Principles of Economics 4th Edition

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Exam

Name___________________________________

MULTIPLE CHOICE. Choose the one alternative that best completes the statement or answers the question.

1) The free market fails to provide public goods because: 1)

A) private firms cannot prevent people from using the good or service
B) the goods and services are not demanded by consumers
C) the private costs of production are greater than the social costs of production
D) the costs of production are zero, therefore private firms cannot determine what output level to
produce to maximise profits
Answer: A
Explanation: A)
B)
C)
D)

2) Imperfect information on the part of buyers of hybrid cars: 2)

A) contributes to market failure
B) can be corrected by information provided by used car salesmen
C) can be corrected by the use of advertising
D) can be corrected by information provided on the websites of the car producers
Answer: A
Explanation: A)
B)
C)
D)

3) Which of the following defines an environmental charge? 3)

A) a tax on output designed to charge for the adverse effects of production on the environment
B) charges for using natural resources or for using the environment as a dump for waste
C) the use of law to charge companies for failure to comply
D) a pollution control that requires firms' emissions to reflect the levels that could be achieved
from using the best available pollution control technology
Answer: B
Explanation: A)
B)
C)
D)

4) Governments often subsidise goods and services that society appears to value more highly than the 4)
individual consumer does. These goods and services are called:
A) private goods B) merit goods C) charities D) public goods
Answer: B
Explanation: A)
B)
C)
D)

1
5) Externalities are a problem only if: 5)
A) decision makers do not take them into account
B) the externalities impose a cost
C) all firms are monopolistic
D) all firms are perfectly competitive
Answer: A
Explanation: A)
B)
C)
D)

6) As fees for higher education in Australia continue to rise, and the sector is increasingly privatised, 6)
it is likely that the quantity of education produced and consumed will:
A) be equal to the socially optimal level
B) more closely reflect the socially optimal level
C) exceed the socially optimal level
D) be less than the socially optimal level
Answer: D
Explanation: A)
B)
C)
D)

7) Which of the following would be classified as an external cost (negative externality)? 7)

A) You are not able to study at night because there is so much noise coming from the room next
to yours.
B) A private firm will not provide national defence since it is impossible to confine the benefits
to only those individuals who have paid for it.
C) When you purchase a product, the cost is higher than you originally anticipated.
D) As more firms began hiring computer programmers, the salaries of computer programmers
increased and therefore the firm's cost of production increased.
Answer: A
Explanation: A)
B)
C)
D)

8) A situation where all individual markets are in equilibrium is called: 8)

A) total equilibrium B) dynamic equilibrium
C) general equilibrium D) global equilibrium
Answer: C
Explanation: A)
B)
C)
D)

2
 9) Relative to a competitively organised industry, a monopoly: 9)
A) produces less output, charges lower prices and earns only a normal profit
B) produces more output, charges higher prices and earns economic profit
C) produces less output, charges higher prices and earns economic profit
D) produces less output, charges lower prices and earns economic profit
Answer: C
Explanation: A)
B)
C)
D)

10) Three of the following are advantages of electronic road pricing. Which one is not? 10)
A) The charge can be varied according to the level of congestion.
B) The charge can be varied according to the time of day.
C) The socially efficient rate to charge can easily be ascertained.
D) The revenues can be used to subsidise public transport.
Answer: C
Explanation: A)
B)
C)
D)

11) To correct for an external benefit, the government should: 11)

A) set a tax equal to the amount by which marginal private cost exceeds the marginal social cost
B) set a tax equal to the amount by which marginal social cost exceeds the marginal private cost
C) provide firms with a subsidy for the amount by which marginal private benefit exceeds the
marginal social benefit
D) provide firms with a subsidy for the amount by which marginal social benefit exceeds the
marginal private benefit
Answer: D
Explanation: A)
B)
C)
D)

12) When the marginal social cost of the production of a good is ________ than the marginal social 12)
benefit, ________ should be produced.
A) less than; more B) less than; less
C) more than; more D) more than; the same amount
Answer: A
Explanation: A)
B)
C)
D)

3
13) Imperfect information on the part of buyers and sellers: 13)
A) remains a barrier to achieving efficiency, in many industries
B) will not stop the economy from achieving efficiency, assuming the other conditions for
efficiency hold
C) cannot persist in a market economy
D) is no longer a problem due to the effective enforcement of advertising standards
Answer: A
Explanation: A)
B)
C)
D)

14) Assume that the marginal cost of producing steel does not include the cost of the damage to the 14)
environment as a result of producing steel. By producing where P=MC, the firm will be producing:
A) the efficient amount of steel B) a zero quantity of steel
C) more than the efficient amount of steel D) less than the efficient amount of steel
Answer: C
Explanation: A)
B)
C)
D)

15) Market failure is used to describe: 15)

A) the failure of the market economy to provide an equal distribution of income to all citizens
B) firms which go bankrupt
C) an economic crisis
D) the failure of the market to provide an efficient quantity of a good and service
Answer: D
Explanation: A)
B)
C)
D)

16) Which of the following would be an example of an external benefit? 16)

A) The government spends a million dollars on improving national parks.
B) A firm has just obtained permission to open a landfill site on property that is adjacent to your
home.
C) More people start to ride the bus and as a result air pollution is reduced.
D) Firms are able to reduce their costs of production by using a more efficient technology.
Answer: C
Explanation: A)
B)
C)
D)

4
17) Which of the following is NOT a source of 'failure' of the free market? 17)
A) imperfectly competitive markets B) external costs and benefits
C) fast market adjustment to disequilibrium D) lack of knowledge by consumers
Answer: C
Explanation: A)
B)
C)
D)

18) In a perfectly competitive market where there are no externalities: 18)

A) marginal social cost will be greater than price
B) marginal social benefit will equal marginal social cost
C) marginal social benefit will be greater than price
D) price will be greater than marginal social benefit
Answer: B
Explanation: A)
B)
C)
D)

19) The deadweight loss associated with monopoly compared to perfect competition is comprised of: 19)
A) a loss of consumer surplus only
B) a loss of consumer surplus and a loss of producer surplus
C) a loss of private surplus
D) a loss of producer surplus only
Answer: B
Explanation: A)
B)
C)
D)

20) Which of the following is not a reason for governments to provide merit goods? 20)
A) providing greater equality of opportunity
B) protecting firms from poor investment decisions
C) protecting consumers from poorly informed decisions
D) protecting children from the decisions made by poorly informed parents
Answer: B
Explanation: A)
B)
C)
D)

5
21) Public goods are characterised by being non-rival in consumption, therefore: 21)
A) they are illegal
B) they are very expensive, thus the private sector cannot provide them
C) the private sector may not provide them because they cannot exclude those who do not pay
D) the government cannot produce them
Answer: C
Explanation: A)
B)
C)
D)

22) General equilibrium occurs when ________ in all markets. 22)

A) prices are fair B) consumers are satisfied
C) firms make profits D) demand equals supply
Answer: D
Explanation: A)
B)
C)
D)

23) From the list below, the best example of a good that is non-excludable but is rival in consumption 23)
would be:
A) transmission of television programs B) national defence
C) fishing waters D) street lighting
Answer: C
Explanation: A)
B)
C)
D)

24) Bill sells Mary a worthless coin that Bill incorrectly told Mary 'belonged to an ancient Persian king 24)
and is of enormous value to coin collectors'. Economists would call this an:
A) efficient exchange, assuming Bill was not intentionally trying to trick Mary
B) inefficient exchange because there were externalities involved
C) efficient exchange since any type of voluntary exchange promotes efficiency
D) inefficient exchange since at least one party used false market information
Answer: D
Explanation: A)
B)
C)
D)

6
25) One role of the Australian Competition and Consumer Commission (ACCC) is to: 25)
A) prevent mergers between companies
B) regulate the use of public goods
C) recommend cuts in tariff protection to industries
D) evaluate potential mergers between companies
Answer: D
Explanation: A)
B)
C)
D)

26) Producer surplus: 26)

A) is equal to total cost minus total revenue
B) is the difference between the price producers would have been willing to accept for a good
and the price they actually receive
C) is the difference between the price producers would have been willing to pay for a good and
the price they actually do pay
D) is represented by the area above the price line and below the demand curve
Answer: B
Explanation: A)
B)
C)
D)

27) An economist has estimated that the maintenance of a public park costs $25 000 a year and that the 27)
public park generates $30 000 a year in revenue for merchants near the park. From society's point
of view, the maintenance of this park is:
A) inefficient because the park has no competition
B) potentially efficient because the value of the gains exceeds the value of the losses
C) inefficient because the additional revenues generated by the park are so low
D) inefficient, because everyone in the community pays taxes to support the park, but only the
merchants near the park benefit
Answer: B
Explanation: A)
B)
C)
D)

28) Social efficiency occurs when: 28)

A) unemployment is low and prices are stable
B) marginal social benefits of an activity are equal to the marginal social costs
C) all markets are in equilibrium
D) the marginal social cost of an activity is greater than the marginal social benefit
Answer: B
Explanation: A)
B)
C)
D)

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29) Assume that price underestimates the value that society places on flu vaccine. If firms produce 29)
where P=MC, firms will be producing:
A) the output where consumer surplus is zero
B) more than the efficient amount of flu vaccine
C) the efficient amount of flu vaccine
D) less than the efficient amount of flu vaccine
Answer: D
Explanation: A)
B)
C)
D)

30) Common resources are characterised by: 30)

A) provision by the government B) non-excludability
C) non-rivalry D) both B and C
Answer: B
Explanation: A)
B)
C)
D)

31) Environmentally harmful effects often tend to be long term, even though the benefits of using the 31)
environment are almost immediate. This is an example of what type of market failure?
A) inter-generational problems B) externalities
C) a common resource D) ignorance
Answer: A
Explanation: A)
B)
C)
D)

32) If an external cost arises in the production of paint: 32)

A) the free market will not produce enough paint
B) too much paint will be produced
C) painting competitions should be organised in local schools to use up the excess paint
D) the government should subsidise the production of paint
Answer: B
Explanation: A)
B)
C)
D)

33) If non-payers cannot be excluded from consuming a good this gives rise to the: 33)
A) pubic good problem B) free rider problem
C) private good problem D) fallacy of composition problem
Answer: B
Explanation: A)
B)
C)
D)

8
34) Because public goods are characterised by being collectively consumed: 34)
A) the government cannot produce them
B) they are very expensive, thus the private sector cannot provide them
C) the private sector may not provide them because they cannot exclude those who do not pay
D) they are illegal
Answer: C
Explanation: A)
B)
C)
D)

35) Suppose a company moves its most polluting production to a factory in a developing country 35)
where it knows environmental regulation is less strict than in its home location. In the new location
the firm's output is likely to:
A) not relevant as the company is producing outside its home country
B) be less than the efficient level of output
C) be greater than the efficient level of output
D) be less than the efficient level of output as an infinite increase in output would benefit a
developing economy
Answer: C
Explanation: A)
B)
C)
D)

36) Your next-door neighbour has a beautiful flower garden. However, you are allergic to flowers and 36)
cannot use your patio because of the flower pollen that drifts into it. In this case, the flower garden
is an example of:
A) a good that provides an external benefit B) market power
C) a good that imposes an external cost D) a public good
Answer: C
Explanation: A)
B)
C)
D)

37) In order to induce a more socially optimal level of output governments can ________ goods 37)
associated with negative externalities and ________ goods associated with positive externalities.
A) tax; subsidise B) subsidise; tax
C) subsidise; subsidise D) tax; tax
Answer: A
Explanation: A)
B)
C)
D)

9
38) An external cost of production will occur when: 38)
A) common property resources exist
B) public goods are not provided by the free market
C) a firm does not consider the total social cost of production when choosing what level of
output to produce
D) a firm does not consider the total social benefit of production when choosing what level of
output to produce
Answer: C
Explanation: A)
B)
C)
D)

39) Which of the following is NOT an example of an externality? 39)

A) exhaust fumes from cars
B) a lack of competition in the market
C) your enjoyment of your neighbour's beautiful garden
D) individuals paying for child immunisation
Answer: B
Explanation: A)
B)
C)
D)

40) Which of the following is not a characteristic of a tradable permit system of pollution control? 40)
A) Firms are not permitted to sell their pollution permits to other firms.
B) Firms can emit pollution above their permitted level if they are able to buy a permit from
another firm.
C) It combines both regulations and market-based systems.
D) The permit allows firms to emit pollution up to a pre-determined level.
Answer: A
Explanation: A)
B)
C)
D)

41) Street signs are an example of a good characterised by ________ and ________. 41)
A) non-rivalry; non-excludability B) rivalry; non-excludability
C) excludability: rivalry D) non-rivalry; excludability
Answer: A
Explanation: A)
B)
C)
D)

10
42) Residents in the Hunter Valley of New South Wales claim that open cut coal mining is linked to 42)
high rates of asthma amongst children in the area. This health problem is:
A) an external benefit of the local coal mining
B) estimated to be less than the economic benefits of the coal mining
C) an external cost of the local coal mining
D) a private cost of coal production
Answer: C
Explanation: A)
B)
C)
D)

43) When the social benefit of production exceeds the private benefit of production: 43)
A) there is not enough of the good being produced
B) the government should regulate the use of the common property resource
C) there is too much of the good being produced
D) there will be incidental costs from production
Answer: A
Explanation: A)
B)
C)
D)

44) Which of the following is NOT an advantage of taxing negative externalities? 44)
A) It is often difficult to accurately measure external costs such as pollution costs.
B) The tax provides a financial incentive for a firm to decrease the level of the negative
externality.
C) Taxes force the producer of the externality to pay for the cost of the externality.
D) The tax internalises the externality.
Answer: A
Explanation: A)
B)
C)
D)

45) If the production of a product is associated with an external benefit, and the firm does not consider 45)
the external benefit when deciding how much to produce, then the firm will produce:
A) the efficient level of output, as long as P = MC
B) the efficient level of output, as long as the firm is perfectly competitive
C) an output level that is greater than the efficient one
D) an output level that is less than the efficient one
Answer: D
Explanation: A)
B)
C)
D)

11
 46) If an industry changes from being highly competitive to a monopoly, this change can be 46)
represented by the:
A) loss in consumer surplus plus the loss in producer surplus
B) loss in producer surplus minus the gain in consumer surplus
C) gain in producer surplus plus the gain in consumer surplus
D) loss in consumer surplus plus the gain in producer surplus plus the deadweight loss
Answer: D
Explanation: A)
B)
C)
D)

SHORT ANSWER. Write the word or phrase that best completes each statement or answers the question.

47) Correctly complete the sentences below from the options which follow. 47)
Statement
(a) If the MSC > the MSB then:
(b) If the MSB > the MSC, then:
(c) If the MSC = MC, then:

Answer
(i) the appropriate level of output is being produced that will lead to social efficiency.
(ii) insufficient output will be produced by the private sector for social efficiency to be
achieved.
(iii) too much output will be produced by the private sector for social efficiency to be
achieved.
Answer: (a) iii (b) ii (c) i
Explanation:

48) What steps can the government take to help alleviate pollution using market forces? 48)
Answer: Taxes imposed on firms can internalise the external cost created by the production
process. Another option would be the use of tradable permits, which will allow the
market to set the price for the 'right' to pollute.
Explanation:

49) A firm produces an output level at which price is greater than marginal cost. Explain why 49)
this is inefficient.
Answer: It is inefficient because the value that society places on using these resources to
produce this product is greater than the cost of using resources to produce the
product.
Explanation:

50) Use a diagram to illustrate the concepts of consumer and producer surplus. 50)
Answer: Students should draw a demand and supply diagram, correctly labelled with price
on the vertical axis and quantity on the horizontal. The area above the price line and
below the demand curve represents consumer surplus. It is the amount consumers
would have been willing to pay for a good but did not have to because they paid the
equilibrium price. Producer surplus is the triangle below the price line and above
the supply curve. This area represents the price producers would have been willing
to accept for a good but did not have to as they received the equilibrium price.
Explanation:

12
51) Explain the factors that can make it difficult for governments to set optimal levels of taxes 51)
and regulations to correct for pollution.
Answer: It is difficult to determine what society perceives as the optimal level of emissions,
for example, the solution may require global agreements, which can be difficult to
reach and enforce. It is also difficult to measure the costs of pollution in money
terms in order to levy taxes that accurately internalise pollution costs. For example,
what is the cost of acid rain and what firms are responsible for what quantities of
this type of pollution?
Explanation:

52) What is the free rider problem and how does government action help to overcome it? 52)
Answer: If non-payers cannot be excluded from the consumption of a good or service, this
gives rise to the free-rider problem. All consumers have an incentive not to pay, in
the expectation that others will pay, and the non-payers will then be able to
consume the good at zero price. The free-rider problem means such a good or
service is unlikely to be provided by a private sector firm.
Explanation:

53) Under what circumstances will electronic road pricing be most effective in reducing the 53)
level of traffic congestion?
Answer: When there are ready alternatives for the motorist: either in terms of altering the
timing of journeys, or the route, or the means of transport.
For example, road pricing will be more effective if there is an attractive form of
public transport available.
Explanation:

54) Use a diagram to illustrate and explain how monopoly market power impacts the 54)
distribution of consumer and producer surplus compared to a perfectly competitive
outcome?
Answer: Students should draw a diagram similar to Figure 7.4 on page 163 of the text. The
monopoly firm produces less than the perfectly competitive firm and charges a
higher price. Consumer surplus is reduced (to area 1 in the diagram). Producer
surplus increases (area 2 in the diagram), and a deadweight welfare loss is incurred.
This is equivalent to areas 3 and 5 in the diagram.
Explanation:

55) Explain what economists mean when they refer to 'negative externalities'. 55)
Answer: A negative externality is a cost which occurs in the production of a good that falls on
a third party. The third party does not benefit either from the production or the
consumption of the good. For example, suppose coal is produced in the Hunter
Valley of New South Wales and exported to China. Most of the residents of the
Hunter Valley do not benefit from either the consumption or the production of the
coal, but must bear a third party cost from the pollution associated with the mining.
Explanation:

13
 56) Using examples, explain the difference between a public good and a merit good. 56)
Answer: A public good has the characteristics of non-excludability and non-rivalry. This
means that firstly it is not possible to provide a good or service to one person
without it being available for others and secondly that the consumption of a good by
one person will not prevent others from enjoying it. Together these imply that
public goods will not be provided by the market. Examples include national defence
and street lights.
Merit goods, on the other hand, are excludable and rival. You can prevent others
from consuming them and if one person consumes the good or service, others can be
prevented from doing so. A merit good is a good that the government feels that
consumers undervalue and hence it will be under-consumed if it is not provided
free or subsidised. Examples include healthcare and education. Despite being
provided by the government, they are not public goods.
Explanation:

57) Provide some arguments for government intervention in the working of the economic 57)
system.
Answer: 1. To take account of the existence of externalities
2. To subsidise merit goods
3. To provide for the production of public goods
4. To offset the imperfect information available to individuals and firms
5. To correct imperfections in markets
Explanation:

58) Explain why an external benefit is likely to be associated with the purchase of smoke 58)
detectors. How may this externality be internalised?
Answer: An individual using a smoke detector may lead to early fire detection, thus
preventing fire spreading to other houses, and therefore benefiting others who were
not involved in the purchase of the smoke detector. To internalise the externality, a
subsidy could be provided which would increase the quantity of smoke detectors
demanded to more closely reflect the socially efficient level.
Explanation:

59) Correctly complete the sentences below from the options which follow. 59)
Statement
(a) Private efficiency in consumption is where:
(b) Efficiency in production for the producer is where:
(c) Social efficiency in the market is where:

Answer
(i) marginal social benefit (MSB) equals marginal social cost (MSC).
(ii) price equals marginal utility (MU).
(iii) marginal cost (MC) equals price.
Answer: (a) ii (b) iii (c) i
Explanation:

TRUE/FALSE. Write 'T' if the statement is true and 'F' if the statement is false.

60) Non-rivalry means that one extra person using the good will not deplete it. 60)
Answer: True False
Explanation:

14
61) Public goods are non-rival in consumption and non-excludable. 61)
Answer: True False
Explanation:

62) A tax set equal to the marginal social cost of production can correct for an external cost from a 62)
production process.
Answer: True False
Explanation:

63) Government market intervention can reduce market efficiency. 63)

Answer: True False
Explanation:

64) A common resource is a resource that without government intervention would have no access 64)
restrictions.
Answer: True False
Explanation:

65) The goal of equity is realised when income is equally distributed amongst the citizens of a nation. 65)
Answer: True False
Explanation:

66) If the marginal social cost of producing a good is less than the marginal social benefit, then more of 66)
the good should be produced.
Answer: True False
Explanation:

67) A free rider is someone who cannot be made to pay for consuming something that other people 67)
have paid for.
Answer: True False
Explanation:

68) Cost-benefit analysis looks at the social costs and benefits of proposed actions. 68)
Answer: True False
Explanation:

69) Tradable permits are a mix of regulation and market-based systems. 69)
Answer: True False
Explanation:

70) The deadweight loss of monopoly refers to the loss of consumer surplus caused by the monopolist's 70)
pricing and output decisions.
Answer: True False
Explanation:

71) The free-rider problem arises because of the non-rivalry characteristic of public goods. 71)
Answer: True False
Explanation:

15
 72) Resale price maintenance involves a supplier specifying a minimum price at which a product can 72)
be sold, therefore it is beneficial for consumers.
Answer: True False
Explanation:

73) Sporting facilities are considered by the Australian government to be merit goods. 73)
Answer: True False
Explanation:

74) Taxing externalities such as pollution provides a financial incentive for firms to decrease pollution. 74)
Answer: True False
Explanation:

75) The difference between the maximum amount a person is willing to pay for a good and its current 75)
market price is the consumer surplus.
Answer: True False
Explanation:

76) Social efficiency occurs in the market where marginal private benefit equals marginal social cost. 76)
Answer: True False
Explanation:

77) A profit-maximising monopolist will normally produce a socially efficient level of output. 77)
Answer: True False
Explanation:

78) The results of a decision which affect people other than the decision-taker are called externalities. 78)
Answer: True False
Explanation:

79) Higher education facilities are considered by the Australian government to be merit goods. 79)
Answer: True False
Explanation:

ESSAY. Write your answer in the space provided or on a separate sheet of paper.

80) Until quite recently the Australian government provided higher education free of charge to Australian students.
Explain the economic argument for free higher education.
Answer: Many economists believe higher education is a good with positive externalities so that the social benefits
exceed the benefits to the individuals who undertake higher education. If this is indeed the case, the
quantity of education provided by the market would be less than the socially efficient outcome. Higher
education could therefore be subsidised in order to increase the quantity consumed, or, as in former
times in Australia, the government might decide to simply provide the good free of charge. Some reasons
for this decision included protecting students from poor decision making by their parents; ensuring the
workforce was well skilled and providing equality of opportunity to all Australians.

16
81) Outline and critically evaluate the use of taxes to correct for external pollution costs arising from production.
Answer: Where production of a good also involves pollution, economists describe the pollution as an externality.
It is an external cost to society. The quantity of the good produced is therefore said to be greater than the
socially optimal quantity because the external cost of the pollution is not included in the firm's
production costs. By levying a tax equal to the cost of the pollution, the firm can be forced to internalise
the cost. Students can draw a diagram similar to Figure 7.5 on page 167 of the text to illustrate this
theoretical approach. The problem in practice is that costs of pollution are difficult to calculate accurately
in order to levy the tax. There are many different types of pollution, which would all have to be
separately measured according to their costs to society. Sometimes it might be theoretically possible to
calculate costs of pollution, for example, in terms of health care costs incurred, but in practice this is
normally impossible. Governments therefore often prefer approximate taxes or more simply, anti
pollution legislation.

82) In what ways does the market system fail to provide protection for the environment?
Answer: There are major externalities associated with the environment, meaning that the costs of using it to
pollute are invariably borne by others. The marginal social cost is larger than the private cost and hence it
is overused. It also has elements of a public good as many parts of the environment are not privately
owned, they are non-excludable and hence overused. Most environmental resources, however, are scarce
and therefore also rivalrous in consumption. Ignorance is also a market failure here, as much
environmental damage has been done without knowledge, e.g. the use of aerosols before the 1980s. Even
if companies want to take action to counter environmental damage, factors of production are relatively
immobile in the short run, hence time lags will be an issue. There is also the problem of the costs of
environmental damage not being truly felt until the long term, whereas the benefits of using/damaging
the environment are much more immediate. We place a larger value on the short-term benefits than on
the long-term costs, hence there is a trade-off.

83) Explain how tradeable permits could be used to reduce carbon emissions. (Restrict your discussion to a national
level).
Answer: The appropriate government department uses available scientific evidence to determine an acceptable
level of carbon emissions for the nation as a whole, both in the present, and in terms of reductions over
time. Individual carbon emitting entities are then allocated an allowed emission level for the present,
which is normally reduced over time. Divisible permits are then allocated on the basis of the allowed
emissions. If firms are able to reduce their emissions below the allocated level, they are able to sell their
unused permits in tradeable permit markets. The permit prices should be determined by the interaction
of demand and supply in the market for tradeable permits.
Firms which can reduce emissions relatively cost effectively have an incentive to do so in order to profit
from the sale of their permits. Those firms in industries where costs of emission reduction are higher may
emit beyond their allocations by buying additional permits. This results in efficiency in emission
reduction.

84) Why is ignorance and poor decision making a cause of market failure?
Answer: In the model of perfect competition, market participants are assumed to be well informed with respect to
the price and characteristics of the products they purchase and are therefore able to make well informed
decisions. In reality, consumers are often ill informed and therefore make less than optimal decisions.
This could be because some goods are complex, or consumers buy them infrequently, or are confused by
misleading advertising. Governments may try to remedy this, for example, through high taxes on goods
which are harmful such as cigarettes.

17
85) What are public goods, and why won't the free market provide them?
Answer: Public goods are characterised by being non-rival and non-excludable. Non-rivalry means that the
consumption by one person does not deplete the quantity of the good available for others.
Non-excludability means non-payers cannot be excluded from consumption and leads to the free-rider
problem. Free-riders are non-payers who 'free-ride' on the payment of others. Private firms are therefore
unlikely to earn a profit providing such goods, and hence they are often provided by the government.

18
Answer Key
Testname: C7

1) A
2) A
3) B
4) B
5) A
6) D
7) A
8) C
9) C
10) C
11) D
12) A
13) A
14) C
15) D
16) C
17) C
18) B
19) B
20) B
21) C
22) D
23) C
24) D
25) D
26) B
27) B
28) B
29) D
30) B
31) A
32) B
33) B
34) C
35) C
36) C
37) A
38) C
39) B
40) A
41) A
42) C
43) A
44) A
45) D
46) D
47) (a) iii (b) ii (c) i
48) Taxes imposed on firms can internalise the external cost created by the production process. Another option would be
the use of tradable permits, which will allow the market to set the price for the 'right' to pollute.

19
Answer Key
Testname: C7

49) It is inefficient because the value that society places on using these resources to produce this product is greater than the
cost of using resources to produce the product.
50) Students should draw a demand and supply diagram, correctly labelled with price on the vertical axis and quantity on
the horizontal. The area above the price line and below the demand curve represents consumer surplus. It is the
amount consumers would have been willing to pay for a good but did not have to because they paid the equilibrium
price. Producer surplus is the triangle below the price line and above the supply curve. This area represents the price
producers would have been willing to accept for a good but did not have to as they received the equilibrium price.
51) It is difficult to determine what society perceives as the optimal level of emissions, for example, the solution may
require global agreements, which can be difficult to reach and enforce. It is also difficult to measure the costs of
pollution in money terms in order to levy taxes that accurately internalise pollution costs. For example, what is the cost
of acid rain and what firms are responsible for what quantities of this type of pollution?
52) If non-payers cannot be excluded from the consumption of a good or service, this gives rise to the free-rider problem.
All consumers have an incentive not to pay, in the expectation that others will pay, and the non-payers will then be
able to consume the good at zero price. The free-rider problem means such a good or service is unlikely to be provided
by a private sector firm.
53) When there are ready alternatives for the motorist: either in terms of altering the timing of journeys, or the route, or the
means of transport.
For example, road pricing will be more effective if there is an attractive form of public transport available.
54) Students should draw a diagram similar to Figure 7.4 on page 163 of the text. The monopoly firm produces less than
the perfectly competitive firm and charges a higher price. Consumer surplus is reduced (to area 1 in the diagram).
Producer surplus increases (area 2 in the diagram), and a deadweight welfare loss is incurred. This is equivalent to
areas 3 and 5 in the diagram.
55) A negative externality is a cost which occurs in the production of a good that falls on a third party. The third party does
not benefit either from the production or the consumption of the good. For example, suppose coal is produced in the
Hunter Valley of New South Wales and exported to China. Most of the residents of the Hunter Valley do not benefit
from either the consumption or the production of the coal, but must bear a third party cost from the pollution
associated with the mining.
56) A public good has the characteristics of non-excludability and non-rivalry. This means that firstly it is not possible to
provide a good or service to one person without it being available for others and secondly that the consumption of a
good by one person will not prevent others from enjoying it. Together these imply that public goods will not be
provided by the market. Examples include national defence and street lights.
Merit goods, on the other hand, are excludable and rival. You can prevent others from consuming them and if one
person consumes the good or service, others can be prevented from doing so. A merit good is a good that the
government feels that consumers undervalue and hence it will be under-consumed if it is not provided free or
subsidised. Examples include healthcare and education. Despite being provided by the government, they are not
public goods.
57) 1. To take account of the existence of externalities
2. To subsidise merit goods
3. To provide for the production of public goods
4. To offset the imperfect information available to individuals and firms
5. To correct imperfections in markets
58) An individual using a smoke detector may lead to early fire detection, thus preventing fire spreading to other houses,
and therefore benefiting others who were not involved in the purchase of the smoke detector. To internalise the
externality, a subsidy could be provided which would increase the quantity of smoke detectors demanded to more
closely reflect the socially efficient level.
59) (a) ii (b) iii (c) i
60) TRUE
61) TRUE
62) FALSE
63) TRUE
20
Answer Key
Testname: C7

64) TRUE
65) FALSE
66) TRUE
67) TRUE
68) TRUE
69) TRUE
70) FALSE
71) FALSE
72) FALSE
73) TRUE
74) TRUE
75) TRUE
76) FALSE
77) FALSE
78) TRUE
79) FALSE
80) Many economists believe higher education is a good with positive externalities so that the social benefits exceed the
benefits to the individuals who undertake higher education. If this is indeed the case, the quantity of education
provided by the market would be less than the socially efficient outcome. Higher education could therefore be
subsidised in order to increase the quantity consumed, or, as in former times in Australia, the government might
decide to simply provide the good free of charge. Some reasons for this decision included protecting students from
poor decision making by their parents; ensuring the workforce was well skilled and providing equality of opportunity
to all Australians.
81) Where production of a good also involves pollution, economists describe the pollution as an externality. It is an
external cost to society. The quantity of the good produced is therefore said to be greater than the socially optimal
quantity because the external cost of the pollution is not included in the firm's production costs. By levying a tax equal
to the cost of the pollution, the firm can be forced to internalise the cost. Students can draw a diagram similar to Figure
7.5 on page 167 of the text to illustrate this theoretical approach. The problem in practice is that costs of pollution are
difficult to calculate accurately in order to levy the tax. There are many different types of pollution, which would all
have to be separately measured according to their costs to society. Sometimes it might be theoretically possible to
calculate costs of pollution, for example, in terms of health care costs incurred, but in practice this is normally
impossible. Governments therefore often prefer approximate taxes or more simply, anti pollution legislation.
82) There are major externalities associated with the environment, meaning that the costs of using it to pollute are
invariably borne by others. The marginal social cost is larger than the private cost and hence it is overused. It also has
elements of a public good as many parts of the environment are not privately owned, they are non-excludable and
hence overused. Most environmental resources, however, are scarce and therefore also rivalrous in consumption.
Ignorance is also a market failure here, as much environmental damage has been done without knowledge, e.g. the use
of aerosols before the 1980s. Even if companies want to take action to counter environmental damage, factors of
production are relatively immobile in the short run, hence time lags will be an issue. There is also the problem of the
costs of environmental damage not being truly felt until the long term, whereas the benefits of using/damaging the
environment are much more immediate. We place a larger value on the short-term benefits than on the long-term
costs, hence there is a trade-off.

21
Answer Key
Testname: C7

83) The appropriate government department uses available scientific evidence to determine an acceptable level of carbon
emissions for the nation as a whole, both in the present, and in terms of reductions over time. Individual carbon
emitting entities are then allocated an allowed emission level for the present, which is normally reduced over time.
Divisible permits are then allocated on the basis of the allowed emissions. If firms are able to reduce their emissions
below the allocated level, they are able to sell their unused permits in tradeable permit markets. The permit prices
should be determined by the interaction of demand and supply in the market for tradeable permits.
Firms which can reduce emissions relatively cost effectively have an incentive to do so in order to profit from the sale
of their permits. Those firms in industries where costs of emission reduction are higher may emit beyond their
allocations by buying additional permits. This results in efficiency in emission reduction.
84) In the model of perfect competition, market participants are assumed to be well informed with respect to the price and
characteristics of the products they purchase and are therefore able to make well informed decisions. In reality,
consumers are often ill informed and therefore make less than optimal decisions. This could be because some goods are
complex, or consumers buy them infrequently, or are confused by misleading advertising. Governments may try to
remedy this, for example, through high taxes on goods which are harmful such as cigarettes.
85) Public goods are characterised by being non-rival and non-excludable. Non-rivalry means that the consumption by
one person does not deplete the quantity of the good available for others. Non-excludability means non-payers cannot
be excluded from consumption and leads to the free-rider problem. Free-riders are non-payers who 'free-ride' on the
payment of others. Private firms are therefore unlikely to earn a profit providing such goods, and hence they are often
provided by the government.

22