Chapter-15 Part-4 

Aplia Homework: The Shortcomings of Free Markets

1. Externalities

If the consumption of a good generates beneficial externalities, then which of the following is correct?

            Market forces may lead to an under allocation of resources to production of the good.

            The government can subsidize consumption of the good to increase efficiency.

            Both of these answers are correct.

2. Externalities - More practice

Hilary gives tap-dancing lessons late at night in her room on an upper floor of a densely populated dormitory. The dancing involves very loud tapping on the floor.

Which one of the following is true of the annoying tapping noises?

            They will generate a detrimental externality.

            They will generate both beneficial and detrimental externalities.

            They will generate a beneficial externality.

            They will not generate any externalities.

3. Externalities - Definition and examples

An externality arises when a firm or person engages in an activity that affects the well-being of a third party, yet neither pays nor receives any compensation for that effect. If the impact on the third party is positive, it is called a _________ externality.

The following graph shows the marginal social benefit and marginal social cost curves for a good with this type of externality. The dashed drop lines on the graph reflect the free market price and quantity for this good.

Shift one or both of the curves to reflect the presence of the externality. (Hint: If there are incidental costs, then you should shift the marginal social cost curve (MSC) curve to reflect the incidental costs associated with the good; similarly, if there are incidental benefits, then you should shift the marginal social benefit curve to reflect the incidental benefits.)

Note: Select and drag one or both of the curves to the desired position. Curves will snap into position, so if you try to move a curve and it snaps back to its original position, just drag it a little farther.

With this type of externality, in the absence of government intervention, the free market quantity produced will be _______ than the socially optimal quantity.

Which of the following generate the type of externality previously described? Check all that apply.

            Jake has planted several trees in his backyard that increase the beauty of the neighbourhood, especially during the fall foliage season.

            Your roommate, Rosa, has bought a puppy that barks all day while you are trying to study economics.

            The city where you live has granted a permit to put a movie theater in your neighbourhood, causing traffic jams at night and on weekends.

            A leading electronics manufacturer has discovered a new technology that dramatically improves the picture quality of plasma televisions. Firms of all brands have free access to this technology.

4. Efficiency in the presence of externalities

Cars impose many incidental costs on society: carbon dioxide emissions that contribute to air pollution, congestion on roadways, and so on. Therefore, the market equilibrium quantity of cars is not equal to the socially optimal quantity. The following graph shows the marginal private benefit (MPB) for cars, the marginal private cost (MPC) of cars (the private cost of producing them), and the marginal social cost (MSC) of cars, including both the marginal private cost and incidental costs.

Use the black point (plus symbol) to indicate the market equilibrium quantity. Then, use the purple point (diamond symbol) to indicate the socially optimal quantity.

Which of the following policies could help the government achieve the efficient outcome? Check all that apply.

            Offer a subsidy equal to the price at the efficient outcome

            Implement tradable pollution permits

            Introduce emission taxes

            Offer a subsidy to producers equal to the vertical distance between the marginal private benefit curve and marginal social benefit curve

            Offer a subsidy to consumers equal to the vertical distance between the marginal private benefit curve and the marginal social benefit curve

5. Externalities and efficient resource allocation

The following graph shows the production possibility frontier (PPF) for an economy that produces two goods, X and Y. Assume that goods X and Y are substitutes.

Suppose the free market selects allocation M, but the socially optimal allocation (the one that sets marginal social benefit equal to marginal social costs) is allocation N. Which of the following statements is consistent with this? Check all that apply.

            The market price of good X is too low relative to the market price of good Y.

            The market price of good Y is too low relative to the market price of good X.

            Good Y generates detrimental externalities.

            Good X generates detrimental externalities.

Suppose the government decides there is too much production of good Y and too little production of good X. It decides to levy a tax on each unit of good Y produced and use that money to fund public education.

On the following diagram, assuming goods X and Y are substitutes, show the effect of this policy on the market for good X.

Note: Select and drag one or both of the curves to the desired position. Curves will snap into position, so if you try to move a curve and it snaps back to its original position, just drag it a little farther.

Which of the following are possible results of a tax levied on each unit of good Y produced? Check all that apply.

            The price producers receive for selling good Y rises relative to the price they receive from selling good X.

            The economy shifts production from point M to point L.

            The price producers receive for selling good Y falls relative to the price they receive from selling good X.

            The economy continues to produce at point M.

6. Delectability and excludability

A good is not delectable if:

            One person's benefit from the good does not reduce the benefit available to other people.

            Those who are unwilling or unable to pay for the good do not obtain its benefits.

            The quantity of the good is affected by the price a consumer pays for the good.

            It is not possible to prevent an individual from using the good.

7. Market failure associated with public goods

Public goods are sometimes funded voluntarily, but in other cases, they must be provisioned through alternative means. For example, the government approach to providing public goods is usually to:

            Use taxes or regulations to limit production of the public good

            Rely on the invisible hand to solve the problem through voluntary trade

            Hold a lottery in which one of a number of firms is designated randomly as the only supplier of the public good

            Provide the public good directly, paying for it out of tax revenues

8. Allocation of resources between present and future

A carpenter is deciding whether to purchase a new power drill. The drill costs $250 and has a useful life of just one year. The expected revenue from the drill is $275, which means the expected profit is $25.

Use this information to fill in the table. Determine whether or not the carpenter should purchase the drill at the stated interest rate.

The preceding example demonstrates how the interest rate can allocate resources among different time periods. However, economists have questioned the effectiveness of this mechanism for the efficient allocation of resources in practice.

Which of the following are reasons for such doubt? Check all that apply.

            Governments frequently manipulate interest rates to affect consumption and investment.

            Economic prosperity has widely fluctuated from one decade to the next.

            People do not give adequate weight to the future when making economic decisions today.

9. Problems in insurance markets

Consider the following story:

The economic problem in this story is known as:

            Rent seeking

            Adverse selection

            Moral hazard

            Free-rider problem

10. A principal-agent problem: A case of shirking

Caroline sells bottled water from a small stand by the beach. On the last day of summer vacation, many people are on the beach, and Caroline realizes that she can make a lot more money this day if she hires someone to walk up and down the beach selling water. She finds a college student named Antonio and makes him the following offer: They'll each sell water all day and split their earnings equally at the end of the day. Caroline knows that if they both work hard, Antonio will earn $110 on the beach and Caroline will earn $240 at her stand, so they will each take home half of their total revenue: $110+$2402=$175. If Antonio shirks, he'll generate only $60 in earnings. Caroline does not know that Antonio estimates his personal cost (or disutility) of working hard as opposed to shirking at $30.

Once out of Caroline's sight, Antonio faces a dilemma: work hard (put in full effort) or shirk (put in low effort).

In terms of Antonio's total utility, it is worse for him to ________.

Taking into account the loss in utility that working hard brings to Antonio, Caroline and Antonio together _______ better off if Antonio shirks instead of working hard.

Caroline knows Antonio will shirk if unsupervised. She considers hiring her good friend Carrie to keep an eye on Antonio. The most Caroline should be willing to pay Carrie to supervise Antonio, assuming supervision is sufficient to encourage Antonio to work hard, is ________.

It turns out that Caroline's friend Car rue is unavailable that day, so Caroline cannot find a reliable person to watch Antonio. Which of the following arrangements will ensure that Antonio works hard without making Caroline any worse off than she is when Antonio shirks?

            Pay Antonio $20, regardless of how many bottles of water he sells

            Make Antonio promise to work hard

            Allow Antonio to keep 57% of the revenue from the bottles of water he sells instead of 50%

            Allow Antonio to keep 75% of the revenue from the bottles of water he sells instead of 50%

11. The cost disease of personal services

Everyone on the small island of Narcissus is very concerned with image. In fact, the island has only two industries: beauty salons and shirt manufacturing. It exports its (extremely fashionable) shirts to the rest of the world, and imports the rest of the goods it needs (food, energy, gel, mousse, and so on). The world price of Narcissi an shirts is constant at $120.

Over the past few years, advances in the technology of shirt manufacturing have doubled the shirt-manufacturing capacity of the island. However, the number of haircuts that can be given in beauty salons is limited by the fact that haircuts are personal services; hence, given the same population, exactly the same number of haircuts can be produced as before.

The following graph shows the daily production possibilities frontier (PPF) of this economy before and after the technological advance:

Suppose the economy is producing 1,000 haircuts a day. Before the technology improvement, the opportunity cost (in dollar amount of lost exports) of producing another thousand haircuts each day (that is, moving from point M to point L) was _________ per day.

After the technology improvement, the opportunity cost (in dollars of lost exports) of increasing production from 1,000 haircuts to 2,000 haircuts each day (that is, moving from point Y to point X) was ________ per day.

The fact that a technological improvement has allowed twice as many shirts to be made for any given quantity of haircuts means that:

            The price of both haircuts and shirts has doubled.

            The price of a haircut has doubled relative to the price of a shirt.

            The price of both haircuts and shirts has been cut in half.

            The price of a shirt has doubled relative to the price of a haircut.