Ch.17 ENG-market Failure

Chapter 17 The roles of government (I): market failure
Multiple Choice Questions
Question code: B3C17Q001

Which of the following are NOT situations of market failure?
(1) Luciano Pavarotti, a famous tenor, sang in an opera house in London and was
fully compensated.
(2) Oil producers form a cartel and try to restrict output and raise prices.
(3) Eddie buys a diamond ring as a gift for his girlfriend but receives nothing in
return from his girlfriend.
A. (1) and (2) only
B. (1) and (3) only
C. (2) and (3) only
D. (1), (2) and (3)
Answer: B

If all firms in the market form a cartel, then we may conclude that
A. efficiency can still be attained.
B. the price level will fall.
C. the firms will not earn any extra profit if they follow the decisions of the cartel.
D. there is a market failure.
Answer: D

Externalities exist when a party’s action affects other parties but there is no
_____________ or ____________.
A. increase in output; decrease in price
B. compensation paid; payment received
C. tax paid; subsidy received
D. production cost paid; profits earned
Answer: B
NSS Exploring Economics 3 1 © Pearson Education Asia Limited 2010

Question Bank (Chapter 17)
________ externalities exist when a party’s action _______ other parties but no
compensation is paid.
A. Beneficial; benefits
B. Positive; benefits
C. Harmful; harms
D. Negative; negates
Answer: C

A negative externality exists if there is a divergence between ________ in the market.
A. private and social costs
B. total cost and total benefit
C. private and social benefits
D. social benefit and social cost
Answer: A

A positive externality exists if there is a divergence between __________ in the
market.
A. average and social benefits
B. private and social benefits
C. total cost and total benefit
D. social benefit and social cost
Answer: B

*Which of the following is an example of a divergence between private and social
benefits?
A. A teacher teaches his students without receiving payment from his students.
B. On Mother’s Day, a mother receives a kiss from her daughter free of charge.
C. Chrissie puts beautiful photos onto her blog without receiving any reward.
D. Janice sings in a charity show and is fully compensated.
Answer: C
Explanation
Option A is not correct. If the economic agent is paid according to his contribution,
there is no beneficial externality. In this case, the teacher receives compensation from
his school to teach his students.
Option C is correct. Chrissie’s action benefits others in society but she receives no
reward.

Which of the following parties needs to bear the private cost of an action?
A. An economic agent who does not take any related action
B. All stakeholders
C. Only the person who takes the action privately instead of in public
D. None of the above
Answer: D

Which of the following may be included in the private cost of an action?
(1) Rent
(2) Interest rates
(3) Pollution
A. (1) and (2) only
B. (1) and (3) only
C. (2) and (3) only
D. All of the above
Answer: D

Which of the following may be included in the social cost of an action?
(1) Wages
(2) The price of a concert ticket
(3) The HK$1 billion spent on cleaning the harbour a year ago
A. (1) and (2) only
B. (1) and (3) only
C. (2) and (3) only
D. All of the above
Answer: A
Explanation
Option (3) is incorrect. The cost incurred in the past (sunk cost) should not be treated
as a cost. Thus, the money spent in the past on cleaning the harbour should not be

included in the social cost.
Social cost includes the cost borne by
(1) the government.
(2) the economic agent taking the action.
(3) individuals who are affected by the action.
A. (1) and (2) only
B. (1) and (3) only
C. (2) and (3) only
D. All of the above
Answer: D

Social cost is measured by
A. the value of the resources to society as a whole.
B. the value of the highest-valued use of the resources to society as a whole.
C. the opportunity cost to society as a whole of using the resources.
D. the opportunity cost of using the resources to the economic agent taking the
action.
Answer: C

*Suppose Ming only considers the private cost of having lunch at McDonald’s. Which
of the following is correct?
A. Inefficiency must exist as he does not consider the social cost.
B. There will be a divergence between private cost and social cost because the wages
for McDonald’s staff are too low.
C. The government should intervene as the social cost will be greater than the private
cost.
D. Ming’s action can be efficient.
Answer: D

If there is a divergence between private and social costs,
A. inefficiency may exist due to underproduction.
B. an external benefit must exist.
C. the difference between the costs is the external cost.
D. the government must take action to correct it.
Answer: C

If all drivers considered the external costs they imposed on other drivers, then
A. no one would drive.
B. travel time would be shortened.
C. the road must not be fully utilised.
D. society would suffer a loss.
Answer: B

The socially optimal output level will be attained when
A. private cost equals social cost.
B. marginal private cost equals marginal private benefit.
C. total social benefit equals total social cost.
D. there is no deadweight loss.
Answer: D

Given the quantity transacted, marginal social benefit equals marginal private cost in
the market. Which of the following are correct?
(1) If there is no negative externality, efficiency will be attained.
(2) If there is an external cost, a deadweight loss exists.
(3) If there is no external cost, inefficiency exists.
A. (1) and (2) only
B. (1) and (3) only
C. (2) and (3) only
D. All of the above
Answer: A

Suppose there is no external benefit. The efficient output level is attained if
A. the marginal social cost is equal to the marginal private cost.
B. the marginal social benefit is equal to the marginal private cost.
C. the marginal social cost is equal to the marginal private benefit.
D. Insufficient information to determine
Answer: C

Society will experience overconsumption if the
A. marginal social benefit is greater than the marginal private cost.
B. marginal private cost is greater than the marginal private benefit.
C. marginal private benefit is greater than the marginal social cost.
D. marginal social cost is greater than the marginal social benefit.
Answer: D

Private benefit measures
A. the value of the product to the producer or consumer.
B. productivity.
C. income level.
D. the value of the product to all people in society.
Answer: A

Social benefit measures
A. the value of the highest-valued option forgone to society as a whole.
B. the value of an action to a third party.
C. the value of an action to the economic agent taking the action.
D. the value of an action to society as a whole.
Answer: D

Andy loves to sing at midnight. This is an example of
A. a negative externality.
B. an external benefit if Andy’s neighbourhood loves his songs and he does not
receive any payment.
C. an external cost as it is illegal to sing at midnight.
D. an external benefit because this will help Andy become an excellent singer.
Answer: B
If there is a deadweight loss,
A. an underproduction must exist.
B. an overproduction must exist.
C. marginal social surplus must not be zero.
D. marginal social benefit must not be equal to marginal private cost.
Answer: C

Refer to the diagram below, which of the following are INCORRECT?
$
MSC
X
Marginal
external Y
benefit
Z
MSB
MPB
0 Q2 Q1 Q
(1) Efficiency is attained at point X.

(2) Area XYZ is the deadweight loss if the output level is at Q1.
(3) At point Y, there is an overproduction.
A. (1) and (2) only
B. (1) and (3) only
C. (2) and (3) only
D. All of the above
Answer: D

Under which of the following situations will underproduction most likely occur?
A. Ann talks loudly and disturbs other colleagues.
B. Bob studies hard and gets full marks on his examination.
C. Cathy, a web designer, builds a website for her client.
D. Donald volunteers to do magic tricks in Victoria Park every Sunday to entertain
pedestrians.
Answer: D
If there is an external cost, taxation may be used to correct the market because
taxation can
A. decrease the output level by increasing the marginal social cost.
B. increase the output level by decreasing the marginal social benefit.
C. decrease the output level by increasing the marginal private cost.
D. decrease the output level by decreasing the marginal external cost.
Answer: C

Under which of the following situations may taxation help improve efficiency?
A. The excellent performance of Hong Kong athletes in the 2009 East Asian Games
improves the image of Hong Kong.
B. Some people watched the fireworks free of charge during the opening ceremony
of the 2009 East Asian Games.
C. Drinkers in Lan Kwai Fong (蘭桂芳) disrupt pedestrians.
D. Some restaurants provide special offers at Christmas.
Answer: C

$
MSC
MPC + Tax
X
Y MPC
P2
Marginal
Z external cost
MB
0 Q
Q2 Q1
(1) After taxation, the socially optimal output level is not attained as the marginal
external cost is greater than the tax.
(2) Efficiency is attained at Point Y.
(3) After taxation, the price (excluding tax) received by the producers is P2.
A. (1) and (2) only
B. (1) and (3) only
C. (2) and (3) only
D. All of the above
Answer: B

From the viewpoint of society, which of the following are the benefits of imposing a
pollution tax to correct negative externalities?
(1) Tax revenue from the pollution tax can be used to reduce pollution.
(2) The deadweight loss decreases to zero.
(3) Factories cut their output level to an efficient level.
A. (1) and (2) only
B. (1) and (3) only
C. (2) and (3) only
D. All of the above
Answer: D

If there is a positive externality, which of the following measures may be used by the
government to correct the problem?
A. Taxation
B. Price ceiling
C. Quota
D. Subsidy
Answer: D

A subsidy may be used to correct the problem of externalities because it can
A. reduce external cost.
B. increase external benefit.
C. reduce marginal private cost.
D. reduce the output level.
Answer: C

If marginal social benefit is greater than marginal private benefit, then
A. market exchange will not work.
B. a subsidy must be provided to correct the market.
C. an external benefit must exist.
D. there is an overproduction.
Answer: C

*Under which of the following situations can a subsidy help improve efficiency?
A. An economics teacher shares his teaching materials with the public free of charge.
B. Pirate Bay provides BitTorrent files free of charge (BitTorrent is an Internet file
sharing method).
C. Internet search engine providers provide web searches free of charge.
D. Baidu (百度) provides free MP3 song downloads.
Answer: A
Explanation
In options B, C and D, the firms are usually paid by advertisers and the pay is
positively related to the websites’ number of hits. Hence, to increase their websites’
hit rates, the firms will provide different services free-of-charge. In addition, some of
their activities may infringe on the rights of copyright holders who do not receive
compensation. Thus, subsidising those activities may lead to a decrease in efficiency,
instead of an increase in efficiency.

Refer to the diagram below, which of the following about the subsidy are
INCORRECT?
$
MC
X MC – Subsidy
Z
Y
H MSB
MPB
0 Q
Q1 Q2
(1) The grey area is the deadweight loss caused by the provision of a subsidy.
(2) Before the provision of a subsidy, the market equilibrium is at Point Z.
(3) The distance ZH measures the unit subsidy.
A. (1) and (2) only
B. (1) and (3) only
C. (2) and (3) only
D. All of the above
Answer: A

If there is a harmful externality, then the government may
A. restrict the output level to reduce the deadweight loss.
B. provide services for free to compensate for the externality.
C. do nothing because government failure must exist.
D. take over all private firms because only public firms can produce without
generating an external cost.
Answer: A

Recently, the Chinese government tore down some illegal cement plants because the
plants could not meet environmental protection requirements. This intervention is an
example of
A. taxation and subsidisation
B. public ownership.
C. defining and granting rights.
D. restriction or removal.
Answer: D

In Hong Kong, some primary and secondary schools are owned and run by the
government. This is an example of
A. market exchange.
B. defining rights.
C. free goods.
D. public ownership.
Answer: D

*The government may reduce pollution by issuing pollution permits because
A. the government knows the efficient output level and can implement the permit
system efficiently.
B. the marginal cost of producing the goods will increase as the producers must buy
permits to increase production.
C. the permits will justify pollution and increase the output level.
D. the permits are given to firms exercising social responsibility and cannot be
traded.
Answer: B

If pollution permits are granted and can be traded freely, then
A. the pollution level must increase because pollution is legal now.
B. the socially optimal output level must not be attained because a government
failure must exist.
C. firms will earn higher profits because they can pollute unrestrictedly if they can
pay for the permits.
D. the marginal private cost of production will increase so that the output level will
decrease.
Answer: D

$
MSC
MPC’
C Price of pollution permit
B MPC
P2
A
MB
Q
0 Q2 Q1
(1) The price of a pollution permit is too high and this leads to underproduction.
(2) The efficient output level is Q1.
(3) The grey area will be the potential gain to society from granting permits.
A. (1) and (2) only
B. (1) and (3) only
C. (2) and (3) only
D. All of the above
Answer: A

*Refer to the diagram below, which of the following are correct?
$
MSC
X MPC’
K Price of pollution permit
Y MPC
P2
L G
Z
MB
H
0 Q2 Q1 Q
(1) Triangle XYP2 represents the consumer surplus at Q2.

(2) Triangle P2YZ represents the producer surplus at Q2 after the pollution permits
are granted.
(3) Triangle XGH represents the total social surplus before the pollution permits
are granted.
A. (1) and (2) only
B. (1) and (3) only
C. (2) and (3) only
D. All of the above
Answer: A
Explanation
Option (3) is incorrect. We should use the MSC and MB curves to find the total social
surplus at Q1. The total social surplus should be equal to:
(Consumer surplus + Producer surplus – Total external cost) at Q1
= Triangle XGL + Triangle LGH – Triangle KGH
= Total social surplus at efficient output level (Q2) – Deadweight loss at Q1
= Triangle XYH – Triangle KGY

*Refer to the diagram below, which of the following are correct?
$
MSC
X MPC’
K Price of pollution permit
Y MPC
P2
L G
Z
MB
H
Q
0 Q2 Q1
(1) Triangle P2YH represents the producer surplus after the pollution permits are
granted.
(2) Triangle LGH represents the producer surplus at Q1.
(3) Triangle KGY represents the deadweight loss without granting the pollution
permits.
A. (1) and (2) only
B. (1) and (3) only
C. (2) and (3) only
D. All of the above
Answer: C

If the cost of monitoring pollutant emissions is extremely high, then
A. the introduction of emission trading may not solve the problem of externality.
B. the introduction of emission trading will be efficient.
C. the government must intervene to stop pollution.
D. the level of pollutant emissions must be equal to the level permitted.
Answer: A

If there is a transaction cost, then the market exchange for correcting the negative
externality
A. must not work because the transaction cost must lead to a failure of market
exchange.
B. must work because the market solution is always the best solution.
C. may still work when the transaction cost is small.

D. may still work when the gain from market exchange is greater than the transaction
cost.
Answer: D

Internalisation means that
A. firms solve externalities via their internal divisions.
B. firms reduce or remove harmful externalities through integration with each other.
C. firms or people involved in harmful externalities will find their own ways to
reduce or remove externalities.
D. firms or people gain from internal economies of scale.
Answer: C

In Hong Kong, some bus operators try to reduce air pollution by buying new bus
models which emit fewer pollutants. This is an example of
A. market exchange.
B. integration.
C. self-restraint.
D. government intervention.
Answer: C

A cattle raiser erects a fence to prevent the cattle from damaging his neighbour’s
crops. This is an example of
A. subsidisation.
B. substitution.
C. integration.
D. internalisation.
Answer: D

The problem of externality can be solved by combining separate firms into one under
the same ownership because
A. the combined firm will enjoy economies of scale.
B. private costs become external costs.
C. the combined firm must be under public ownership and so it will be concerned

about society.
D. the new firm will try to maximise the total gain from all activities under its
control.
Answer: D

*Suppose the US Justice Department successfully breaks Microsoft into two
companies. Which of the following is correct?
A. This must lead to a deadweight loss.
B. An external cost will exist as the two companies will care about their own profits
only.
C. Society may benefit from the increase in competition.
D. The output level of software will decrease.
Answer: C

There is emission trading (排污交易) between Country A (a developing country) and
Country B (a developed country). Which of the following is correct?
A. To achieve efficiency, most of the pollution permits should be assigned to Country
A as it does not have money to buy the permits.
B. It is fair for Country A to have more pollution permits as the pollution level in
Country A should be lower.
C. If the transaction costs are negligible, the initial assignment of pollution permits
will not affect the result of resource allocation.
Answer: C

To attract more customers, a stall at a book fair employs a young model to distribute
its free gift. Which of the following is correct?
A. To achieve efficiency, all other stalls at the book fair should pay the stall
mentioned as they enjoy the external benefits from the employment of the young
model.
B. As the stall mentioned attracts customers from other stalls, it should compensate
other stalls for their losses.
C. The activity mentioned is just a means of non-price competition. Thus, no
externality exists.
Answer: D

To attract more customers, a stall at a book fair employs a young model to distribute
its free gift. This attracts a group of amateur photographers to take photographs of the
young model. Some stalls claim that the photographers disturb their business
operation. Which of the following is correct?
A. The stall which employs the young model should pay compensation to the
affected stalls.
B. If the transaction cost of obtaining compensation is extremely high, the affected
stalls may choose to do nothing.
C. If the affected stalls have the right to compensation, the problem of harmful
externality must be solved.
D. There is a divergence between private and social costs as the group of amateur
photographers can take photographs of the young model free of charge.
Answer: B
Explanation
Option D is not correct. The reason for the existence of the divergence between
private and social costs is not based on the price charged for taking photographs. Even
the photographers need to pay a positive money price, if their actions harm other
parties but if they do not pay compensation to the affected parties, the divergence
between private and social costs will exist.

To attract more customers, a stall at a book fair employs lots of young models to
distribute its free gift. This attracts a group of amateur photographers to take
photographs of the young models. Some stalls claim that the photographers disturb
their business operation. Suppose the transaction costs involved are negligible and
property rights are well-defined. Which of the following is correct?
A. If the photographers have the right to take photographs and disturb business
operations, then they will take more photographs at the book fair.
B. If the affected stalls have the right to compensation from the photographers, no
photographer will appear at the book fair.
C. Regardless of the assignment of the property right, the problem of harmful
externality can be solved by market exchange.
D. Regardless of the assignment of the property right, the affected stall will be
efficient and receive the same amount of compensation.
Answer: C

Suppose there is no beneficial externality and the transaction costs involved are
negligible. A factory’s production now pollutes a fish farm. Which of the following is
correct?
A. The production will not be efficient if the potential gain from correcting the
externality is small.
B. The factory will stop polluting the fish farm.
C. However the property rights are assigned, if the rights are well-defined, the
production will be efficient.
D. If the factory has the right to pollute, it will ignore the fish farm and continue to
emit pollutants. This leads to deadweight loss.
Answer: C

Private goods are goods of which
A. one’s consumption reduces the amount produced.
B. one’s consumption increases the amount available for others’ consumption.
C. one’s consumption will not increase the amount available for others’ consumption.
D. one’s consumption reduces the amount available for others’ consumption.
Answer: D

Public goods are
A. goods provided by the government.
B. goods distributed freely.
C. goods consumed by the public.
D. non-rival and non-excludable in consumption.
Answer: D

Which of the following comes closest to a public good?
A. A hot dog
B. Beatles’ songs
C. A television set
D. A public fish pond
Answer: B

Which of the following comes closest to a private good?
A. A TV programme
B. Wi-Fi wireless Internet access services
C. Newspapers distributed at MTR stations
D. An advertisement on a bus
Answer: C

Stephy has dinner with her boyfriend and pays the bill. This is an example of
A. an externality because Stephy’s boyfriend does not pay for his dinner.
B. a free good because Stephy’s boyfriend can have his dinner for free.
C. a public good because Stephy shares her money with her boyfriend.
D. distributing output by prices because Stephy enjoys her dinner and pays the bill.
Answer: D
Explanation
Option A is not correct. There is no third party as the decision to have the dinner and
pay the bill is made collectively by Stephy and her boyfriend. Thus, no externality is
involved.

Public goods are goods which are
A. rival and non-excludable.
B. non-rival and excludable.
C. non-rival or non-excludable.
D. non-rival and non-excludable.
Answer: D

National defence is an example of a pure public good because
A. all citizens are willing to pay for it.
B. it can be consumed by all citizens at the same time.
C. it is paid for with public funds.
D. it is provided by the government.
Answer: B

Suppose an MP3 song by Andy Lau is now downloadable at his official website free
of charge, and Andy Lau announces that all his fans may freely distribute the song to
anyone. Which of the following is correct?
A. The song can be regarded as an impure public good because it can only be freely
shared on the Internet.
B. The song can be regarded as a private good because Andy Lau holds the private
property rights to it.
C. The song is close to a pure public good as it can be consumed by nearly all
individuals at the same time.
D. The song is close to a private good because a computer is needed to store it and
play it.
Answer: C

We say that a public good is ‘impure’ if
A. it is not purely provided by the government.
B. it is not purely consumed by the public.
C. some degree of rivalry exists in its consumption.
D. it is not purely financed by public funds.
Answer: C

The City Forum (城市論壇) in Victoria Park can be regarded as an impure public
good because
A. the audience can participate free of charge.
B. it can serve many but not all individuals at the same time.
C. all individuals can join the Forum but only a few are interested.
D. the speakers do not receive any payment.
Answer: B

It may be more efficient for the government to provide public goods because
A. no one will pay for consumption as it is easy to escape from making a payment.
B. the government is more efficient in collecting money as the government can send
all non-payers to prisons.
C. the goods should be financed by public funds.
D. it is too costly for private firms to collect payment from consumers.
Answer: D

Andy owns a factory that pollutes a small pool. This is an example of
A. a pure public good as the small pool can be consumed by all individuals
concurrently.
B. beneficial externalities if Andy emits pollutants without being paid.
C. a government failure because the government does not set a regulation to restrict
Andy’s behaviour.
D. harmful externalities if Andy does not bear all costs related to his production.
Answer: D

Government intervention is justified if
A. the market fails to allocate resources efficiently.
B. the resource allocation favours the rich.
C. it can increase income levels.
Answer: D
Explanation
Option A is incorrect. Even if there is a market failure, government intervention may
not be efficient if the cost of government intervention is greater than its benefit.

Even if there is a market failure, it is not necessary for the government to intervene.
This is because
A. government intervention involves a high cost.

B. government intervention may not be the least costly method to correct any market
failure.
C. it is impossible for the government to allocate resources efficiently.
D. government intervention is not the only solution.
Answer: B

Which of the following will NOT result in government failure?
(1) In Country A, government officials have a super computer and advanced
technology so that they can obtain perfect information.
(2) In Country B, all government officials are honest and concerned only about
the public interest.
(3) In Country C, government officials are lazy and lack the incentive to work.
A. (1) and (2) only
B. (1) and (3) only
C. (2) and (3) only
D. (1), (2) and (3)
Answer: A

Which of the following are possible factors that prevent the government from
allocating resources efficiently?
(1) In Country A, government officials aim to maximise their own benefits.
(2) In Country B, the government needs to pay a high cost to obtain information.
(3) In Country C, government officials have an incentive to improve their work
quality.
A. (1) and (2) only
B. (1) and (3) only
C. (2) and (3) only
D. (1), (2) and (3)
Answer: A

Imperfect information
A. is only faced by the government.
B. must not exist if private property rights are well-defined.
C. may be faced by all economic agents.
D. is the only source of government failure.
Answer: C
Short Questions

Mary says, ‘Without government intervention, when a perfectly competitive market is
in equilibrium, efficiency in resource allocation must be achieved.’ Do you agree?
Explain your answer. (7 marks)
Answers:
• No. (1 mark)
• Market equilibrium is attained when the price has no tendency to change, i.e., at
the intersection point of the demand and supply curves. (1 mark)
• Efficiency in resource allocation is achieved when total social surplus is
maximised. (1 mark)
• When there is an externality, market equilibrium will be attained when marginal
private benefit is equal to marginal private cost. (1 mark)
• However, the condition for efficiency occurs when marginal social benefit is equal
to marginal social cost. (1 mark)
• As economic agents only consider their own interests and ignore the gain or loss
of the third party, their output level will be different from the efficient level and
deadweight loss exists even at market equilibrium. In this case, attaining market
equilibrium may not achieve efficiency in resource allocation. (2 marks)

‘If there is a market failure, the government must take action to correct the market.’
Do you agree? Briefly explain your answer. (2 marks)
Answer: No. The cost of government intervention may be higher than its potential
benefit (i.e., the reduction in deadweight loss). Thus, the government’s action to
correct the market may lead to a greater loss to society. (2 marks)

What is market failure? Explain your answer with the concept of externality.
(3 marks)
Answers:
• Market failure is a situation in which the market fails to allocate resources
efficiently, i.e., total social surplus is not maximised. (1 mark)
• When there is an externality, economic agents will ignore the effect of their
actions on other parties. Thus, they will overproduce or underproduce and so total
social surplus will not be maximised. Market failure exists. (2 marks)

Suggest ONE situation in which government intervention may help achieve
efficiency. Briefly explain your answer with ONE real-life example. (2 marks)
Answers:
• Lack of competition (i.e., monopoly or oligopoly), e.g., electricity supply, petrol
market
• Presence of externalities, e.g., education, smoking
• Provision of public goods, e.g., national defence
(Any of the above situations with one relevant example, 2 marks)

*In Hong Kong, if a person over 18 years old commits a murder, he will be sentenced
to life in prison (終身監禁). As the legal punishment for killing one person or more
than one person is the same, once a person commits a murder, his marginal private
cost of murdering an additional person will be zero.
Student A says, ‘There is a divergence between private and social costs in a murder
case. Thus, if the government introduces the death penalty (死刑), the number of
murder cases will be reduced to the efficient level.’
Explain whether the student is correct. (6 marks)
Answers:
• The first statement is correct. The private cost of a murder is equal to the value to
the murderer of being in prison for life. However, society also has to bear an
external cost for the murder, i.e., the value of the victim’s life and the cost to put
the murderer into prison. Thus, there is a divergence between private and social
costs. (3 marks)
• The second statement is incorrect. When the government introduces the death
penalty, the number of murder cases will decrease as more potential murderers are
deterred. However, the marginal private cost of murdering an additional person is
still zero. Thus, the increase in the punishment will not help deter serial murderers
(連環謀殺犯). In addition, murderers may try to find a better way to cover their
tracks. Thus, the introduction of the death sentence will not lead to efficiency as a
murderer does not bear all the costs of the murder. (3 marks)

‘Private cost is a cost borne by a private firm, while social cost is a cost borne by a
social enterprise.’ Use the definitions of private cost and social cost to explain why
the statement is INCORRECT. (4 marks)
Answers:
• Private cost is the cost borne by the economic agent taking the action. (1 mark)
• Social cost is the cost borne by society as a whole. (1 mark)
• Thus, both the private cost and social cost may be borne by a private firm and a
social enterprise. The main difference is that the private cost includes only the cost
borne by the economic agent taking the action, while the social cost includes both
private cost and the external cost borne by other economic agents affected by the
action. (2 marks)

‘Private cost is a part of the social cost, but the social cost may not be the private
cost.’ Do you agree? Briefly explain your answer. (3 marks)
Answers:
• Yes. (1 mark)
• As the economic agent taking the action is a member of society, his cost should be
included in the social cost. (1 mark)
• When an external cost exists, the social cost will be greater than the private cost.
Thus, the social cost may not be the private cost. (1 mark)

‘There is a negative externality if a social cost exists.’ Do you agree? Briefly explain
your answer. (3 marks)
Answers:
• No. (1 mark)
• Social cost is the cost borne by society as a whole. It is equal to the sum of the
private cost and the external cost. (1 mark)
• Thus, a social cost exists even if a negative externality does not exist. It is equal to
the private cost in this case. (1 mark)

‘Although a factory pollutes the surrounding environment, it may still be efficient if it
needs to bear all the costs involved in its production.’ Do you agree? Briefly explain
your answer. (3 marks)
Answers:
• Yes. (1 mark)
• Provided that the factory considers the cost of polluting the environment, there
will be no divergence between the private cost and the social cost. Thus, even if
there is pollution, the factory may still be efficient. (2 marks)

*‘Negative externality will lead to underpricing, while positive externality will lead to
overpricing.’ Comment on this statement. Explain your answer with TWO separate
diagrams. (8 marks)
Answers:
The first half of the statement is correct.
• When there is a negative externality, firms will ignore the cost they impose on the
third party. Thus, they will charge a price based on their marginal private cost.
(1 mark)
• Hence, the market price (P0) will be lower than the efficient level (Pe). (1 mark)
(2 marks)
$
MSC
Pe MPC
P0
MPB = MSB
Q
0
The second half is incorrect.

• When there is a positive externality, consumers will ignore the benefits enjoyed by
the third party. Thus, they will be willing to pay a price up to their marginal
private benefits, which are lower than the marginal social benefit. (1 mark)
• Hence, the market price (P1) will be lower than the efficient level (Pe). (1 mark)

(2 marks)
$
MPC = MSC
Pe
P1
MSB
MPB
Q
0

‘Education must be subsidised because it generates beneficial externalities.’ Do you
agree? Briefly explain your answer. (4 marks)
Answers:
• No. Subsidisation may not be efficient if: (1 mark)
 it is not the least costly method for solving the problem of externalities; or
(1 mark)
 the benefit from subsidisation is smaller than its cost. (1 mark)
• It is possible that subsidisation may lead to a greater loss to society. For example,
the government may have insufficient information to determine how much of a
subsidy should be provided. Thus, the cost involved in the provision of a subsidy
may be higher than the potential benefit from it. (1 mark)

With the aid of a diagram, show that a deadweight loss exists if there is a divergence
between private and social costs. (5 marks)
Answers:
• When there is a divergence between private and social costs, firms will ignore the
cost they impose on the third party and this leads to overproduction. They will
produce at Q0 where MPB = MPC and MSC > MSB. (2 marks)
• There will be a deadweight loss equal to Area ABC, which is the sum of the
difference between MSC and MSB for the overproduced units (Q0 – Qe).
(1 mark)

(2 marks)
$
MSC
A
B MPC
Pe
C
P0
MPB = MSB
Q
0 Qe Q0

With the aid of a diagram, show that an overproduction will exist if there is a
divergence between private and social costs. (5 marks)
Answers:
• When there is a divergence between private and social costs, firms will ignore the
cost they impose on the third party. Thus, they will produce at Q0 where MPB =
MPC. (2 marks)
• There will be an overproduction as the equilibrium output level Q0 is greater than
the efficient level Qe. (1 mark)
(2 marks)
$
MSC
Pe MPC
P0
MPB = MSB
Q
0 Qe Q0

List TWO government solutions to the problem of externalities. Discuss ONE
potential problem in implementing each solution. (4 marks)
Answers:
• Taxation or subsidisation:
 The government needs to know the levels of divergence between private and
social costs (or benefits) but the cost of obtaining this information may be
high.
 Government officials may be more concerned about their own interests. They
may accept bribes to implement policies favourable to the bribers, such as
providing a privileged tax exemption or too much of a subsidy.
• Restriction or removal: The government needs to know the efficient output level
but the cost of obtaining this information may be high.
• Public ownership:
 This may be implemented through legislation. The cost involved may be high
and may outweigh the potential benefit from this solution.
 The government may lack incentives to run the firms efficiently.
 Some government officials may accept bribes to greatly increase takeover
prices.
• Defining and granting rights:

 The government has to decide how and for whom to distribute the rights.
Firms may compete for the rights through non-price competition which may
waste resources.
 The government may need to know the efficient output level but the cost of
obtaining such information may be high.
(Any two of the above with one relevant problem for each solution. 2 × 2 marks = 4
marks)

With the aid of TWO separate diagrams, explain how taxation and subsidisation can
solve the problem of externalities. (12 marks)
Answers:
• The government can correct the problem of harmful externalities by taxation. It
should impose a unit tax which is equal to the marginal external cost at the
efficient output level. (1 mark)
• After the imposition of the unit tax, the MPC of production is increased by the
amount of the unit tax. (1 mark)
• The producers will decrease their output level from Q0 to Qe where MPC’ = MPB.
(1 mark)
• Assuming there is no external benefit, the market will achieve efficiency in
resource allocation when MSC = MSB at Qe. (1 mark)

(2 marks)
$
MSC
Unit tax = MEC at Qe
MPC’
MPC
MPB = MSB
0 Q
Qe Q0
• The government can correct the problem of beneficial externalities by

subsidisation. It should provide a unit subsidy which is equal to the marginal
external benefit at the efficient output level. (1 mark)
• After the provision of the unit subsidy, the MPC of production is decreased by the
amount of the unit subsidy. (1 mark)
• The producers will increase their output level from Q1 to Qe where MPC’ = MPB.
(1 mark)
• Assuming there is no external cost, the market will achieve efficiency in resource
allocation when MSB = MSC at Qe. (1 mark)
(2 marks)
$
Unit subsidy = MEB at Qe

MPC = MSC
MPC’
MSB
MPB
0 Q
Q1 Qe

What are the prerequisites for using market exchange to solve the problem of
externalities? Briefly explain your answer. (4 marks)
Answers:
• Property rights are well-defined. (2 marks)
• Transaction costs are smaller than the potential benefits from market exchange.
(2 marks)

‘Books in a public library are public goods because they can be borrowed by any
Hong Kong citizen.’ Is this statement correct? Explain. (4 marks)
Answers:
• No. (1 mark)
• Public goods are goods which are non-rival and non-excludable in consumption.
(1 mark)
• Books in a public library cannot be consumed by all people at the same time.
(1 mark)
• They are rival in consumption and so are not public goods. (1 mark)

‘All economic goods are private goods.’ Do you agree with this statement? Explain.
(4 marks)
Answers:
• No. (1 mark)
• Economic goods are goods whose available quantities are insufficient to satisfy all
human wants for them. (1 mark)
• Private goods are goods which are rival and excludable in consumption. (1 mark)
• Some economic goods are not private goods, e.g., national defence and free TV
programmes. They are non-rival in consumption but their available quantities are
insufficient to satisfy all human wants for them. (1 mark)
Thus, economic goods may not be private goods.
Structured Questions

It has been found that agriculture is responsible for about 14% of the world's
greenhouse gases (溫室氣體). Most emissions from agriculture are methane (甲烷),
which comes from ruminant animals (反芻動物) (e.g., cows). Methane is produced
during digestion. Thus, if we consume more beef, more cows will graze and so more
methane will be emitted.
(a) Explain briefly why the beef market is inefficient. (3 marks)
*(b) To protect domestic agriculture, the government of Country A provides a huge unit
subsidy to agriculture. For example, the government subsidises a farmer $1,000
for each cow.
Student A says, ‘The provision of a subsidy will benefit society as both the
consumer surplus and producer surplus in the beef market will increase.’
With the aid of a diagram, explain whether student A is correct. (9 marks)
(c) Countries in Virtual Earth hold a climate change conference to settle their
problems. Suppose all countries have perfect information. Can the following
policies help solve the problem in (a)? Briefly explain your answer, with the aid of
diagrams.
(i) All countries impose unit taxes on the production of beef. (4 marks)
(ii) All countries set a restriction on the number of grazing cows. (4 marks)
Answers:
(a) • The market for beef is inefficient because there is a divergence between
private and social costs. (1 mark)
• The producers of beef ignore the external cost (the emission of methane) they
impose on the rest of the world. Thus, they overproduce beef and this leads to
a deadweight loss. (2 marks)
(b) • It is correct to say that both a consumer surplus and producer surplus will
increase. The consumer surplus will increase from Area TXU to Area TZV.
The producer surplus will increase from Area UXR to Area VZS. (2 marks)
• However, society will not benefit from the subsidisation. As government
expenditure on the subsidy (Area RSZY) is greater than the increase in the
sum of the consumer surplus and the producer surplus (RSZX), the subsidy
creates an additional loss for society (equal to Area YXZ). (2 marks)
• In addition, the provision of a subsidy will increase the output level. As there
is a negative externality in the beef market, the increase in output level will
worsen the problem of overproduction and lead to an increase in total external
cost (by Area BXYC). (2 marks)
• In conclusion, the provision of a subsidy will lead to an increase in deadweight
loss [by Area BXZC (= Area YXZ + Area BXYC)]. Thus, it is not efficient to
provide the subsidy. (1 mark)

$ MSC
T C MPC
B
A Y MPC’ = MPC – Unit subsidy
X
U Z
V
R
S MPB = MSB
0 Q
Qe Q0 Q1
(2 marks)
(c) (i) As governments have perfect information, the unit tax will be equal to MEC at
the efficient output level (Qe). The marginal private costs of beef producers
will increase by the amount of the unit tax. Then, the output level for beef will
decrease to the efficient level (Qe) where MSB = MSC. Thus, the policy can
help solve the overproduction problem. (2 marks)
(2 marks)
$ Unit tax MSC
= MEC at Qe MPC’ = MPC + Unit tax
MPC
MPB = MSB
0 Q
Qe Q0
(ii) As governments have perfect information, the quota will be set at the efficient
output level (Qe). Then, the output level of beef will decrease to the efficient
level (Qe) where MSB = MSC. Thus, the policy can help solve the
overproduction problem. (2 marks)

(2 marks)
$
MSC
SQ
MPC
MPB = MSB
0 Q
Qe Q0

Some politicians have called on the HKSAR government to resume the building of
Home Ownership Scheme (HOS) flats. On the other hand, some property developers
argue that the provision of HOS flats is inefficient and harmful to the property market
as well as society.
(a) Suppose you were one of the politicians. Justify your claim for the provision of
HOS flats with the concept of market failure. (4 marks)
(b) Suppose you were the CEO of a property development company. Persuade the
public that the provision of HOS flats may NOT improve efficiency, with the
concept of government failure. (6 marks)
(c) Instead of providing HOS flats, the government can help people buy their homes
by providing a unit subsidy. Suppose there is no market failure in the property
market. With the aid of a diagram, explain why the subsidy may cause a loss to
society. (6 marks)
Answers:
(a) • Market failure is a situation in which the market fails to allocate resources
efficiently. (1 mark)
• The market structure of the property market in Hong Kong is an oligopoly.
There is a lack of competition in the market. (1 mark)
• The output level will be lower than the efficient level. (1 mark)
• The provision of HOS flats will increase the supply of flats. This may help
achieve efficiency in the property market. (1 mark)
(b) • Government failure is a situation in which the government fails to allocate

resources efficiently. (1 mark)
• Even if there is a market failure, the provision of HOS flats may not
necessarily improve efficiency. The cost involved may be higher than the
benefit. (1 mark)
• The possible reasons are:
 The government faces the problem of imperfect information. It may provide
too many HOS flats so that the price of flats decreases greatly and
overproduction results.
 Government officials lack the incentive to minimise costs and improve
efficiency.
 Some officials may accept bribes and contract the project of building HOS
flats to the bribers.
(Any two of the above. Accept any other reasonable answers. 2 marks × 2 = 4
marks)
(c) • If there is no market failure and before the subsidy is provided, the property
market will achieve efficiency at Qe. (1 mark)
• The subsidy will shift the supply curve downwards from S1 to S2. (1 mark)
• The amount of the subsidy (Area BCGF) is greater than the increase in the
sum of the consumer surplus and the producer surplus (Area BCGE).
(1 mark)
• Thus, the subsidy will lead to deadweight loss (Area EGF) and cause a loss to
society. (1 mark)
$
S1 = MC
A Deadweight loss
F
E
Pe
S2 = MC – Unit subsidy
B
P1 G
Unit subsidy
C
D = MB
0 Q
Qe Q1
(2 marks)


Ch.17 ENG-market Failure

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Ch.17 ENG-market Failure

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Chapter 17 The roles of government (I): market failure

Multiple Choice Questions

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NSS Exploring Economics 3 3 © Pearson Education Asia Limited 2010

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(1) Efficiency is attained at point X.

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NSS Exploring Economics 3 11 © Pearson Education Asia Limited 2010

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(1) Triangle XYP2 represents the consumer surplus at Q2.

NSS Exploring Economics 3 13 © Pearson Education Asia Limited 2010

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