Market Failure and Externalities: practice questions

Question 1

A leather tannery discharges chemical waste into a river. A rice farm downstream relies on the river to irrigate its paddies, and the waste reduces the farm's rice yields. This cost imposed on the rice farm is not included in the market price of the leather the tannery sells.

Which equation correctly relates the tannery's marginal social cost (MSC), marginal private cost (MPC) and marginal external cost (MEC) of production?

Accepted Answer

B

Question 2

Rockford Cement Works produces bags of cement for the construction industry. Its production process releases dust into the air, which increases respiratory illness among people living in the nearby town of Millbrook. This health cost is not paid by Rockford Cement Works and is n…

Accepted Answer

((a)) Rockford Cement Works only takes account of its own marginal private cost (MPC) when deciding how much to produce, but its dust emissions impose an additional marginal external cost (MEC) on Millbrook residents that it does not pay for, so the true marginal social cost (MSC = MP…  ((b)) (i) The free-market output is 4 thousand bags per week, where MPB equals MPC; (ii) the socially optimum output is 3 thousand bags per week, where MSB equals MSC  ((c)) At the free-market output of 4 thousand bags, MEC = MSC - MPC = 80 - 60 = $20 per bag; since this gap rises in a straight line from $0 at the socially optimum output (3 thousand bags) to $20 at the free-market output (4 thousand bags), the deadweight welfare loss is the triangul…  ((d)) A specific tax of $20 per bag, equal to the constant marginal external cost, would raise Rockford Cement Works' effective marginal cost from MPC to MPC plus tax, which equals MSC, so the profit-maximising firm would now choose to produce where MPB equals MSC, i.e. at the sociall…

Question 3

Bellview Health Clinic offers seasonal flu vaccinations to the public. Because a vaccinated person is less likely to catch and spread flu to others, each vaccination also protects people who are not vaccinated themselves. A benefit that vaccinated individuals do not personally r…

Accepted Answer

((a)) A person who is vaccinated reduces the chance of passing flu on to others, so the marginal social benefit (MSB) of each vaccination, which includes this benefit to third parties, is greater than the marginal private benefit (MPB) that the vaccinated person alone receives - this…  ((b)) The free-market output is 3 thousand vaccinations per month, where MPB equals MPC; the socially optimal output is 4 thousand vaccinations per month, where MSB equals MSC; since the free-market output is below the socially optimal output, the free market under-provides vaccinatio…  ((c)) At the free-market output of 3 thousand vaccinations, MEB = MSB - MPB = 60 - 40 = $20 per dose; since this gap falls in a straight line from $20 at the free-market output (3 thousand) to $0 at the socially optimal output (4 thousand), the deadweight welfare loss is the triangula…

Question 4

SafeDrive Insurance sells comprehensive car insurance policies. Once a driver has bought a policy, SafeDrive cannot observe every decision the driver makes. For example, how carefully they drive, or whether they always park in a secure, well-lit area overnight. (a) Define asymme…

Accepted Answer

((a)) Asymmetric information exists when one party to a transaction has access to relevant information that the other party does not (here, the driver knows how carefully they drive and park, but SafeDrive cannot fully observe this); it is a source of market failure because SafeDrive…  ((b)) Moral hazard occurs when a person changes their behaviour after entering an agreement in a way that increases risk for the other party, because they no longer bear the full cost of that risk themselves; a driver with comprehensive cover may take less care since SafeDrive bears m…  ((c)) SafeDrive could include a compulsory excess (deductible) in its policies, so the policyholder must still pay the first part of any claim themselves, restoring some financial cost to the policyholder and preserving an incentive to take reasonable care

Question 5

Burning coal to generate electricity releases carbon dioxide, which contributes to global climate change. The resulting costs (such as more frequent extreme weather, rising sea levels and damage to agriculture) fall on people around the world, often far from the power station an…

Accepted Answer

((a)) Allocative efficiency requires marginal social benefit to equal marginal social cost; because the power station only takes account of its own marginal private cost and ignores the marginal external cost of its carbon dioxide emissions, it produces where marginal private benefit…  ((b)) Because MSC = MPC + MEC, the free market for coal-fired electricity produces where MPB = MPC rather than at the socially optimal output where MSB = MSC, over-allocating resources to coal generation and creating a deadweight welfare loss; how significant this misallocation is dep…

Question 6

Economists judge how well a market is performing partly by whether it achieves productive efficiency and partly by whether it achieves allocative efficiency. These are two distinct conditions.

Which of the following best describes productive efficiency, as distinct from allocative efficiency?

Accepted Answer

B

Question 7

Port Elwyn is a small fishing village on an exposed coastline. Local business owners are discussing whether to fund a new sea wall that would protect the village's harbour and homes from storm-surge flooding. No private firm has come forward to build the sea wall and sell protec…

Accepted Answer

((a)) Non-excludability means that once the sea wall is built, it is impossible (or prohibitively costly) to prevent any resident of Port Elwyn from benefiting from its flood protection, even a resident who refused to pay towards it; non-rivalry means that one resident benefiting from…  ((b)) Because no resident can be excluded from the sea wall's protection once it exists, each resident has an incentive to let others pay for it while still enjoying the flood protection themselves for free; if every resident reasons this way and refuses to contribute voluntarily, thi…  ((c)) Since a private firm could not exclude non-payers from benefiting from the sea wall, it could not guarantee enough people would pay to cover its costs, so it would have no financial incentive to build the wall at all; the free market is therefore likely to fail to provide the se…

Question 8

Goldenhill Apiary keeps bees to produce and sell jars of honey. While foraging for nectar, the bees also pollinate the apple trees at the neighbouring Orchard Vale farm, increasing Orchard Vale's fruit yields. This pollination benefit is not paid for by Orchard Vale and is not r…

Accepted Answer

((a)) Goldenhill Apiary only takes account of its own marginal private cost (MPC) of keeping bees and producing honey when deciding how much to produce, but the bees also pollinate Orchard Vale's apple trees, creating a marginal external benefit (MEB) that the apiary is not paid for,…  ((b)) (i) The free-market output is 3 thousand jars of honey per month, where MPB equals MPC; (ii) the socially optimal output is 5 thousand jars per month, where MSB equals MSC; since the free-market output is below the socially optimal output, the free market under-provides honey pr…  ((c)) At the free-market output of 3 thousand jars, MEB = MPC − MSC = 43 − 19 = $24 per jar; since this gap falls in a straight line from $24 at the free-market output (3 thousand jars) to $0 at the socially optimal output (5 thousand jars), the deadweight welfare loss is the triangul…  ((d)) A specific subsidy of $24 per jar, equal to the constant marginal external benefit, would lower Goldenhill Apiary's effective marginal cost from MPC to MPC minus the subsidy, which equals MSC, so the profit-maximising firm would now choose to produce where MPB equals MSC, i.e. a…

Question 9

The Anchorage is a bar with an outdoor terrace that hosts amplified live music several nights a week. Customers who visit the terrace enjoy the music, but the noise also carries into nearby apartment blocks, disturbing the sleep and reducing the wellbeing of residents who are no…

Accepted Answer

((a)) Customers who visit The Anchorage's terrace enjoy the live music based on their own marginal private benefit (MPB), but the amplified noise disturbs the sleep and wellbeing of nearby residents, so the marginal social benefit (MSB), which subtracts this cost to third parties, is…  ((b)) The free-market output is 4 thousand customer-visits per month, where MPB equals MPC; the socially optimal output is 3 thousand customer-visits per month, where MSB equals MSC; since the free-market output is above the socially optimal output, the free market over-consumes terra…  ((c)) At the free-market output of 4 thousand visits, MEC = MPB − MSB = 42 − 26 = $16 per visit; since this gap falls in a straight line from $16 at the free-market output (4 thousand visits) to $0 at the socially optimal output (3 thousand visits), the deadweight welfare loss is the…

Question 10

BrightPath Logistics runs a regional warehouse and needs skilled staff to operate forklifts and manage its inventory systems. It gives new employees several weeks of specialist training that leaves them highly skilled. Some trained staff later leave BrightPath for better-paid jo…

Accepted Answer

((a)) BrightPath Logistics only captures the benefit of a trained worker's skills for as long as that worker stays with the firm, but some of the value of the training is captured by rival firms that hire the worker away without paying for any of the training themselves, so the margin…  ((b)) A subsidy would lower BrightPath's effective cost of training, encouraging it to provide training closer to the socially optimal level, and is relatively simple to administer through the tax system; but its effectiveness depends on the government correctly estimating the true si…

Output (thousand jars of honey per month)	Price = MPB = MSB ($ per jar)	MPC ($ per jar)	MEB ($ per jar)	MSC = MPC − MEB ($ per jar)
0	61	25	24	1
1	55	31	24	7
2	49	37	24	13
3	43	43	24	19
4	37	49	24	25
5	31	55	24	31
6	25	61	24	37

Output (thousand customer-visits to the terrace per month)	MPB ($ per visit)	MEC ($ per visit)	MSB = MPB − MEC ($ per visit)	MPC = MSC ($ per visit)
0	74	16	58	10
1	66	16	50	18
2	58	16	42	26
3	50	16	34	34
4	42	16	26	42
5	34	16	18	50
6	26	16	10	58

Market Failure and Externalities: Economics 9708 (Cambridge International AS & A Level)

Syllabus coverage

Question 1

Question 2

Question 3

Question 4

Question 5

Question 6

Question 7

Question 8

Question 9

Question 10

Output (thousand bags per week)	Price = MPB = MSB ($ per bag)	MPC ($ per bag)	MEC ($ per bag)	MSC = MPC + MEC ($ per bag)
0	100	20	20	40
1	90	30	20	50
2	80	40	20	60
3	70	50	20	70
4	60	60	20	80
5	50	70	20	90
6	40	80	20	100

Output (thousand vaccinations per month)	MPB ($ per dose)	MEB ($ per dose)	MSB = MPB + MEB ($ per dose)	MPC = MSC ($ per dose)
0	70	20	90	10
1	60	20	80	20
2	50	20	70	30
3	40	20	60	40
4	30	20	50	50
5	20	20	40	60
6	10	20	30	70

Output (thousand jars of honey per month)	Price = MPB = MSB ($ per jar)	MPC ($ per jar)	MEB ($ per jar)	MSC = MPC − MEB ($ per jar)
0	61	25	24	1
1	55	31	24	7
2	49	37	24	13
3	43	43	24	19
4	37	49	24	25
5	31	55	24	31
6	25	61	24	37

Output (thousand customer-visits to the terrace per month)	MPB ($ per visit)	MEC ($ per visit)	MSB = MPB − MEC ($ per visit)	MPC = MSC ($ per visit)
0	74	16	58	10
1	66	16	50	18
2	58	16	42	26
3	50	16	34	34
4	42	16	26	42
5	34	16	18	50
6	26	16	10	58

Output (thousand bags per week)	Price = MPB = MSB ($ per bag)	MPC ($ per bag)	MEC ($ per bag)	MSC = MPC + MEC ($ per bag)
0	100	20	20	40
1	90	30	20	50
2	80	40	20	60
3	70	50	20	70
4	60	60	20	80
5	50	70	20	90
6	40	80	20	100

Output (thousand vaccinations per month)	MPB ($ per dose)	MEB ($ per dose)	MSB = MPB + MEB ($ per dose)	MPC = MSC ($ per dose)
0	70	20	90	10
1	60	20	80	20
2	50	20	70	30
3	40	20	60	40
4	30	20	50	50
5	20	20	40	60
6	10	20	30	70

Output (thousand jars of honey per month)	Price = MPB = MSB ($ per jar)	MPC ($ per jar)	MEB ($ per jar)	MSC = MPC − MEB ($ per jar)
0	61	25	24	1
1	55	31	24	7
2	49	37	24	13
3	43	43	24	19
4	37	49	24	25
5	31	55	24	31
6	25	61	24	37

Output (thousand customer-visits to the terrace per month)	MPB ($ per visit)	MEC ($ per visit)	MSB = MPB − MEC ($ per visit)	MPC = MSC ($ per visit)
0	74	16	58	10
1	66	16	50	18
2	58	16	42	26
3	50	16	34	34
4	42	16	26	42
5	34	16	18	50
6	26	16	10	58

Output (thousand bags per week)	Price = MPB = MSB ($ per bag)	MPC ($ per bag)	MEC ($ per bag)	MSC = MPC + MEC ($ per bag)
0	100	20	20	40
1	90	30	20	50
2	80	40	20	60
3	70	50	20	70
4	60	60	20	80
5	50	70	20	90
6	40	80	20	100

Output (thousand vaccinations per month)	MPB ($ per dose)	MEB ($ per dose)	MSB = MPB + MEB ($ per dose)	MPC = MSC ($ per dose)
0	70	20	90	10
1	60	20	80	20
2	50	20	70	30
3	40	20	60	40
4	30	20	50	50
5	20	20	40	60
6	10	20	30	70

Output (thousand jars of honey per month)	Price = MPB = MSB ($ per jar)	MPC ($ per jar)	MEB ($ per jar)	MSC = MPC − MEB ($ per jar)
0	61	25	24	1
1	55	31	24	7
2	49	37	24	13
3	43	43	24	19
4	37	49	24	25
5	31	55	24	31
6	25	61	24	37

Output (thousand customer-visits to the terrace per month)	MPB ($ per visit)	MEC ($ per visit)	MSB = MPB − MEC ($ per visit)	MPC = MSC ($ per visit)
0	74	16	58	10
1	66	16	50	18
2	58	16	42	26
3	50	16	34	34
4	42	16	26	42
5	34	16	18	50
6	26	16	10	58