
C. the total benefit will be small since individuals cannot share the benefits of public goods.
D. it cannot really be a public good since the benefit of public goods is always large.

139. With regard to public goods provided by the government,
A. individuals reveal their demand when they buy the good.
B. a free rider problem is unlikely.
C. individuals have an incentive to conceal their willingness to buy the good.
D. individuals have an incentive to exaggerate their willingness to buy the good.

140. Real-world markets:
A. often involve deception, cheating, and inaccurate information.
B. ensure that sellers will always be honest and provide accurate information because those who are dishonest or provide inaccurate information go out of business.
C. can operate efficiently only if government takes steps to correct informational problems.
D. provide no mechanism for solving informational problems.

141. If a consumer is willing to pay $100 for a used Blu-Ray player that is a "cherry" and $30 for a used Blu-Ray player that is a "lemon", the consumer will offer:
A. $30 for any used Blu-Ray player even if the probability that it is a "lemon" is 50 percent.
B. $100 for any used Blu-Ray player even if the probability that is a "cherry" is 50 percent.
C. $65 for any used Blu-Ray player if the probability that it is a "lemon" is 50 percent.
D. $130 for any used Blu-Ray player if the probability that it is a "cherry" is 50 percent.


142. Adverse selection problems are most likely to be a problem when:
A. one side of the market, either buyer or seller, has better information than the other side.
B. there are public goods involved.
C. the good being exchanged has negative externalities.
D. the good being exchanged has free-rider problems.

143. In economics, the term "signaling" refers to a way of lessening the problem of:
A. free riders.
B. negative externalities.
C. bad information by all market participants.
D. unequal information between buyers and sellers.

144. At one time many economists were suspicious of brand names. They saw them as a barrier to entry with no benefits to consumers. In the 1970s economists began to see a possible benefit of brand names to consumers. They discovered that brand names were a way to:
A. signal quality.
B. market public goods.
C. overcome negative externalities.
D. overcome the free-rider effect.

145. John and Jack are both trying to sell a used car to Jim. John's car is a lemon, a car that has a serious but non-obvious problem. Jack's car is a cherry, a car that has no problems. Jim cannot tell the difference between the cars. Economists say this information problem might be solved with signaling. Who has an incentive to find a way to signal quality?
A. Both Jack and John.
B. Jack, but not John.
C. John, but not Jack.
D. Jim.


146. A lawyer who drives a beat-up car and wears frumpy clothes may have a hard time getting clients. Potential clients may conclude from his appearance that he is poor, and if he is poor, he probably is not very good. If the above is true for a lawyer, dressing in expensive and stylish clothing is a way of:
A. internalizing externalities.
B. changing a nonrival good into a rival good.
C. changing a nonexcludable good into an excludable good.
D. signaling quality.

147. In the early days of the internet, selling and buying from other individuals was dangerous because one never knew if the person on the other side of the transaction was honest. Ebay.com became successful because it lessened that problem with its feedback rating system that let buyers and sellers develop a reputation. Ebay.com's innovation is an example of overcoming:
A. the free rider effect.
B. negative externalities.
C. positive externalities.
D. an information problem.

148. How do economists explain the value firms and consumers place on brand names?
A. Brand names show that firms can easily manipulate consumers.
B. Brand names are a way firms can provide information about quality to consumers.
C. Brand names are a way of turning private goods into public goods, increasing their value to both seller and buyer.
D. Brand names are an example of adverse selection, by which producers advertise the options to consumers.

149. The Consumer Product Safety Commission (CPSC) is charged with protecting the public from unreasonable risks of serious injury or death from more than 15,000 types of consumer products. The CPSC is designed to overcome:
A. information problems.
B. positive externalities.
C. negative externalities.
D. direct regulation.


150. Which of the following is an argument an economist would use to argue against market regulation designed to protect consumers?
A. Information is costless and readily available, so it is up to consumers to beware.
B. When a brand name product is found unsafe, the value of the brand is reduced, which gives companies with brand names an incentive to produce high quality.
C. Manufacturers have no incentive to stop the sale of counterfeit products.
D. Government is more likely to have consumer's interest in mind than the market.

151. If a consumer is willing to pay $5,000 for a used car that is a free of mechanical problems and $1,000 for a used car that will require extensive repairs, the consumer will offer:
A. $1,000 for a used car if the probability that it is free of mechanical problems is 50 percent.
B. $3,000 for a used car if the probability that it is free of mechanical problems is 50 percent.
C. $5,000 for a used car if the probability that it is free of mechanical problems is 50 percent.
D. $6,000 for a used car if the probability that it is free of mechanical problems is 50 percent.

152. If buyers cannot distinguish between "lemons" and "cherries" in the used car market, but sellers can, the price buyers are willing to pay for used cars will be:
A. high enough to guarantee that at least 50 percent of the used cars offered for sale are "cherries."
B. so low that sellers with "cherries" will be unwilling to sell.
C. so low that sellers with "lemons" will be unwilling to sell.
D. equal to zero since no one would take the chance of purchasing a "lemon," even if the value of a car known to be a lemon is greater than zero.

153. If medical insurers could use information contained in DNA to predict the likelihood of major medical illnesses, the most likely outcome is that:
A. there would be an adverse selection problem and average insurance rates would rise.
B. there would be an adverse selection problem and average insurance rates would fall.
C. the adverse selection problem would be decreased and average insurance rates would rise.
D. the adverse selection problem would be decreased and average insurance rates would fall.


154. The reason the Federal Trade Commission regulates advertising to prevent false and misleading claims is:
A. because firms that make false and misleading claims would earn lower profit, resulting in many firms being forced to shut down and many workers losing their jobs.
B. to create a market for information.
C. to prevent a market failure caused by inaccurate information.
D. to eliminate persuasive advertising.

155. Economists believe that if government provides information about product quality:
A. there will be less incentive for consumers to pay extra for quality guarantees supplied by firms.
B. consumers will be forced to pay for information when otherwise it would have been available for free.
C. the overall quality of products sold will increase substantially, eliminating the information problem.
D. the cost of providing information will be zero.

156. A market for information is more likely to develop even in the absence of government regulation of information as long as the marginal:
A. cost of information is zero.
B. benefit of information is zero.
C. cost of information exceeds the marginal benefit.
D. benefit of information exceeds the marginal cost.

157. The basis of the argument favoring government intervention to correct informational and rationality problems is that:
A. if information is not perfect or if one trader is not rational, a trade can result in one party benefiting and the other losing.
B. entry into certain markets may be restricted so that excess profits cannot be eliminated by the forces of competition.
C. people cannot possibly know how well off they will be as a result of a trade until after the trade has occurred.
D. if individuals are free to produce whatever goods they want, then when excess profit is being made, more people will enter into the production of that good and consumers will benefit as the price is pushed down.


158. Milton Friedman argues that medical licensure benefits doctors because it:
A. allows them to restrict supply, increase prices, and significantly increase their incomes.
B. protects them from malpractice suits.
C. ensures that they will not have to compete against each other for patients.
D. prevents other doctors from advertising and stealing their patients.

159. Which of the following is not a question raised by critics of medical licensure?
A. Why, if licensed medical treatment is so great, do we even need formal restrictions to keep other types of medicine from being practiced?
B. Whom do these restrictions benefit: the general public or the doctors who practice mainstream medicine?
C. What have the long-run effects of licensure been?
D. Why does the public need to have accurate information about a doctor's competency?

160. Which of the following is the best example of an adverse selection problem?
A. Once individuals are insured, they are less likely to take efficient precautions.
B. Individuals are unlikely to pay for something if they can receive the benefits for free.
C. When a firm pollutes the air, families living nearby suffer the consequences.
D. Individuals who seek to purchase health insurance have better information about their health than insurance companies.

161. If employers were made responsible for injuries suffered by employees while working at home:
A. there might be an adverse selection problem since employees have better information about the safety conditions of their own homes than employers.
B. employers would never permit employees to work at home.
C. more employees would be able to safely work at home.
D. there might be an adverse selection problem since employers have better information about the safety conditions of their employees than the employees have themselves.


162. Opponents of government intervention in the economy argue that government's attempts to correct informational problems:
A. are justified in most cases, though politically difficult to implement.
B. are not necessary since an efficiently operating market system ensures that adequate information will be provided.
C. often create greater problems, such as FDA restrictions on experimental drugs for AIDS which could save lives.
D. will make market transactions much more efficient.

163. Opponents of government intervention in the economy argue that externalities:
A. do not create problems for the model.
B. are themselves the inevitable result of government policies.
C. should be corrected with regulations rather than subsidies.
D. may not be effectively corrected by the government.

164. Suppose that a negative externality creates $1 billion worth of costs to third parties. The government attacks the problem with regulations that cut the cost of the externality to $500 million but cost business and consumers $1.5 billion. This situation illustrates the idea that:
A. regulations are an effective way to curb externalities.
B. externalities can never be corrected.
C. correcting market failure can result in government failure.
D. getting rid of externalities requires a great deal of necessary sacrifice for all of us.

165. Opponents to government intervention argue that government makes decisions based upon:
A. marginal social costs and marginal social benefits.
B. marginal political costs and marginal political benefits.
C. irrational choices.
D. total costs and total benefits.


166. Both opponents of and proponents of government intervention would most likely agree with which of the following?
A. Government can and does create proper incentives to correct for externalities.
B. Property rights eliminate the need for government.
C. The market is inherently fair.
D. Property rights must exist for a market to operate.

167. Government failure occurs when:
A. government fails to implement policy designed to correct a market failure.
B. government intervention in the market to improve a market failure succeeds.
C. government intervention in the market to correct a market failure actually makes things worse.
D. there is no need for government intervention into the market because there is no market failure.

168. Suppose a public good that is worth $1 billion is not produced by the market, so the government provides it, but at a cost of $3 billion. This attempt to correct a market failure has:
A. been successful since the public good is now produced.
B. given rise to the problem of free riders.
C. resulted in a government failure since use of resources is now less efficient.
D. resulted in an information asymmetry for the government.

169. A European Union official, Mr. McGreevey, claims a portion of EU law involves over-regulation. McGreevey is suggesting the EU suffers in part from:
A. market failure.
B. fairness.
C. government failure.
D. the rule of law.

170. All of the following are justifications for government intervention except:
A. too much competition.
B. informational problems.
C. externalities.
D. public goods.


171. Government may not have an incentive to correct a market failure because:
A. government doesn't have the information it needs to correct the market failure.
B. government reflects politics, which reflects individuals' interests in trying to gain more for themselves.
C. policymakers fear that intervention will lead to a Pareto optimal outcome.
D. the benefit of correcting the market failure might exceed the cost of correcting the market failure.

172. Government failure is likely to occur for all of the following reasons except:
A. special interest groups might lobby government to the detriment of the public good.
B. individuals have better information about a situation that affects them than government.
C. intervention in markets is always simpler than it initially seems.
D. the bureaucratic nature of government intervention does not allow fine-tuning.


Chapter 21 Market Failure versus Government Failure Answer Key


True / False Questions

1. Externalities can be either positive or negative.
TRUE

Positive externalities have positive effects on third parties and negative externalities have negative effects.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Easy
Learning Objective: 21-1
Topic: Externalities

2. Economists generally prefer direct regulation to incentive-based programs because explicit regulation tends to be more efficient.
FALSE

Direct regulation is not generally as efficient as incentive-based programs.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Easy
Learning Objective: 21-2
Topic: Direct Regulation

3. Direct regulation means that government sets specific limits on the use of scarce resources.
TRUE

See the definition of direct regulation in the textbook.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Easy
Learning Objective: 21-2
Topic: Direct Regulation


4. Economists are likely to oppose direct regulation because they do not believe there is any need for government to take action when negative externalities exist.
FALSE

Economists' opposition to direct regulation is generally based on their findings that direct regulation doesn't accomplish a given goal as efficiently as possible.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Medium
Learning Objective: 21-2
Topic: Direct Regulation

5. Economists tend to believe that market incentive plans are generally more efficient than direct regulation.
TRUE

Market incentive plans are more likely to equal marginal costs and marginal benefits, and thus are likely to be more efficient.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Medium
Learning Objective: 21-2
Topic: Tradable Permits

6. An optimal policy is one in which the marginal cost of undertaking the policy is less than the marginal benefit of that policy.
FALSE

An optimal policy is one in which the marginal cost of undertaking the policy equals the marginal benefit of that policy.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Hard
Learning Objective: 21-2
Topic: Marginal Costs and Marginal Benefits


7. If a program requires people to pay a price that reflects the cost of an externality associated with their actions for which previously they did not pay, it will be in their best interest to change their behavior.
TRUE

If a person were required to pay the higher price that reflects the cost of an externality, that person would reduce quantity demanded (law of demand).


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Medium
Learning Objective: 21-2
Topic: Tax and Subsidy Programs

8. Government provides secondary education because of its private good aspects.
FALSE

Education has public good aspects, which is one reason why government provides it.


AACSB: Analytic
BLOOM'S TAXONOMY: Application
Difficulty: Easy
Learning Objective: 21-3
Topic: Public Goods

9. Economists believe that free riders can often undermine the social commitment of many in the society, causing voluntary policies to fail.
TRUE

Economists believe that the incentives facing individuals is to maximize individual utility. This would lead to an individual cheating (free riding) to reduce MC while enjoying the benefits of others' actions.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Medium
Learning Objective: 21-3
Topic: Voluntary Programs


10. Adverse selection problems can occur when buyers and sellers have different amounts of information about the good for sale.
TRUE

This is the way in which adverse selection problems are defined.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Medium
Learning Objective: 21-4
Topic: Asymmetric Information

11. Government attempts to offset market failures can prevent the market from dealing with the problem more effectively.
TRUE

The market's way of dealing with problems generally only works in the long run. If government deals with the problems in the short run, it may eliminate incentives that would have brought about a long-run market solution.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Medium
Learning Objective: 21-5
Topic: Government Failure

12. If government action is likely to do some good, then it is always best for government to intervene in the marketplace.
FALSE

Even in those cases where government action might do some good, it could lead to additional intervention in cases where it could make the situation worse.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Medium
Learning Objective: 21-5
Topic: Government Failure


Multiple Choice Questions


13. What do economists mean when they say there is "market failure"?
A. Business has introduced a product that consumers did not want.
B. Free markets have led to excessive profits.
C. Markets have surpluses or shortages so that government rationing is necessary.
D. Free markets yield results that economists do not consider socially optimal.

Economists define socially optimal in terms of economic efficiency. Market failure means that there is lost value--it is at least theoretically possible to change something to increase end value.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Medium
Learning Objective: 21-1
Topic: Market Failure

14. Some economists believe that the market will not solve all problems. They are referring to:
A. market failure.
B. market incentive plans.
C. optional policy.
D. the need to balance the good of the individual with the good of society as a whole.

Market failures are market results that are less than optimal.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Easy
Learning Objective: 21-1
Topic: Market Failure


15. All of the following are considered sources of market failure except:
A. public goods.
B. imperfect information.
C. profit-maximizing behavior.
D. externalities.

Profit-maximizing behavior is assumed in the competitive market model; it is not itself a source of market failure.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Medium
Learning Objective: 21-1
Topic: Market Failure

16. The criterion that no person can be made better off without another being made worse off is known as the:
A. normative criterion.
B. Pareto criterion.
C. Nirvana criticism.
D. second-best criticism.

Refer to Added Dimension: Pareto Optimality and the Perfectly Competitive Benchmark.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Medium
Learning Objective: 21-1
Topic: Pareto Optimality


17. John has ten apples and six bananas. Jane has 2 bananas and 2 apples. If this situation is Pareto optimal, what mutually beneficial exchange could be made?
A. None; there is no exchange that can help one without hurting the other.
B. Fruit should be taken from John and given to Jane to equalize their holdings.
C. Jane should give up apples to get bananas.
D. Jane should give up bananas to get apples.

No voluntary exchange will take place if the start is Pareto optimal.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Medium
Learning Objective: 21-1
Topic: Pareto Optimality

18. The perfectly competitive output level is Pareto-optimal because at this output level:
A. the total cost to society equals the total benefit.
B. the marginal cost to society equals the marginal benefit.
C. the marginal cost to society is minimized.
D. the marginal benefit to society is maximized.

Refer to Added Dimension: Pareto Optimality and the Perfectly Competitive Benchmark.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Medium
Learning Objective: 21-1
Topic: Pareto Optimality


19. The economist who mathematically proved that a complete set of competitive markets could yield a socially (or Pareto) optimal result was:
A. Adam Smith.
B. Kenneth Arrow.
C. Milton Friedman.
D. Ronald Coase.

See the Added Dimension box titled Pareto Optimality and the Perfectly Competitive Benchmark in the text.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Medium
Learning Objective: 21-1
Topic: Pareto Optimality

20. If there is a complete set of markets that are perfectly competitive:
A. the marginal cost of producing goods will exceed their marginal benefit.
B. the marginal cost of producing goods will be less than their marginal benefit.
C. every person's utility function is at a maximum.
D. the invisible hand guides the economy to a Pareto optimal position.

Refer to Added Dimension: Pareto Optimality and the Perfectly Competitive Benchmark.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Hard
Learning Objective: 21-1
Topic: Pareto Optimality


21. If a system has multiple defects but those defects in effect offset each other, then curing one defect may make the system perform more poorly. This possibility is known as:
A. the Hume Dictum.
B. the normative criticism of Pareto optimality.
C. the second-best criticism of Pareto optimality.
D. the Nirvana criticism of Pareto optimality.

For example, a firm that is a monopolist and a polluter causes two market failures. Monopoly makes it produce too little; the externalities make it produce too much. Curing one problem could move the system further from efficiency. See Added Dimension: Pareto Optimality and the Perfectly Competitive Benchmark.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Hard
Learning Objective: 21-1
Topic: Pareto Optimality

22. Can outcomes that are not Pareto optimal be considered better than outcomes that are Pareto optimal?
A. No; Pareto optimal is defined as the best possible outcome.
B. Yes, if the non-Pareto-optimal outcome is more efficient than the Pareto-Optimal outcome.
C. Yes, if the distribution of wealth in the Pareto-optimal outcome is considered undesirable.
D. Yes, if there are too many market failures in the Pareto-optimal outcome.

Pareto optimality is defined without consideration to the distribution of wealth. A situation in which one person has everything may be Pareto optimal, but few would consider it a good outcome.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Hard
Learning Objective: 21-1
Topic: Pareto Optimality


23. If a market has no externalities, then marginal private costs:
A. exceed marginal social costs.
B. equal marginal social costs.
C. are below marginal social costs.
D. intersect marginal social costs.

The difference in marginal social costs and marginal private costs is due to externalities.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Hard
Learning Objective: 21-1
Topic: Externalities

24. Economists generally call the effect of an agreement on others which is not taken into account by the parties making the agreement:
A. excess burden.
B. welfare loss.
C. Pareto optimality.
D. an externality.

The effects not taken into account are external to the parties making the agreement.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Easy
Learning Objective: 21-1
Topic: Externalities


25. The best example of a positive externality is:
A. roller coaster rides.
B. pollution.
C. alcoholic beverages.
D. education.

Pollution is an example of a negative externality. Roller coaster rides and alcoholic beverages are private goods.


AACSB: Analytic
BLOOM'S TAXONOMY: Application
Difficulty: Medium
Learning Objective: 21-1
Topic: Externalities

26. Alex is playing his music at full volume in his dorm room. The other people living on his floor find this to be nuisance, but Alex does not care. Alex's music playing is an example of a:
A. negative externality.
B. positive externality.
C. normative externality.
D. Pareto externality.

A negative externality is a spillover effect that harms third parties.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Easy
Learning Objective: 21-1
Topic: Externalities


27. Alex is playing his music at full volume in his dorm room. The other people living on his floor are enjoying his music, but Alex does not know or care. Alex's music playing is an example of a:
A. negative externality.
B. positive externality.
C. normative externality.
D. Pareto externality.

A positive externality is a spillover effect that benefits third parties.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Easy
Learning Objective: 21-1
Topic: Externalities

28. James enjoys gardening in the nude because he says it puts him in touch with nature. His neighbors find his gardening routine very offensive, but James replies that they should mind their own business and not watch him. To an economist this situation illustrates the concept of:
A. tragedy of the commons.
B. negative externality.
C. positive externality.
D. adverse selection.

A negative externality is a spillover effect that harms third parties.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Easy
Learning Objective: 21-1
Topic: Externalities


29. Carbon dioxide emissions are thought to contribute to global warming, and there is concern that changes in climate will be costly. Emitting carbon dioxide is an example of:
A. a public good.
B. a negative externality.
C. an adverse selection problem.
D. an effluent fee.

If climate-changing emissions of carbon dioxide impose costs on society, then it is an example of a negative externality.


AACSB: Analytic
BLOOM'S TAXONOMY: Application
Difficulty: Medium
Learning Objective: 21-1
Topic: Externalities

30. In the Flint Hills Area of Kansas, proposals to build wind turbines to generate electricity have pitted environmentalist against environmentalist. Members of the Kansas Sierra Club support the turbines as a way to reduce use of fossil fuel, while local chapters of the Nature Conservancy say they will befoul the landscape. The Sierra Club argues that wind turbines:
A. are a source of negative externalities.
B. reduce negative externalities elsewhere in the economy.
C. create a free-rider problem.
D. are a way of solving a free-rider problem.

Burning fossil fuels creates a variety of types of air pollution, a negative externality. The attraction of wind power to many is that it reduces that negative externality. The Nature Conservancy is pointing out another negative externality created by the windmills.


AACSB: Analytic
BLOOM'S TAXONOMY: Application
Difficulty: Medium
Learning Objective: 21-1
Topic: Externalities


31. Proposals in Flint Hills, KS to build wind turbines to generate electricity have pitted environmentalist against environmentalist. Members of the Kansas Sierra Club support the turbines as being a way to reduce use of fossil fuel, while local chapters of the Nature Conservancy say they will befoul the landscape. The chapters of the Nature Conservancy argue that wind turbines:
A. are a source of negative externalities.
B. reduce negative externalities elsewhere in the economy.
C. create a free-rider problem.
D. are a way of solving a free-rider problem.

If the windmills are an eyesore, they are creating a negative externality.


AACSB: Analytic
BLOOM'S TAXONOMY: Application
Difficulty: Medium
Learning Objective: 21-1
Topic: Externalities

32. College education provides higher income for the individual, but also a more productive and more educated person who will contribute to society in many ways. Higher education is an example of
A. a positive externality.
B. a negative externality.
C. a non-excludable service.
D. adverse selection.

The spillover effects that of a person who is educated making others around him more productive is a positive externality. It is a primary justification for the state subsidizing higher education.


AACSB: Analytic
BLOOM'S TAXONOMY: Application
Difficulty: Medium
Learning Objective: 21-1
Topic: Externalities


33. Richard Vedder argues that the states that have spent the most on higher education in the past 25 years have experienced the least economic growth. One might conclude that higher education:
A. does not have important positive externalities.
B. does not have important negative externalities.
C. is a non-excludable service.
D. has problems of adverse selection.

The spillover effects of a person who is educated—making others around him more productive—is a positive externality. It is a primary justification for the state subsidizing higher education. Vedder's findings indicate that these positive externalities do not exist, or at least that they are outweighed by other costs.


AACSB: Reflective Thinking
BLOOM'S TAXONOMY: Application
Difficulty: Medium
Learning Objective: 21-1
Topic: Externalities

34. Under the Texas law known as "rule of capture," land owners "get to pump as much of the water under it as they want.... 'This means whoever sucks it out first, it's their water'--even if that means there isn't enough left for others." Under this law, pumping large amounts of water:
A. imposes a negative externality on others.
B. imposes a positive externality on others.
C. imposes the free-rider effect on others.
D. is a private decision with no effects on others.

When property rights are poorly allocated, there can be external effects, as in this case.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Medium
Learning Objective: 21-1
Topic: Externalities


35. Which of the following is not an example of an externality?
A. Carbon dioxide from energy generation that adds to the worldwide, long-term greenhouse effect.
B. Heat from a factory that makes the neighboring tomato patches more productive.
C. A defective part that causes an automobile to break down three months after purchase.
D. Acidic by-products of fossil fuel combustion that produce acid rain.

An externality is the effect of a decision of a third party not taken into account by the decision-makers. The defective part is affecting one of the decision-makers, not a third party.


AACSB: Analytic
BLOOM'S TAXONOMY: Application
Difficulty: Hard
Learning Objective: 21-1
Topic: Externalities

36. An externality is present in a free market whenever:
A. a monopolist spends funds to keep potential competitors out of the market.
B. an activity generates costs or benefits that are not reflected in market prices.
C. firms hire employees from outside the firm to fill positions normally filled by promotion from within the firm.
D. a tax is imposed on the supplier of a good.

Externalities cause marginal social costs and benefits and marginal private costs and benefits to differ. Thus, marginal costs and benefits are not reflected in market prices.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Medium
Learning Objective: 21-1
Topic: Externalities


37. When negative externalities are present, market failure often occurs because:
A. the marginal external cost resulting from the activity is not reflected in the market price.
B. the marginal external cost resulting from the activity is reflected in the market price.
C. the existence of imports from foreign countries takes jobs (and income) away from U.S. citizens.
D. consumers will consume the good at a level where their individual marginal benefits exceed the marginal costs borne by the firm producing the good.

Externalities cause marginal social costs and marginal private costs to differ. Thus, costs and benefits are not reflected in market prices.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Medium
Learning Objective: 21-1
Topic: Externalities

38. The existence of negative externalities:
A. prevents the market from working efficiently.
B. prevents government from intervening in the marketplace.
C. causes the market to work more effectively.
D. necessarily means that government must intervene in the marketplace.

Externalities are one type of market failure. As the text later shows, it is not always beneficial to have government intervention.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Medium
Learning Objective: 21-1
Topic: Externalities


39. An example of a negative externality is the:
A. decrease in your real income that results when photographic equipment you purchase increases in price because of increased demand by others for these items.
B. cost you bear when your neighbor has a noisy party and does not compensate you for your discomfort.
C. benefit you receive without paying when your neighbor installs a smoke detector.
D. decrease in income to farmers that results from a drought.

Negative externalities are negative effects of trades not taken into account by the decision makers. The smoke detector has a positive effect on a third party and is an example of a positive externality. The decrease in your real income from higher photographic equipment prices is a monetary externality that does not generate a net cost to society. It is not a negative externality.


AACSB: Analytic
BLOOM'S TAXONOMY: Application
Difficulty: Hard
Learning Objective: 21-1
Topic: Externalities

40. If a negative externality is associated with burning firewood:
A. the marginal social cost of burning firewood falls short of its price.
B. the marginal social cost of burning firewood is exactly equal to its price.
C. less than the efficient amount of firewood for burning will be used each year.
D. the marginal social cost of burning firewood exceeds the price of burning firewood.

A negative externality causes the marginal social cost to exceed the marginal private cost (the market price).


AACSB: Analytic
BLOOM'S TAXONOMY: Application
Difficulty: Medium
Learning Objective: 21-1
Topic: Externalities


41. When negative externalities exist in the production of a good, the marginal social cost of producing the good:
A. is equal to the marginal benefit received by consumers if competitive markets exist and there is no government intervention.
B. equals the marginal cost borne by the firm minus the marginal external cost resulting from the production and consumption of the good.
C. is less than the marginal cost borne by the firm.
D. equals the marginal cost borne by the firm plus the marginal cost borne by third parties from the production and consumption of the good.

A negative externality causes the marginal social cost to exceed the marginal private cost. The difference between the two is the cost borne by third parties.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Medium
Learning Objective: 21-1
Topic: Externalities

42. The cost of running an electrical utility includes costs for fuel, labor, and capital. In addition, there are sometimes costs associated with pollution from the utility, such an increased health-care costs for people living near the utility. To an economist, the costs associated with the pollution resulting from additional electricity are:
A. marginal private costs.
B. marginal social costs.
C. the difference between marginal social costs and marginal private costs.
D. the sum of marginal social costs and marginal private costs.

The costs the producer bears (the marginal private costs) plus the costs imposed on third parties equal the marginal social costs. The cost associated with the pollution is marginal social cost less marginal private cost.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Medium
Learning Objective: 21-1
Topic: Externalities


43. If a positive externality is associated with the purchase of smoke detectors:
A. the marginal social benefit of smoke detectors exceeds their price.
B. the marginal social benefit of smoke detectors is zero.
C. the marginal social benefit of smoke detectors equals their price.
D. more than the efficient quantity of smoke detectors will be sold.

A positive externality causes the marginal social benefit to exceed the marginal private benefit (and marginal private cost, or price).


AACSB: Analytic
BLOOM'S TAXONOMY: Application
Difficulty: Medium
Learning Objective: 21-1
Topic: Externalities

44. When positive externalities exist in the consumption of a good, the marginal social benefit:
A. equals the marginal benefit received by consumers of the good minus the marginal benefit to third parties.
B. equals the marginal cost of producing the good plus the marginal cost to third parties.
C. equals the marginal benefit received by consumers of the good plus the marginal benefit to third parties.
D. could be either greater than or less than the marginal benefit received by consumers of the good depending on the equilibrium price determined in competitive markets.

Positive externalities are not included in the marginal benefit to those involved in the trade. The marginal social benefit is the benefit to the trader plus the benefit to third parties.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Medium
Learning Objective: 21-1
Topic: Externalities


45. If a negative externality exists in the production of paper and paper is sold in a perfectly competitive market, then at the equilibrium output:
A. additional net gains to society are possible by reducing the output of paper.
B. additional net gains to society are possible by increasing the output of paper.
C. the marginal social benefit of paper equals its marginal social cost.
D. additional net gains to society are not possible from either increasing or decreasing the output of paper.

If negative externalities exist, the marginal social cost exceeds the marginal private cost and too much of the good is produced. Net social gains are possible by reducing production.


AACSB: Analytic
BLOOM'S TAXONOMY: Application
Difficulty: Hard
Learning Objective: 21-1
Topic: Externalities

46. If a positive externality exists in the provision of education when education is provided in a perfectly competitive market without government intervention, then at the market equilibrium level of education:
A. additional net gains to society are possible by reducing the level of education.
B. additional net gains to society are possible by raising the level of education.
C. the marginal social benefit of education equals the marginal social cost.
D. additional net gains to society are not possible by either increasing or decreasing the level of education.

Since there is a positive externality, marginal social benefit exceeds marginal private benefit. The market equilibrium occurs where marginal private benefit equals marginal private cost, but the socially optimal level is where marginal social benefit equals marginal private cost.


AACSB: Analytic
BLOOM'S TAXONOMY: Application
Difficulty: Hard
Learning Objective: 21-1
Topic: Externalities


47. If a negative externality exists in the market for dirt bikes and that market is perfectly competitive:
A. less than the efficient output of dirt bikes will be produced.
B. the price of dirt bikes exceeds the marginal social cost.
C. the price of dirt bikes equals the marginal social cost.
D. the price of dirt bikes is less than the marginal social cost.

A negative externality causes the marginal social cost to exceed the marginal social benefit. Too much of the good is produced and too low a price is charged for consumers.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Medium
Learning Objective: 21-2
Topic: Externalities

48. Refer to the graph above. There is a 10-cent-per-gallon marginal external cost associated with the use of gasoline. Assuming that gasoline is sold in perfectly competitive markets, the market equilibrium price will be:
A. $0.95.
B. $1.00.
C. $1.05.
D. $1.10.

Equilibrium is where MC = MB, point G.


AACSB: Analytic
BLOOM'S TAXONOMY: Application
Difficulty: Medium
Learning Objective: 21-2
Topic: Externalities

49. Refer to the graph above. If the marginal external cost associated with the use of gasoline is 10-cents-per-gallon, the point on the graph corresponding to the efficient quantity and price is:
A. G.
B. H.
C. K.
D. L.

The efficient point is where MSC = MSB, point K.


AACSB: Analytic
BLOOM'S TAXONOMY: Application
Difficulty: Medium
Learning Objective: 21-2
Topic: Externalities


50. Refer to the graph above. Assuming a 10-cent-per-gallon marginal external cost associated with gasoline, the market price of gasoline necessary to induce consumers to purchase the efficient quantity each year is:
A. $1.10.
B. $1.00.
C. $1.05.
D. 95 cents.

The externality, .10 per gallon, must be internalized by a tax to result in an efficient point, K. Some of the tax burden is borne by producers.


AACSB: Analytic
BLOOM'S TAXONOMY: Application
Difficulty: Hard
Learning Objective: 21-2
Topic: Tax and Subsidy Incentives


51. Refer to the graph below.

Assuming a marginal external cost equal to the tax shown in the above graph, the market price necessary to induce consumers to purchase the efficient quantity each year is:
A. P1.
B. P2.
C. P3.
D. P4.

The efficient price is where MSC = MSB, or, P2.


AACSB: Analytic
BLOOM'S TAXONOMY: Application
Difficulty: Hard
Learning Objective: 21-2
Topic: Externalities


52. Once vaccinated, a person cannot catch a cold nor give a cold to someone else. As a result the marginal social benefit resulting from consumption of the vaccine:
A. exceeds the marginal benefit received by consumers of the vaccine.
B. equals the marginal social cost of producing the vaccine in a competitive equilibrium.
C. equals the marginal benefit received by consumers of the vaccine in a competitive equilibrium.
D. is less than the marginal benefit received by consumers of the vaccine.

There is a positive externality associated with the vaccine. The MSB curve is to the right of the demand curve for the vaccinated person.


AACSB: Analytic
BLOOM'S TAXONOMY: Application
Difficulty: Hard
Learning Objective: 21-2
Topic: Externalities

53. Refer to the graph above, which shows the demand and supply for a new vaccine against the common cold. Once vaccinated, a person cannot catch a cold or give a cold to someone else. As a result, the marginal social benefit curve will:
A. coincide with the market demand curve.
B. lie strictly below the market supply curve.
C. lie below the market demand curve.
D. lie above the market demand curve.

There is a positive externality associated with the vaccine. The MSB curve is to the right of (above) the demand curve shown.


AACSB: Analytic
BLOOM'S TAXONOMY: Application
Difficulty: Medium
Learning Objective: 21-2
Topic: Externalities

54. Refer to the graph above, which shows the demand and supply for a new vaccine against the common cold. Once vaccinated, a person cannot catch a cold or give a cold to someone else. At the competitively determined output level, the marginal social benefit will be:
A. equal to P0.
B. less than P0.
C. greater than or less than P0 depending on the income elasticity of demand and the effectiveness of the vaccine.
D. greater than P0.

There is a positive externality associated with the vaccine. The MSB curve is to the right of the demand curve shown. Without intervention, equilibrium price (MB) is P0. Thus MSB is greater than P0 at Q0.


AACSB: Analytic
BLOOM'S TAXONOMY: Application
Difficulty: Medium
Learning Objective: 21-2
Topic: Externalities


55. Refer to the graph above, which shows the demand and supply for a new vaccine against the common cold. Once vaccinated, a person cannot catch a cold or give a cold to someone else. The socially efficient level of output is:
A. less than Q0.
B. greater than or less than Q0 depending on the income elasticity of demand and the effectiveness of the vaccine.
C. greater than Q0.
D. equal to Q0.

There is a positive externality associated with the vaccine. The MSB curve is to the right of the demand curve shown. Without intervention, the equilibrium quantity is Q0. The efficient level of output is where MSB = MC, greater than Q0.


AACSB: Analytic
BLOOM'S TAXONOMY: Application
Difficulty: Medium
Learning Objective: 21-2
Topic: Externalities

56. Refer to the graph above, which shows the demand and supply for a new vaccine against the common cold. Once vaccinated, a person cannot catch a cold or give a cold to someone else. If government does not subsidize the production of this vaccine:
A. the number of workers hired to produce the vaccine will be less than the socially efficient level.
B. the firm producing the vaccine will use too much capital in producing the vaccine.
C. the vaccine will be overproduced because consumers will not take into account the fact that many of their neighbors and coworkers will consume the vaccine.
D. No positive externality can be created.

There is a positive externality associated with the vaccine. The MSB curve is to the right of the demand curve shown. Without intervention, too little vaccine will be produced to equate marginal social benefits and marginal social costs.


AACSB: Analytic
BLOOM'S TAXONOMY: Application
Difficulty: Medium
Learning Objective: 21-2
Topic: Tax and Subsidy Incentives


57. Refer to the graph below.

The point on the graph corresponding to the socially optimal output per year and the price sellers must receive to make that amount available is shown by point:
A. G.
B. H.
C. I.
D. K.

The efficient output is where MSC = MSB.


AACSB: Analytic
BLOOM'S TAXONOMY: Application
Difficulty: Medium
Learning Objective: 21-2
Topic: Externalities


58. If a negative externality is to be internalized to the decision maker, the:
A. producers' marginal costs should be increased by an amount equal to the marginal external cost resulting from production of the good.
B. producers' marginal costs should be reduced by an amount equal to the marginal external cost resulting from production of the good.
C. consumer of the good should receive a subsidy equal to the marginal external cost resulting from production of the good.
D. consumer of the good should pay a tax equal to the marginal external benefit resulting from consuming the good.

To internalize a negative externality, MC must be increased by the amount of the externality.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Medium
Learning Objective: 21-2
Topic: Tax and Subsidy Incentives

59. If a positive externality is to be taken full advantage of, the:
A. consumer of the good should receive a subsidy equal to the marginal external cost resulting from production (or consumption) of the good.
B. producers' marginal costs should be increased by an amount equal to the marginal external benefit resulting from production of the good.
C. consumer of the good should pay a tax equal to the marginal external benefit resulting from production (or consumption) of the good.
D. producers' marginal costs should be decreased by an amount equal to the marginal external cost resulting from production of the good.

To internalize a positive externality, MB must be increased by the amount of the externality. That is, consumers must be subsidized.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Medium
Learning Objective: 21-2
Topic: Tax and Subsidy Incentives


60. If a corrective tax on gasoline results in the efficient output of gasoline by internalizing negative externalities associated with pollution:
A. pollution from gasoline will increase because people are also harmed by the tax.
B. there will be no effect on pollution from gasoline because the tax is paid by the supplier.
C. pollution from gasoline will be zero because environmental cleanliness is priceless.
D. the tax will generate enough revenue to compensate society for the damages resulting from the pollution that still occurs.

Since the tax is equal to the marginal external cost of the consumption of gasoline, the revenue generated by the tax equals the total cost of the pollution to society.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Hard
Learning Objective: 21-2
Topic: Tax and Subsidy Incentives

61. Refer to the graph above. Say that there is a negative externality associated with the production of the good depicted. The marginal social benefit from consuming this good at the competitive equilibrium output level is:
A. greater than P0.
B. equal to P0.
C. either greater than or less than P0, depending on the elasticities of supply and demand.
D. less than P0.

If there is a negative externality, the marginal social cost is to the left of the supply curve. However, the competitive equilibrium remains at Q0, P0. Since the marginal social benefit is still given by the demand curve and the externality is not charged for, the competitive equilibrium remains at P0 and Q0.


AACSB: Analytic
BLOOM'S TAXONOMY: Application
Difficulty: Hard
Learning Objective: 21-2
Topic: Externalities

62. Refer to the graph above. Say that there is a negative externality associated with the production of the good depicted. The marginal social cost from consuming this good at the competitive equilibrium output level is:
A. either greater than or less than P0, depending on the elasticities of supply and demand.
B. greater than P0.
C. less than P0.
D. equal to P0.

If there is a negative externality, the marginal social cost is to the left of the supply curve. The competitive equilibrium remains at Q0, P0, where MSC>MC = P0.


AACSB: Analytic
BLOOM'S TAXONOMY: Application
Difficulty: Hard
Learning Objective: 21-2
Topic: Externalities


63. Refer to the graph above. There is a negative externality associated with the production of the good depicted. The socially efficient level of output is:
A. either greater than or less than Q0, depending on the elasticities of supply and demand.
B. less than Q0.
C. equal to Q0.
D. greater than Q0.

If there is a negative externality, the marginal social cost is to the left of the supply curve. The efficient level of output is to the left of the competitive equilibrium.


AACSB: Analytic
BLOOM'S TAXONOMY: Application
Difficulty: Medium
Learning Objective: 21-2
Topic: Externalities

64. The rule for making optimal decisions is that an activity should be increased until:
A. average costs are minimized.
B. total costs are minimized.
C. total benefits are maximized.
D. marginal benefits equal marginal costs.

We want to maximize net benefits, the excess of total benefits over total costs. This happens when marginal benefits equal marginal costs.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Hard
Learning Objective: 21-2
Topic: Marginal Costs and Marginal Benefits


65. A strategy that achieves a goal at the lowest cost in total resources without consideration as to who pays those costs is:
A. efficient.
B. inefficient.
C. impossible.
D. always the most profitable to the firm.

See the definition of efficient in the textbook.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Medium
Learning Objective: 21-2
Topic: Marginal Costs and Marginal Benefits

66. Direct regulation is inefficient because:
A. affected firms ignore regulations; for example, by dumping toxic waste illegally.
B. it does not take into account that the costs of reducing consumption are the same for all individuals.
C. it does not take into account the fact that the costs of reducing consumption may differ among individuals.
D. it does not take negative externalities into account.

The purpose of regulation is to correct for negative externalities by reducing consumption to the socially optimal level, but the costs of reducing consumption differ among individuals, so an optimal policy would not require the same reduction for everyone.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Hard
Learning Objective: 21-2
Topic: Direct Regulation


67. Suppose that government wants a policy that will encourage people to use less oil. For this policy to be efficient, it must:
A. induce those with the highest cost of conserving to reduce their oil consumption the most.
B. induce those with the lowest cost of conserving to reduce their oil consumption the most.
C. force everyone to reduce oil consumption equally.
D. force rich people to reduce oil consumption proportionally more than poor people.

Efficiency means that marginal costs equal marginal benefits. If the marginal cost of reducing consumption is less for some individuals, it is efficient that they reduce consumption the most.


AACSB: Analytic
AACSB: Reflective Thinking
BLOOM'S TAXONOMY: Comprehension
Difficulty: Hard
Learning Objective: 21-2
Topic: Marginal Costs and Marginal Benefits

68. Economists generally oppose direct regulation because:
A. it is unlikely to achieve the desired end as efficiently as possible.
B. it assumes that people behave rationally.
C. it is generally unfair.
D. it does not assume that people behave rationally.

Because direct regulation is less likely to equate marginal costs and marginal benefits, it is not as efficient as market incentive plans.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Medium
Learning Objective: 21-2
Topic: Direct Regulation


69. A market incentive plan:
A. regulates the amount of a resource a person can consume through direct limits.
B. requires that people choose to consume until the marginal costs exceed the marginal benefits.
C. makes the price of a resource reflect not only the marginal private costs but also the marginal social costs of consuming that resource.
D. makes the price of a resource reflect the marginal private costs of consuming that resource.

See the definition of market incentive plan in the textbook.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Hard
Learning Objective: 21-2
Topic: Tradable Permits

70. To address the problems created by negative externalities, economists prefer programs that:
A. require government to conserve, using general tax revenues to pay for the program.
B. require all people to reduce consumption equally.
C. make people who have the lowest benefit of reducing consumption choose to undertake the most reduction.
D. make people who have the lowest cost of reducing consumption choose to undertake the most reduction.

Economists prefer efficient programs. That is, those which require that individuals equate marginal costs and marginal benefits. This means that those people for whom reducing consumption is less costly will undertake the greatest reduction.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Medium
Learning Objective: 21-2
Topic: Tradable Permits


The table below shows four firms, the amount each pollutes, the marginal cost for each firm to clean up pollution, and the total cost to each firm of eliminating all pollution.

The total discharge of these four companies is 300 tons. Assume there is no one else who pollutes.

71. Refer to the table above. If the goal of the government is to reduce pollution by 50%, the cheapest way would be to have:
A. all four firms cut their discharge by 50%.
B. each firm reduce discharge by 37.5 tons.
C. firms A and D stop discharging and allow B and C to continue.
D. firms B and C stop discharging and allow A and D to continue.

A and D have the lowest per unit cost of cleanup. If we want to use the fewest resources to get a 50% reduction in pollution, this is the low cost way to do it.


AACSB: Analytic
BLOOM'S TAXONOMY: Application
Difficulty: Medium
Learning Objective: 21-2
Topic: Marginal Costs and Marginal Benefits


72. Refer to the table above. Assume that these firms want to maximize profits. If the government wishes to cut discharge by 50%, it could do so by establishing an effluent fee of:
A. $3.00
B. $4.50
C. $5.50
D. $10.00

A and D would find it cheaper to clean up their pollution than pay the tax, while firms B and C would find it cheaper to pay the tax than clean up.


AACSB: Analytic
BLOOM'S TAXONOMY: Application
Difficulty: Hard
Learning Objective: 21-2
Topic: Tax and Subsidy Incentives

73. Refer to the table above. If the government establishes an effluent fee of $7.00, how much tax would firms pay to the government?
A. $660
B. $1,050
C. $1,820
D. $2,100

A and D clean up for a cost of $660. B and C pay the tax for a cost of $1,050.


AACSB: Analytic
BLOOM'S TAXONOMY: Application
Difficulty: Hard
Learning Objective: 21-2
Topic: Tax and Subsidy Incentives


74. Refer to the table above. If the government establishes an effluent fee of $7.00, how much would the firms spend on reducing pollution?
A. $660
B. $1,710
C. $1,820
D. $2,100

A and D clean up for a cost of $660. B and C pay the tax for a cost of $1,050, but this is not part of the cost of cleanup.


AACSB: Analytic
BLOOM'S TAXONOMY: Application
Difficulty: Hard
Learning Objective: 21-2
Topic: Tax and Subsidy Incentives

75. Refer to the table above. If the government establishes a regulation requiring each company to reduce pollution by 50%, what would be spent on reducing pollution?
A. $660
B. $910
C. $1,050
D. $1,710

If all the firms clean up completely, the total cost would be $1,820. If each has to pay 1/2 of that, the total is $910. The difference between $910 and $660, the least cost way of reducing pollution by 50%, is the efficiency cost of this regulation.


AACSB: Analytic
BLOOM'S TAXONOMY: Application
Difficulty: Medium
Learning Objective: 21-2
Topic: Direct Regulation


76. Refer to the table above. Suppose that the government gives each company a pollution permit equal to 50% of its present discharge. However, companies are allowed to reduce pollution more than 50% and sell their permit or reduce less than 50% and buy a permit from another company. If firms maximize profits, what would happen?
A. Each firm would reduce pollution by 50%.
B. Firms A and D would eliminate pollution and sell their permits to B and C, who would continue to pollute as before.
C. Firms B and C would eliminate pollution and sell their permits to A and D, who would continue to pollute as before.
D. There is not enough information to answer this question.

The market price of the permits should be between $5.00 and $7.50. At that price, A and D will find it profitable to clean up and sell their permits, while B and C will find it profitable to buy the permits and continue polluting. Any other solution results in less profit, which violates the assumption in the question that firms are maximizing profits.


AACSB: Reflective Thinking
BLOOM'S TAXONOMY: Application
Difficulty: Hard
Learning Objective: 21-2
Topic: Tradable Permits

77. An effluent fee is an example of:
A. voluntary approach to pollution.
B. direct regulation of pollution.
C. a tax incentive policy.
D. a market incentive policy.

An effluent fee is a tax on pollution. The more one pollutes, the more one pays. Hence there is an incentive to reduce pollution in order to reduce the tax.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Easy
Learning Objective: 21-2
Topic: Tax and Subsidy Incentives


78. Based on economic theory, most economists believe market incentive plans are:
A. equitable.
B. efficient.
C. inefficient.
D. unfair.

Economic theory tells us that the plans are efficient; it says nothing about equity or fairness.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Hard
Learning Objective: 21-2
Topic: Tradable Permits

79. In a tax incentive program, the person who conserves the most pays:
A. relatively less tax.
B. relatively more tax.
C. no tax.
D. no penalties.

Tax incentive programs impose a tax on the consumption of a good. Those who consume the least pay the least tax.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Medium
Learning Objective: 21-2
Topic: Tax and Subsidy Incentives


80. Which of the following methods of reducing the amount of trash society generates is most likely to be efficient?
A. A mandatory recycling program
B. A completely voluntary recycling program
C. A "trash tax"
D. Landfills and incinerators

Market based programs, such as a trash tax, are more likely to equate marginal benefit and marginal cost.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Medium
Learning Objective: 21-2
Topic: Tax and Subsidy Incentives

81. Which policy is likely to be the most efficient in dealing with automobile emission pollution?
A. A mandatory requirement to reduce pollution
B. Voluntary emission control guidelines
C. Subsidizing research and development for alternative forms of transportation
D. An emission tax

Taxes are more likely to equate marginal benefit and marginal cost.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Medium
Learning Objective: 21-2
Topic: Tax and Subsidy Incentives


82. A policy that requires everyone to certify that they have reduced total consumption, not necessarily their own individual consumption, by a specified amount, is a:
A. external incentive plan.
B. internal incentive plan.
C. tax incentive plan.
D. market incentive plan.

See the definition of market incentive plan in the textbook.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Easy
Learning Objective: 21-2
Topic: Tradable Permits

83. Suppose Mary finds it easier to conserve than Jim. The difference between a tax incentive program and a marketable certificate plan in this case is that:
A. Mary undertakes most of the conservation in the case of a tax incentive program and least in the marketable certificate program.
B. Mary undertakes least of the conservation in the case of a tax incentive program and most in the marketable certificate program.
C. Mary takes on most of the conservation in both cases, but is paid by Jim in the marketable certificate program.
D. Jim takes on most of the conservation in both cases, but is paid by Mary in the marketable certificate program.

Since Mary finds it easier to conserve, she conserves the most in both cases. In the market incentive plan, however, Jim pays Mary to conserve for him. Thus she gains financially.


AACSB: Analytic
AACSB: Reflective Thinking
BLOOM'S TAXONOMY: Comprehension
Difficulty: Medium
Learning Objective: 21-2
Topic: Tradable Permits


84. If markets are perfectly competitive and production of a good results in water pollution, the imposition of a tax on that good will:
A. increase the price of that good and increase pollution.
B. reduce the price of that good and increase pollution.
C. reduce the price of that good and decrease pollution.
D. increase the price of that good and reduce pollution.

Market supply shifts to the left, so equilibrium price rises and equilibrium quantity falls, thereby reducing pollution.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Hard
Learning Objective: 21-2
Topic: Tax and Subsidy Incentives

85. If markets are perfectly competitive and production of a good results in water pollution, the imposition of a tax on the good will:
A. reduce the number of firms producing that good in the long run.
B. increase the number of firms producing that good in the long run.
C. reduce the number of firms producing that good in the short run.
D. increase the number of firms producing that good in the short run.

By assumption, the number of firms in a perfectly competitive industry can only change in the long run.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Hard
Learning Objective: 21-2
Topic: Tax and Subsidy Incentives


86. An individual with a highly elastic demand for gasoline will:
A. cut consumption more than an individual with a highly inelastic demand when price goes up.
B. cut consumption less than an individual with a highly inelastic demand when price goes up.
C. refuse to cut consumption for any reason.
D. stop using gasoline entirely if a tax is imposed.

Since that person finds it easy to conserve gasoline, he/she will reduce consumption of gasoline by a lot.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Hard
Learning Objective: 21-2
Topic: Tax and Subsidy Incentives

87. A firm with a highly inelastic demand for coal will:
A. cut consumption more than a firm with a highly elastic demand when price goes up.
B. cut consumption less than a firm with a highly elastic demand when price goes up.
C. refuse to cut consumption for any reason.
D. stop using gasoline entirely if a tax is imposed.

Since that person finds it difficult to conserve gasoline, he/she will reduce consumption of gasoline by comparatively less.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Hard
Learning Objective: 21-2
Topic: Tax and Subsidy Incentives


88. A policy is considered optimal if it:
A. is supported by a majority of voters.
B. equates total costs with total benefits.
C. equates marginal costs with marginal benefits.
D. forces people to conserve on scarce resources.

See definition of optimal policy.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Medium
Learning Objective: 21-2
Topic: Marginal Costs and Marginal Benefits

89. An optimal corrective tax levied on polluters will:
A. be equal to the marginal external cost of their actions.
B. not generate enough revenue to pay for the cost of the damage resulting from pollution that occurs at the efficient output of the good.
C. decrease pollution to zero.
D. increase the supply of polluting goods.

An optimal policy equates marginal costs (including external costs) with marginal benefits. Because the amount of the tax equals the total external cost of the pollution, it equals the cost of the pollution to society.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Easy
Learning Objective: 21-2
Topic: Tax and Subsidy Incentives


90. A policy in which the marginal costs of undertaking the policy equal the marginal benefits of that policy is best called an:
A. equality policy.
B. incentive policy.
C. optimal policy.
D. opportunity policy.

See the definition of optimal policy in the textbook.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Easy
Learning Objective: 21-2
Topic: Marginal Costs and Marginal Benefits

91. An efficient policy to reduce pollution would reduce pollution to the point where:
A. the marginal costs of reducing pollution equals the marginal benefits of reducing pollution.
B. it is eliminated.
C. the marginal costs of reducing pollution are greater than the marginal benefits of reducing pollution.
D. the marginal costs of reducing pollution are less than the marginal benefits of reducing pollution.

Economists believe in efficient policies, that is, those policies that equate marginal costs and marginal benefits.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Medium
Learning Objective: 21-2
Topic: Marginal Costs and Marginal Benefits


92. The efficient amount of pollution control is:
A. the amount for which the total social benefit equals the total social cost of pollution.
B. the amount for which the marginal social benefit equals the marginal social cost of pollution.
C. always zero.
D. always 100% abatement.

The efficient amount of pollution control is where MC = MB.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Medium
Learning Objective: 21-2
Topic: Marginal Costs and Marginal Benefits

93. The optimal quantity of pollution control occurs at the point where the:
A. level of pollution is reduced to zero.
B. marginal social benefit is at its maximum.
C. marginal social cost equals the marginal social benefit of pollution.
D. total benefit equals the total cost of pollution.

The optimal amount of pollution control is where MC = MB.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Medium
Learning Objective: 21-2
Topic: Marginal Costs and Marginal Benefits

94. Economists' attitude toward voluntary programs causes them to:
A. actively oppose them on the grounds that they will do more harm than good.
B. actively oppose them on the grounds that they are unfair.
C. be skeptical of the potential success of such programs.
D. favor these programs over alternative solutions.

The worst that can happen is that people will not alter their behavior.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Easy
Learning Objective: 21-2
Topic: Voluntary Programs


95. Economists tend to distrust voluntary approaches as a way to deal with externalities. What is their most common concern?
A. Voluntary approaches do not make people develop an awareness of the problem that would lead them to make good life-style changes.
B. Voluntary approaches are often perceived as unfair, imposing a heavy burden on the poor.
C. Voluntary approaches usually require people to ignore their self interest, and economists do not think people do that well.
D. Voluntary approaches are often too effective, and lead to excessive reduction in the externality.

Voluntary programs ignore self interest and often work against it. Economists are specialists in understanding the role of self interest.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Medium
Learning Objective: 21-2
Topic: Voluntary Programs

96. Public television periodically runs pledge drives to raise money. Only a small percentage of the people who benefit from public television are willing to pay. What do economists call the people who do not pay?
A. Free riders
B. The excludables
C. Adverse selectors
D. Thieves

Free riders enjoy public goods for free because they are nonexcludable.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Easy
Learning Objective: 21-2
Topic: Public Goods


97. Public television periodically runs pledge drives to raise money. Only a small percentage of the people who benefit from public television are willing to pay. This low percentage of people willing to contribute illustrates a difficulty with:
A. government regulation.
B. voluntary programs.
C. tax-incentive policies.
D. market-incentive programs.

Pledge drives by public television are an illustration of a voluntary program. Few public television stations are able to obtain enough donations to operate; usually the subscription drives supplement other, larger sources of revenue.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Easy
Learning Objective: 21-2
Topic: Voluntary Programs

98. Economists are most likely to suggest that societies address the inefficiencies created by negative externalities by:
A. direct regulation.
B. voluntary conservation.
C. making the price people pay reflect the cost of the externality.
D. leaving environmental problems alone so that the market can effectively deal with them.

Economists prefer programs that are market based. An unregulated market with negative externalities will not lead to an efficient solution.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Medium
Learning Objective: 21-2
Topic: Externalities


99. In 1990, the Clean Air Act was amended to place a national cap on sulfur dioxide emissions, giving electric utilities an allowance of a set amount of emissions, and allowing the utilities to trade their allowances. This type of plan is:
A. more efficient than direct regulation because utilities that receive a high marginal benefit from emissions can gain additional allowances through trade.
B. more efficient than direct regulation because it forces each utility company to reduce sulfur dioxide emissions by the same amount.
C. less efficient than direct regulation because utilities that receive a high marginal benefit from emissions can gain additional allowances through trade.
D. less efficient than direct regulation because it forces each utility company to reduce sulfur dioxide emissions by the same amount.

A market incentive plan is more efficient than direct regulation because it allows for variation in emissions reduction.


AACSB: Reflective Thinking
BLOOM'S TAXONOMY: Application
Difficulty: Hard
Learning Objective: 21-2
Topic: Tradable Permits

100. If government undertakes to reduce water usage using a market incentive plan, then:
A. each consumer will have to reduce their water usage by an equal amount.
B. consumers who reduce water usage by more than the required amount can sell marketable certificates to consumers who seek to reduce usage by less than the required amount.
C. consumers who do not reduce usage by the required amount will have to pay taxes on the extra water usage.
D. consumers will be asked to reduce water usage voluntarily.

Market incentive plans result in reduced total consumption, but allow those for whom the cost of reduction is lowest to reap financial rewards by selling marketable certificates to those for whom the cost of reduction is greatest.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Medium
Learning Objective: 21-2
Topic: Tradable Permits


101. Since trash generation involves an externality, the way economists might address the problem of trash generation that is most likely to be optimal is by:
A. integrating the cost of the externality into the initial price of the good.
B. having the government require mandatory sorting and recycling of trash.
C. having the cost of the externality be paid by the government.
D. not allowing persons to throw away more trash than acceptable as a maximum.

When people must pay a price that reflects the true cost to society, they will alter their behavior so that the optimal level of the good is consumed. In the case of an externality, the social cost must be added to the private cost.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Hard
Learning Objective: 21-2
Topic: Tax and Subsidy Incentives

102. An economist is most likely to support all of the following methods to address the negative externalities created by the waste from newspapers except:
A. requiring publishers to cut the volume of newspapers generated, but allowing them to sell certificates so that others can meet those requirements for them.
B. taxing the suppliers of newspaper by the pound.
C. having the cost of the externality be paid by the government.
D. ensuring that the social cost of buying a newspaper is reflected in its price.

Economists tend to favor market-based programs. Requiring government to pay the cost of an externality is not such a program.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Hard
Learning Objective: 21-2
Topic: Externalities


103. The inefficiency associated with negative externalities is most likely the result of:
A. special interest groups.
B. the fallacy of composition.
C. government intervention.
D. poorly specified property rights.

Poorly specified property rights result in effects of decisions not taken into account by decision makers. No one owns the right and cannot control the effect on those not involved in the trade. Refer to Applying the Tools: Common Resources and the Tragedy of the Commons.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Medium
Learning Objective: 21-2
Topic: Externalities

104. A per unit tax designed to internalize the external costs of production is called:
A. an excise taxes.
B. an effluent fee.
C. a sin tax.
D. a tariff.

See the definition of effluent fee in the textbook.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Easy
Learning Objective: 21-2
Topic: Tax and Subsidy Incentives


105. The Environment Ministry in Japan proposed a new carbon tax in order to meet Japan's obligations to reduce carbon dioxide emissions under the Kyoto Treaty. The tax would be levied on producers and importers of fossil fuels, and the expectation is that it would be largely passed on to consumers. This proposal is an example of a:
A. progressive tax.
B. voluntary program.
C. tax-incentive policy.
D. free rider problem.

A carbon tax is an example of a tax-incentive program. See the textbook.


AACSB: Analytic
BLOOM'S TAXONOMY: Application
Difficulty: Medium
Learning Objective: 21-2
Topic: Tax and Subsidy Incentives

106. The Environment Ministry in Japan proposed a new carbon tax in order to meet Japan's obligations to reduce carbon dioxide emissions under the Kyoto Treaty. The tax would be levied on producers and importers of fossil fuels, and the expectation is that it would be largely passed on to consumers. The rationale for this tax is that it will:
A. reduce a negative externality.
B. reduce a positive externality.
C. turn a private good into a public good.
D. turn a public good into a private good.

A pollution tax has long been a proposal made by economists; it is usually opposed by business and sometimes by environmentalists who either do not understand it or oppose it on philosophical grounds.


AACSB: Analytic
BLOOM'S TAXONOMY: Application
Difficulty: Medium
Learning Objective: 21-2
Topic: Tax and Subsidy Incentives


107. The Environment Ministry in Japan proposed a new carbon tax in order to meet Japan's obligations to reduce carbon dioxide emissions under the Kyoto Treaty. The tax would be levied on producers and importers of fossil fuels and raise the cost of using fossil fuels. How do most economists view a tax such as this?
A. They prefer direct regulation to taxes because taxes create deadweight loss.
B. They prefer voluntary programs to taxes because they reduce the role of compulsion.
C. They do not believe any government intervention is necessary because the invisible hand of the market will correct the problem.
D. They support taxes on pollution as a way of making decision makers consider all costs.

Economists prefer policies that internalize the externality. A tax on pollution is one way; another is tradable pollution permits. They dislike direct regulation and voluntary programs because the first uses too many resources to get any level of reduction and the second often work poorly.


AACSB: Analytic
BLOOM'S TAXONOMY: Application
Difficulty: Medium
Learning Objective: 21-2
Topic: Tax and Subsidy Incentives

108. Refer to the graph above. The price and quantity that would prevail if all social costs and benefits were taken into account is:
A. $5 and 2,600 units.
B. $3.50 and 2,000 units.
C. $3.95 and 6,800 units.
D. $1.80 and 2,000 units.

Equilibrium would be where marginal social cost intersects marginal social benefit.


AACSB: Analytic
BLOOM'S TAXONOMY: Application
Difficulty: Medium
Learning Objective: 21-2
Topic: Externalities

109. Refer to the graph above. The amount of a tax sufficient to reduce quantity supplied to the level that individuals would have supplied had they included the external cost in their decision is:
A. $2.50
B. $1.70
C. $1.00
D. $0.80

Evaluated at the socially optimal output (2,000), the tax would need to shift the supply curve upward by $1.70 to move equilibrium to where MSC = MSB.


AACSB: Analytic
BLOOM'S TAXONOMY: Application
Difficulty: Hard
Learning Objective: 21-2
Topic: Tax and Subsidy Incentives


110. Refer to the graph above. The free-market equilibrium in the above graph is at a price and quantity of:
A. $5 and 2,600 units.
B. $3.50 and 2,000 units.
C. $2.50 and 2,600 units.
D. $3.50 and 3,100 units.

Free market equilibrium is where marginal private costs equal marginal private benefits.


AACSB: Analytic
BLOOM'S TAXONOMY: Application
Difficulty: Medium
Learning Objective: 21-2
Topic: Externalities

111. A good which, if supplied to one person is supplied to all, and whose consumption by one individual does not prevent its consumption by another individual, is known as:
A. a private good.
B. a public good.
C. an external good.
D. an internal good.

This is the textbook definition of a public good.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Medium
Learning Objective: 21-3
Topic: Public Goods


112. Public television periodically runs pledge drives to raise money. Only a small percentage of the people who benefit from public television are willing to pay. Why does public television have a problem in collecting money from its viewers?
A. Broadcast television has public good aspects.
B. Public television has problems of adverse selection.
C. Public television is an example of government failure.
D. Broadcast television has problems of asymmetric information.

There is no penalty for not contributing because broadcast television is a public good.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Easy
Learning Objective: 21-3
Topic: Public Goods

113. When you purchase and eat a hamburger, no one else can eat the same hamburger. When you download a file on the internet, the file is still available for others to download. Economists explain this difference between hamburgers and computer files by saying that the hamburger is:
A. excludable while the computer file is not.
B. non-excludable while the computer file is not.
C. rival in consumption, while the computer file is not.
D. non-rival in consumption, while the computer file is not.

Public goods are nonrival in consumption, which means everyone can use them. Private goods are rival, which means that if one person uses it, another cannot.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Medium
Learning Objective: 21-2
Topic: Public Goods


114. Television broadcasts are often given as examples of a public good. However, it is possible to code a broadcast so that only people who pay for the decoder box can view it. The use of a coded signal does what to a television broadcast?
A. Makes it rival.
B. Makes it nonrival.
C. Makes it excludable.
D. Makes it nonexcludable.

It is still nonrival because lots of people can get the signal without affecting others, but now those who do not pay can be excluded.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Easy
Learning Objective: 21-3
Topic: Public Goods

115. A meeting of the United Nations Convention on International Trade in Endangered Species ended with greater protection given to great white sharks. Why should sharks need special protection?
A. There is an informational problem in the market; people do not understand the full consequences of their actions.
B. Sharks are not privately owned and can be subject to a tragedy-of-the-commons problem.
C. Sharks are what economists call a public good, and hence there are no incentives to produce or protect them.
D. Sharks are subject to adverse selection problems.

Things that are not owned but available to all can be overused. Economists argue that the development of property rights can be seen as a way of overcoming this problem. The tragedy of the commons was discussed in the Added Dimension box Common Resources and the Tragedy of the Commons.


AACSB: Analytic
BLOOM'S TAXONOMY: Application
Difficulty: Hard
Learning Objective: 21-2
Topic: Externalities


116. A system whereby power plants buy and sell the right to pollute in the form of emission credits is known as:
A. a voluntary program.
B. direct regulation.
C. a tax incentive program.
D. a market incentive program.

See the textbook. Trading emission credits is what a market incentive program does.


AACSB: Analytic
BLOOM'S TAXONOMY: Application
Difficulty: Medium
Learning Objective: 21-2
Topic: Tradable Permits

117. Do economists tend to favor a system where power plants buy and sell the right to pollute in the form of emission credits?
A. No; these programs are ineffective because they encourage major polluters to free ride on the efforts of others.
B. No; it is possible for some firms to do nothing if they simply buy enough credits.
C. Yes; they encourage all firms to cut pollution by the same percentage.
D. Yes; they believe that such a proposal would achieve a level of pollution reduction with the lowest cost to society.

Economists like tradable emissions credits because they achieve any level of pollution reduction using the least costly method. Some environmentalists do not like them because they do not understand economics and others because they consider factors such as fairness that are outside the economists' normal range of consideration.


AACSB: Analytic
BLOOM'S TAXONOMY: Application
Difficulty: Medium
Learning Objective: 21-2
Topic: Tradable Permits


118. Suppose that there are only two firms that pollute, A and B, and each emits 10 tons of waste into the air. Firm A can reduce its pollution at a cost of $100 per ton and Firm B can reduce its pollution at a cost of $500 per ton. Each has been given an emission credit allowing it to pollute 6 tons. If firms maximize profits, what will happen?
A. Each firm will clean up four tons and pollute six tons.
B. Firm B will buy four credits from A; B will emit ten tons and A two tons.
C. Firm A will buy four credits from B; A will emit ten tons and B two tons.
D. Firm B will buy one credit from A; it will cut pollution to seven tons and firm A will cut to 5.

The credits are more valuable to B than A, so firm B will buy all of Firm A's credits. Both firms benefit from the trade.


AACSB: Analytic
BLOOM'S TAXONOMY: Application
Difficulty: Medium
Learning Objective: 21-2
Topic: Tradable Permits

119. Which of the following does not illustrate the free rider problem?
A. Amy does not contribute to public television, but she watches it every day.
B. Roger refuses to help pay for the private security officer who patrols his neighborhood.
C. Amanda, a taxpayer, prefers to check out books from her local library rather than purchasing them herself.
D. Frank enjoys the fireworks from his lawn and does not purchase a ticket to view the display from the stadium.

Since public funds are used to purchase books for the library, Amanda is not enjoying something for free that others have paid for (assuming she pays her taxes). In the other cases, the person described is enjoying a benefit that others have paid for.


AACSB: Analytic
BLOOM'S TAXONOMY: Application
Difficulty: Medium
Learning Objective: 21-3
Topic: Public Goods


120. The unwillingness of individuals to share in the cost of a public good is called the:
A. free rider problem.
B. social conscience problem.
C. volunteer problem.
D. public choice problem.

See definition of free rider problem.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Easy
Learning Objective: 21-3
Topic: Public Goods

121. Which of the following is not a characteristic of a public good?
A. Nonexclusivity.
B. Available to non-buyers.
C. Nonrivalry in consumption.
D. Can only be consumed once.

Public goods are nonexclusive and nonrival by definition. Since they are nonexclusive, they are available to non-buyers (which is what creates the possibility of a free rider problem).


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Easy
Learning Objective: 21-3
Topic: Public Goods


122. Since consumption of a public good by one does not preclude consumption by others, public goods are said to be:
A. nonexclusive.
B. nonrival.
C. exclusive.
D. rival.

It is possible for a good to be nonrival without being nonexclusive. For example, non-payers could be excluded from a national park, but enjoyment of the scenery by one does not preclude enjoyment by another.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Easy
Learning Objective: 21-3
Topic: Public Goods

123. Once a public good is provided, those who do not pay cannot be denied the benefits. For this reason, public goods are said to be:
A. nonexclusive.
B. nonrival.
C. exclusive.
D. rival.

It is possible for a good to be nonexclusive without being nonrival. For example, once a freeway has been provided (without a tollbooth or computer sensors), non-payers cannot be excluded, but if there is heavy traffic, consumption is rival.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Easy
Learning Objective: 21-3
Topic: Public Goods


124. If air pollution control is a public good, it follows that:
A. the efficient output of air pollution control is zero.
B. additional persons can benefit from a given amount of air pollution control without reducing the benefits enjoyed by others.
C. the efficient output of air pollution control can be attained by selling it by the unit in a market.
D. the more air pollution control enjoyed by any one person, the less is available to others.

See the definition of a public good in the textbook.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Medium
Learning Objective: 21-3
Topic: Public Goods

125. The free rider problem:
A. can never prevent pure public goods from being supplied.
B. results because people act unselfishly.
C. results because people behave irrationally.
D. prevents voluntary cost-sharing from achieving the efficient output of a public good.

The free rider problem is individual's unwillingness to share in the cost of a public good. It prevents cost sharing.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Hard
Learning Objective: 21-3
Topic: Public Goods


126. The best example of a public good is:
A. competition.
B. government-subsidized lunches.
C. pollution.
D. national defense.

A public good is one that, when consumed by one individual, does not prevent its consumption by others. National defense protects all individuals in a country. If provided for some, it must also be provided for all.


AACSB: Analytic
BLOOM'S TAXONOMY: Application
Difficulty: Easy
Learning Objective: 21-3
Topic: Public Goods

127. In economic terminology, a free rider is someone who:
A. does not pay for their own consumption of a public good.
B. chooses not to consume a public good.
C. is earning economic profit.
D. raises his or her prices because all other prices are rising.

A free rider is a person who participates in something for free because others have paid for it.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Easy
Learning Objective: 21-3
Topic: Public Goods


128. In the case of public goods, a demand curve that shows the marginal benefit of the good is:
A. nonexistent.
B. the horizontal sum of individual demand curves.
C. the vertical sum of individual demand curves.
D. perfectly inelastic.

This is because the full benefit of the total output is received by everyone.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Easy
Learning Objective: 21-3
Topic: Public Goods

129. Suppose the marginal benefit (MB) of national defense is MB = 1,000 - 10Q, where Q measures units of national defense, for Charlie and MB = 400 - 4Q for Sally. Combining Charlie's and Sally's marginal benefits yields the social MB equation:
A. MB = 1,000 - 6Q.
B. MB = 1,000 - 14Q.
C. MB = 1,400 - 6Q.
D. MB = 1,400 - 14Q.

Since national defense is a public good, social benefit is the sum of individual benefits.


AACSB: Analytic
BLOOM'S TAXONOMY: Application
Difficulty: Hard
Learning Objective: 21-3
Topic: Public Goods


130. Suppose the marginal benefit (MB) of national defense is MB = 1,000 - 10Q, where Q measures units of national defense, for Charlie and MB = 400 - 4Q for Sally. Combining Charlie's and Sally's marginal benefits yields social MB = 1,400 - 14Q. If the marginal cost of providing national defense is constant and equal to 840 (measured in the same units as marginal benefit), the efficient level of national defense is:
A. 16 units.
B. 24 units.
C. 40 units.
D. 100 units.

Set MC equal to social MB and solve for Q: 840 = 1,400 - 14Q.


AACSB: Analytic
BLOOM'S TAXONOMY: Application
Difficulty: Hard
Learning Objective: 21-3
Topic: Public Goods

131. Suppose the marginal benefit (MB) of national defense is MB = 1,000 - 10Q, where Q measures units of national defense, for Charlie and MB = 400 - 4Q for Sally. Combining Charlie's and Sally's marginal benefits yields social MB = 1,400 - 14Q. If the marginal cost of providing national defense is 840 and the efficient level of national defense is provided at a cost of 420 per unit of national defense each for Charlie and Sally, then:
A. Sally would be paying more for national defense than she thinks it is worth.
B. Charlie would be paying more for national defense than he thinks it is worth.
C. the benefits of national defense would exceed the cost for both Charlie and Sally.
D. the cost of national defense would exceed the benefits for both Charlie and Sally.

The efficient level of national defense (where social MB = MC) is 40 units. For Sally, the marginal benefit of 40 units is only 240 (400 - 4x40), so she is paying more than she thinks it is worth.


AACSB: Analytic
BLOOM'S TAXONOMY: Application
Difficulty: Hard
Learning Objective: 21-3
Topic: Public Goods


132. If the marginal benefit of one more unit of a public good is $500 for Sam and $800 for Alex, the social benefit of one more unit of a public good is:
A. $500 since the benefit will go to the person who values it least.
B. $800 since the benefit will go to the person who values it most.
C. $1,300 since the benefit of one more unit goes to both individuals.
D. more than $1,300 since the benefits to society exceed the sum of individual benefits.

The social benefit in the case of a public good is the sum of the individual benefits since each individual gets the benefit of the good.


AACSB: Analytic
BLOOM'S TAXONOMY: Application
Difficulty: Medium
Learning Objective: 21-3
Topic: Public Goods

This table shows the marginal benefits from widgets obtained by the only three people who value them.

133. Refer to the table above. Suppose widgets cost $8.50 to produce. If widgets are a private good, how many will be produced by market incentives and is it the right (efficient) number?
A. Zero will be produced and this is below the socially optimal amount.
B. One will be produced and this is the socially optimal amount.
C. One will be produced and this is below the socially optimal amount.
D. Two will be produced and this is the socially optimal amount.

Helen will buy one because she gets more value than it costs to produce. The second is not worth producing because it costs $8.50 but only provides value of $8.


AACSB: Analytic
BLOOM'S TAXONOMY: Application
Difficulty: Medium
Learning Objective: 21-3
Topic: Public Goods


134. Refer to the table above. Suppose widgets cost $8.50 to produce. If widgets are a public good, how many will be produced by market incentives and is it the right (efficient) number?
A. Zero will be produced, and this is below the socially optimal amount.
B. One will be produced, and this is the socially optimal amount.
C. One will be produced, and this is below the socially optimal amount.
D. Two will be produced, and this is the socially optimal amount.

Helen will buy one because she gets more value than it costs to produce. However, a second is also worth producing because it provides value of $9, which is more than the cost of production.


AACSB: Analytic
BLOOM'S TAXONOMY: Application
Difficulty: Hard
Learning Objective: 21-3
Topic: Public Goods

135. Basic research is more likely to be funded by the federal rather than state and local government because basic research:
A. is usually conducted by oligopoly, the market structure that is most conducive to preliminary research.
B. has negative externalities that are passed on to those who live outside the state.
C. is largely a public good; benefits flow to the whole world, not just the state.
D. has information problems that cause adverse selection.

Basic research is usually funded by the federal government because it is often a public good. For this research to pass a cost-benefit test for California, the benefits must be much greater than the cost because most of them will flow out of the state. If the research results in a private good, then more of the benefits could be captured by California, but if the prospect of arriving at a private good, that is, something protected by patent, were high enough, private firms would be conducting it.


AACSB: Analytic
BLOOM'S TAXONOMY: Application
Difficulty: Hard
Learning Objective: 21-3
Topic: Public Goods


136. Music spreads easily and cheaply on computer networks. As a result, music has become more like:
A. a private good.
B. a public good.
C. a merit good.
D. an inferior good.

A public good is nonrival and nonexclusive. So is digital music.


AACSB: Analytic
BLOOM'S TAXONOMY: Application.
Difficulty: Hard
Learning Objective: 21-3
Topic: Public Goods

137. The Apple iPod is able to play digital music that has a special encoding that makes pirating music more difficult. In economic terms, this encoding is an attempt to:
A. make digital music more like a private good and less like a public good.
B. reduce the negative externalities of digital music.
C. reduce the adverse selection problem of digital music.
D. increase the marginal social benefit of digital music.

Encoding is an attempt to make digital music excludable, that is, to exclude those who do not pay. Hence, it would become more like a private good and less like a public good.


AACSB: Analytic
BLOOM'S TAXONOMY: Application
Difficulty: Medium
Learning Objective: 21-3
Topic: Public Goods


138. If the benefit of a public good is small to each individual in a society of millions of individuals:
A. it will never be efficient for government to provide the public good.
B. the total benefit will be large since social benefit is the sum of all individual benefits.
C. the total benefit will be small since individuals cannot share the benefits of public goods.
D. it cannot really be a public good since the benefit of public goods is always large.

Since there are millions of individuals, summing each person's benefit will result in a large amount of total or social benefit.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Medium
Learning Objective: 21-3
Topic: Public Goods

139. With regard to public goods provided by the government,
A. individuals reveal their demand when they buy the good.
B. a free rider problem is unlikely.
C. individuals have an incentive to conceal their willingness to buy the good.
D. individuals have an incentive to exaggerate their willingness to buy the good.

Public goods are nonrival and nonexclusive, so there is an incentive to exaggerate willingness to buy because they can free ride.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Medium
Learning Objective: 21-3
Topic: Public Goods


140. Real-world markets:
A. often involve deception, cheating, and inaccurate information.
B. ensure that sellers will always be honest and provide accurate information because those who are dishonest or provide inaccurate information go out of business.
C. can operate efficiently only if government takes steps to correct informational problems.
D. provide no mechanism for solving informational problems.

Deception, cheating, and inaccurate information characterize real-world markets, but informational problems can be solved through either government intervention or through markets. For example, a consumer can hire a mechanic to check out a used car before purchase.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Easy
Learning Objective: 21-4
Topic: Asymmetric Information

141. If a consumer is willing to pay $100 for a used Blu-Ray player that is a "cherry" and $30 for a used Blu-Ray player that is a "lemon", the consumer will offer:
A. $30 for any used Blu-Ray player even if the probability that it is a "lemon" is 50 percent.
B. $100 for any used Blu-Ray player even if the probability that is a "cherry" is 50 percent.
C. $65 for any used Blu-Ray player if the probability that it is a "lemon" is 50 percent.
D. $130 for any used Blu-Ray player if the probability that it is a "cherry" is 50 percent.

The expected value of a used Blu-Ray player is equal to the probability that it is a lemon multiplied by the value if it is a lemon plus the probability that it is a cherry multiplied by the value if it is a cherry.


AACSB: Analytic
BLOOM'S TAXONOMY: Application
Difficulty: Hard
Learning Objective: 21-4
Topic: Asymmetric Information


142. Adverse selection problems are most likely to be a problem when:
A. one side of the market, either buyer or seller, has better information than the other side.
B. there are public goods involved.
C. the good being exchanged has negative externalities.
D. the good being exchanged has free-rider problems.

Adverse selection is a problem in markets with asymmetric information.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Medium
Learning Objective: 21-4
Topic: Asymmetric Information

143. In economics, the term "signaling" refers to a way of lessening the problem of:
A. free riders.
B. negative externalities.
C. bad information by all market participants.
D. unequal information between buyers and sellers.

Signaling, transmitting information about quality in a way that is hard to fake, is a way of overcoming the problem of asymmetric information.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Medium
Learning Objective: 21-4
Topic: Asymmetric Information


144. At one time many economists were suspicious of brand names. They saw them as a barrier to entry with no benefits to consumers. In the 1970s economists began to see a possible benefit of brand names to consumers. They discovered that brand names were a way to:
A. signal quality.
B. market public goods.
C. overcome negative externalities.
D. overcome the free-rider effect.

Brand names were a form of signaling, of transmitting information about quality in a way that is hard to fake, and thus a way of overcoming the problem of asymmetric information. When a company has invested a large amount of money creating a meaningful brand name, it is very costly to produce poor quality products under that brand name because it will ruin the brand. Usually a company that has a valuable brand will market lower quality products under a different name. The beer market has a lot of examples.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Medium
Learning Objective: 21-4
Topic: Asymmetric Information

145. John and Jack are both trying to sell a used car to Jim. John's car is a lemon, a car that has a serious but non-obvious problem. Jack's car is a cherry, a car that has no problems. Jim cannot tell the difference between the cars. Economists say this information problem might be solved with signaling. Who has an incentive to find a way to signal quality?
A. Both Jack and John.
B. Jack, but not John.
C. John, but not Jack.
D. Jim.

John has an incentive to communicate the truth about the condition of his car in a way that Jack cannot duplicate. If he can find a way to do it, he will sell his car at a fair price. If he cannot, he will have to take a price that reflects the risk that Jim faces. In many markets manufacturers use some sort of guarantee or warranty to signal quality.


AACSB: Analytic
BLOOM'S TAXONOMY: Application
Difficulty: Medium
Learning Objective: 21-4
Topic: Asymmetric Information


146. A lawyer who drives a beat-up car and wears frumpy clothes may have a hard time getting clients. Potential clients may conclude from his appearance that he is poor, and if he is poor, he probably is not very good. If the above is true for a lawyer, dressing in expensive and stylish clothing is a way of:
A. internalizing externalities.
B. changing a nonrival good into a rival good.
C. changing a nonexcludable good into an excludable good.
D. signaling quality.

Signaling is an attempt to communicate attributes in a way that is difficult for those who do not have the attributes, though in this case, it can be faked to some extent.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Medium
Learning Objective: 21-4
Topic: Asymmetric Information

147. In the early days of the internet, selling and buying from other individuals was dangerous because one never knew if the person on the other side of the transaction was honest. Ebay.com became successful because it lessened that problem with its feedback rating system that let buyers and sellers develop a reputation. Ebay.com's innovation is an example of overcoming:
A. the free rider effect.
B. negative externalities.
C. positive externalities.
D. an information problem.

Transactions between complete strangers are hard because either side may cheat--there is nothing to lose. Ebay's innovation gave cheating a cost and honesty a benefit.


AACSB: Analytic
BLOOM'S TAXONOMY: Application
Difficulty: Medium
Learning Objective: 21-4
Topic: Asymmetric Information


148. How do economists explain the value firms and consumers place on brand names?
A. Brand names show that firms can easily manipulate consumers.
B. Brand names are a way firms can provide information about quality to consumers.
C. Brand names are a way of turning private goods into public goods, increasing their value to both seller and buyer.
D. Brand names are an example of adverse selection, by which producers advertise the options to consumers.

Brand names are one of the ways in which markets overcome the problem of asymmetric information.


AACSB: Analytic
BLOOM'S TAXONOMY: Application
Difficulty: Medium
Learning Objective: 21-4
Topic: Asymmetric Information

149. The Consumer Product Safety Commission (CPSC) is charged with protecting the public from unreasonable risks of serious injury or death from more than 15,000 types of consumer products. The CPSC is designed to overcome:
A. information problems.
B. positive externalities.
C. negative externalities.
D. direct regulation.

Presumably the problem is that consumers are not well informed and need more information.


AACSB: Analytic
BLOOM'S TAXONOMY: Application
Difficulty: Medium
Learning Objective: 21-4
Topic: Asymmetric Information


150. Which of the following is an argument an economist would use to argue against market regulation designed to protect consumers?
A. Information is costless and readily available, so it is up to consumers to beware.
B. When a brand name product is found unsafe, the value of the brand is reduced, which gives companies with brand names an incentive to produce high quality.
C. Manufacturers have no incentive to stop the sale of counterfeit products.
D. Government is more likely to have consumer's interest in mind than the market.

Firms do have an incentive to produce safe products. Those who do not will go out of business or at least suffer loss of sales. Information is not costless.


AACSB: Analytic
BLOOM'S TAXONOMY: Application
Difficulty: Medium
Learning Objective: 21-4
Topic: Asymmetric Information

151. If a consumer is willing to pay $5,000 for a used car that is a free of mechanical problems and $1,000 for a used car that will require extensive repairs, the consumer will offer:
A. $1,000 for a used car if the probability that it is free of mechanical problems is 50 percent.
B. $3,000 for a used car if the probability that it is free of mechanical problems is 50 percent.
C. $5,000 for a used car if the probability that it is free of mechanical problems is 50 percent.
D. $6,000 for a used car if the probability that it is free of mechanical problems is 50 percent.

The expected value of a used car is equal to the probability that it is free of mechanical problems multiplied by the value if it is free of mechanical problems plus the probability that it will require extensive repairs multiplied by the value if it will require extensive repairs. A risk-neutral consumer will offer that expected value.


AACSB: Analytic
BLOOM'S TAXONOMY: Application
Difficulty: Medium
Learning Objective: 21-4
Topic: Asymmetric Information


152. If buyers cannot distinguish between "lemons" and "cherries" in the used car market, but sellers can, the price buyers are willing to pay for used cars will be:
A. high enough to guarantee that at least 50 percent of the used cars offered for sale are "cherries."
B. so low that sellers with "cherries" will be unwilling to sell.
C. so low that sellers with "lemons" will be unwilling to sell.
D. equal to zero since no one would take the chance of purchasing a "lemon," even if the value of a car known to be a lemon is greater than zero.

With uncertainty, buyers would not offer a price high enough to induce the owner of a "cherry" used car to sell. Eventually, buyers would realize that all of the used cars offered for sale must be "lemons," so the price would fall even more, but not to zero unless the value of a car known to be a lemon is zero.


AACSB: Analytic
BLOOM'S TAXONOMY: Application
Difficulty: Medium
Learning Objective: 21-4
Topic: Asymmetric Information

153. If medical insurers could use information contained in DNA to predict the likelihood of major medical illnesses, the most likely outcome is that:
A. there would be an adverse selection problem and average insurance rates would rise.
B. there would be an adverse selection problem and average insurance rates would fall.
C. the adverse selection problem would be decreased and average insurance rates would rise.
D. the adverse selection problem would be decreased and average insurance rates would fall.

Rates would likely fall on average because those with a very low likelihood of major medical illness could purchase insurance at a much lower rate. Currently, an adverse selection problem exists because individuals have better information about their health than do insurance providers.


AACSB: Reflective Thinking
BLOOM'S TAXONOMY: Application
Difficulty: Hard
Learning Objective: 21-4
Topic: Asymmetric Information


154. The reason the Federal Trade Commission regulates advertising to prevent false and misleading claims is:
A. because firms that make false and misleading claims would earn lower profit, resulting in many firms being forced to shut down and many workers losing their jobs.
B. to create a market for information.
C. to prevent a market failure caused by inaccurate information.
D. to eliminate persuasive advertising.

If sellers are allowed to make false and misleading claims about their products, then consumers may end up assuming that all advertising information is false. When advertising information is accurate, consumers can make more efficient choices. Sellers engage in persuasive advertising because this is not considered false or misleading.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Medium
Learning Objective: 21-4
Topic: Asymmetric Information

155. Economists believe that if government provides information about product quality:
A. there will be less incentive for consumers to pay extra for quality guarantees supplied by firms.
B. consumers will be forced to pay for information when otherwise it would have been available for free.
C. the overall quality of products sold will increase substantially, eliminating the information problem.
D. the cost of providing information will be zero.

Left on their own, without government regulation. Information markets will develop to provide the information that people need and are willing to pay for. The market solution is likely to be more efficient (less costly) than government regulation.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Medium
Learning Objective: 21-4
Topic: Asymmetric Information


156. A market for information is more likely to develop even in the absence of government regulation of information as long as the marginal:
A. cost of information is zero.
B. benefit of information is zero.
C. cost of information exceeds the marginal benefit.
D. benefit of information exceeds the marginal cost.

Consumers will pay for information if it makes them better off.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Medium
Learning Objective: 21-4
Topic: Asymmetric Information

157. The basis of the argument favoring government intervention to correct informational and rationality problems is that:
A. if information is not perfect or if one trader is not rational, a trade can result in one party benefiting and the other losing.
B. entry into certain markets may be restricted so that excess profits cannot be eliminated by the forces of competition.
C. people cannot possibly know how well off they will be as a result of a trade until after the trade has occurred.
D. if individuals are free to produce whatever goods they want, then when excess profit is being made, more people will enter into the production of that good and consumers will benefit as the price is pushed down.

The usual case for the market assumes good information and rationality.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Medium
Learning Objective: 21-4
Topic: Asymmetric Information


158. Milton Friedman argues that medical licensure benefits doctors because it:
A. allows them to restrict supply, increase prices, and significantly increase their incomes.
B. protects them from malpractice suits.
C. ensures that they will not have to compete against each other for patients.
D. prevents other doctors from advertising and stealing their patients.

Licensure reduces the supply of doctors, raising the price for their services. They will still have to compete against other licensed doctors.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Medium
Learning Objective: 21-4
Topic: Asymmetric Information

159. Which of the following is not a question raised by critics of medical licensure?
A. Why, if licensed medical treatment is so great, do we even need formal restrictions to keep other types of medicine from being practiced?
B. Whom do these restrictions benefit: the general public or the doctors who practice mainstream medicine?
C. What have the long-run effects of licensure been?
D. Why does the public need to have accurate information about a doctor's competency?

Problems with information is one reason licensing is supported. Refer to the Added Dimension box Licensure and Surgery.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Medium
Learning Objective: 21-4
Topic: Asymmetric Information


160. Which of the following is the best example of an adverse selection problem?
A. Once individuals are insured, they are less likely to take efficient precautions.
B. Individuals are unlikely to pay for something if they can receive the benefits for free.
C. When a firm pollutes the air, families living nearby suffer the consequences.
D. Individuals who seek to purchase health insurance have better information about their health than insurance companies.

The text uses the example of health insurance to illustrate the adverse selection problem. The incorrect responses illustrate moral hazard, the free-rider problem, and negative externalities.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Easy
Learning Objective: 21-4
Topic: Asymmetric Information

161. If employers were made responsible for injuries suffered by employees while working at home:
A. there might be an adverse selection problem since employees have better information about the safety conditions of their own homes than employers.
B. employers would never permit employees to work at home.
C. more employees would be able to safely work at home.
D. there might be an adverse selection problem since employers have better information about the safety conditions of their employees than the employees have themselves.

Although such a policy was recently considered, the plan was rejected due to a likely adverse selection problem. Making employers responsible for injuries suffered by employees working at home would probably reduce the incidence of at-home work, but would not eliminate it entirely.


AACSB: Analytic
BLOOM'S TAXONOMY: Application
Difficulty: Medium
Learning Objective: 21-4
Topic: Asymmetric Information


162. Opponents of government intervention in the economy argue that government's attempts to correct informational problems:
A. are justified in most cases, though politically difficult to implement.
B. are not necessary since an efficiently operating market system ensures that adequate information will be provided.
C. often create greater problems, such as FDA restrictions on experimental drugs for AIDS which could save lives.
D. will make market transactions much more efficient.

Opponents argue that correcting informational problems creates other problems.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Medium
Learning Objective: 21-5
Topic: Government Failure

163. Opponents of government intervention in the economy argue that externalities:
A. do not create problems for the model.
B. are themselves the inevitable result of government policies.
C. should be corrected with regulations rather than subsidies.
D. may not be effectively corrected by the government.

Opponents argue that government is too cumbersome to make the fine tuning choices to correct them and that because of politics they may not be effectively corrected.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Hard
Learning Objective: 21-5
Topic: Government Failure


164. Suppose that a negative externality creates $1 billion worth of costs to third parties. The government attacks the problem with regulations that cut the cost of the externality to $500 million but cost business and consumers $1.5 billion. This situation illustrates the idea that:
A. regulations are an effective way to curb externalities.
B. externalities can never be corrected.
C. correcting market failure can result in government failure.
D. getting rid of externalities requires a great deal of necessary sacrifice for all of us.

In this example the cure is worse than the disease. Government failure is a policy that causes more harm than the problem it was intended to remedy.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Medium
Learning Objective: 21-5
Topic: Government Failure

165. Opponents to government intervention argue that government makes decisions based upon:
A. marginal social costs and marginal social benefits.
B. marginal political costs and marginal political benefits.
C. irrational choices.
D. total costs and total benefits.

Economists focus on incentives of the decision makers. In the case of government, it is the marginal political costs and marginal political benefits.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Medium
Learning Objective: 21-5
Topic: Government Failure


166. Both opponents of and proponents of government intervention would most likely agree with which of the following?
A. Government can and does create proper incentives to correct for externalities.
B. Property rights eliminate the need for government.
C. The market is inherently fair.
D. Property rights must exist for a market to operate.

Property rights must exist for markets to function. Whether those property rights are fair or need correction is a matter of debate.


AACSB: Analytic
AACSB: Reflective Thinking
BLOOM'S TAXONOMY: Comprehension
Difficulty: Hard
Learning Objective: 21-5
Topic: Government Failure

167. Government failure occurs when:
A. government fails to implement policy designed to correct a market failure.
B. government intervention in the market to improve a market failure succeeds.
C. government intervention in the market to correct a market failure actually makes things worse.
D. there is no need for government intervention into the market because there is no market failure.

The text provides 5 reasons to explain government failure.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Easy
Learning Objective: 21-5
Topic: Government Failure


168. Suppose a public good that is worth $1 billion is not produced by the market, so the government provides it, but at a cost of $3 billion. This attempt to correct a market failure has:
A. been successful since the public good is now produced.
B. given rise to the problem of free riders.
C. resulted in a government failure since use of resources is now less efficient.
D. resulted in an information asymmetry for the government.

Instead of losing value of $1 billion, the economy now has lost value of $2.5 billion. The allocation of resources is now inferior to what it was at the start.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Medium
Learning Objective: 21-5
Topic: Government Failure

169. A European Union official, Mr. McGreevey, claims a portion of EU law involves over-regulation. McGreevey is suggesting the EU suffers in part from:
A. market failure.
B. fairness.
C. government failure.
D. the rule of law.

Government policy may not only fail to correct a problem, but it can make it worse. This is government failure.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Easy
Learning Objective: 21-5
Topic: Government Failure


170. All of the following are justifications for government intervention except:
A. too much competition.
B. informational problems.
C. externalities.
D. public goods.

It is true that everyone likes competition except when it affects them; however, too much competition is not a justification for government intervention.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Easy
Learning Objective: 21-5
Topic: Market Failure

171. Government may not have an incentive to correct a market failure because:
A. government doesn't have the information it needs to correct the market failure.
B. government reflects politics, which reflects individuals' interests in trying to gain more for themselves.
C. policymakers fear that intervention will lead to a Pareto optimal outcome.
D. the benefit of correcting the market failure might exceed the cost of correcting the market failure.

Lack of information is a reason for government failure different from incentives. The lack of incentive to correct market failure stems from political pressures to benefit special interest groups.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Hard
Learning Objective: 21-5
Topic: Government Failure


172. Government failure is likely to occur for all of the following reasons except:
A. special interest groups might lobby government to the detriment of the public good.
B. individuals have better information about a situation that affects them than government.
C. intervention in markets is always simpler than it initially seems.
D. the bureaucratic nature of government intervention does not allow fine-tuning.

Intervention is almost always more complicated than it initially seems.


AACSB: Analytic
BLOOM'S TAXONOMY: Comprehension
Difficulty: Easy
Learning Objective: 21-5
Topic: Government Failure

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