Questions for Review with Answers
Chapter 17. Markets and the Government I.
Microeconomic Policy to Correct Market Failure
I. Basics
Chapter 17 – Question 1
Explain why market failure is synonymous with inefficiency.
* Inefficiency takes various forms: Wrong prices that do not equal marginal utility of buyers or marginal costs of producers. Firms do not minimise costs or do not produce maximum output. The result of all these failures is that total surplus is not maximised.
II. Non-Private Goods
Chapter 17 – Question 2
Do you think that knowledge is a public good?
* Knowledge fulfils one of the criteria for public goods: If you convey your knowledge to me, your knowledge does not diminish. Whether it fulfils the second criterion -that public goods can be supplied to everybody or to nobody - is more difficult to say. But it can be argued that, if you give your knowledge to me, you cannot hinder me from conveying it to other people. And the Web has, of course, made knowledge almost non-excludable.
Chapter 17 – Question 3
Distinguish common-property resources and open-access resources.
* Common-property resources are under a collective property regime; open-access resources belong to nobody or everybody and are not regulated.
III. The Infrastructure
Chapter 17 – Question 4
Why is a country's infrastructure of such vital importance to the economy?
* It is of vital importance because it makes indispensable goods like electricity and water nation-wide available and enables nation-wide communication and transportation. As a result, every place becomes accessible and usable for business.
Chapter 17 – Question 5
Why would the private sector fail to provide all the necessary facilities?
* The private sector cannot provide them because its behaviour is guided by the profit motive. The initial investments required are extremely costly; they also require eminent domain. Moreover, competition, which is another hallmark of business behaviour, would be wasteful. The private sector can, however, operate these facilities once the government has set them up.
IV. Externalities
Chapter 17 – Question 6
Define positive and negative externalities and the economic problem they cause.
* Externalities are side-effects that affect bystanders. The economic problem they cause is that they lead to wrong prices. Negative externalities are not included in prices. Positive externalities create a free-rider problem, which violates a very fundamental economic principle: There is no such thing as a free lunch.
Chapter 17 – Question 7
And explain the Coase theorem.
* The Coase theorem suggests that private negotiations are superior to government regulation. This requires that rights are clearly defined. A victim of a polluter can sell him the right to pollute - if the polluter does not have it - or buy it from him if he does have it.
V. The Environment
Chapter 17 – Question 8
Try to list everything that makes up the environment.
* In a narrow sense, it stands for nature. It includes the fauna, the flora, all water, all land, the atmosphere, the air. But ultimately, the environment is an anthropocentric concept; it consists of everything that environs humans. Therefore, in a wider sense, it includes man-made urban and industrial surroundings.
VI. Market Power
Chapter 17 – Question 9
Why are firms with market power inefficient?
* Because they do not obey the marginal-cost-pricing rule and hence do not maximise total surplus.
VII. Asymmetric Information
Chapter 17 – Question 10
Please define the following terms:
A. principal and agent
B. moral hazard
C. signalling
D. screening
E. adverse selection.
* A. A principal is a person who expects an agent to do something on his behalf.
* B. Moral hazard stands for a principal's risk to be cheated by the agent.
* C. Signalling is done by the party that has more information. An example of signalling is advertising.
* D. Screening is done by the party with less information. An example of screening is the requirement that job applicants need not only submit their diplomas but also recommendation letters from their instructors.
* E. Adverse selection is the effect of cheating on people who are not directly involved in a deal, for instance, people who do not buy insurance because the cheaters have driven up its price.
Chapter 17 – Question 11
Explain why asymmetric information is part of the human condition and give three examples.
* In almost any human relationship, one party is, in some respect, superior to the other. This applies in particular to economic relationships. In general, sellers and employers are in superior positions.
Some examples: Teacher/student, seller/buyer, physician/patient, lawyer/client.
Chapter 17 – Question 12
Give three examples of principal-agent relations.
* Employer/employee, insurance company/insured individual or firm, shareholder/manager.
VIII. Microeconomic Policy to Correct Market Failure
Chapter 17 – Question 13
Please define the following terms:
A. internalising externalities
B. socialising externalities
C. Pigovian tax.
* A. Internalising negative externalities means imposing a tax on them. They then become internal costs of the perpetrator.
* B. Socialising costs means spreading the costs of positive externalities over the whole of society. A subsidy for R&D for instance spreads a firm's costs over all taxpayers, many of whom benefit from its spill-over effect.
* C. Pigovian taxes are sin taxes.
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