Test Questions with Answers
Chapter 17. Markets and the Government I.
Microeconomic Policy and Market Failure
Chapter 17 ― Question 1
What does non-rivalness stand for? Give an example.
* Non-rivalness means that your use of a commodity does not diminish my use. Defence and street lightning are examples.
Chapter 17 ― Question 2
Explain why, if there are negative externalities, there is a difference between optimum price and output on the one hand and market equilibrium price and output on the other.
* Negative externalities are costs that are not paid by the people who cause them, for instance by the people who produce certain goods. As a result, these goods are underpriced, which raises demand for them.
Chapter 17 ― Question 3
Explain why private solutions suggested by the Coase theorem often do not work.
* There are various reasons: Often too many people are involved, which makes reaching agreement difficult. In other cases, transaction costs such as the fees of lawyers are too high. Very often people are not willing to pay a price for a solution to which they have an entitlement. And very often spite or hatred prevent an agreement.
Chapter 17 ― Question 4
Why is the market not efficient in supplying non-excludable, non-rival goods?
* Markets can only work where a good changes hands for a price. Who should pay the price for defence and how much should people be expected to pay? Goods like defence and street lightning are, of course, provided by free enterprise. But they are paid for by the government, i.e. by tax payers.
Chapter 17 ― Question 5
If the price charged for a good does not cover the negative externalities it causes, which of the following will happen
- the quantity produced will not be sufficient
- the quantity bought will be low
- too much of the good will be produced
- the price of the good will be lowered
*C. If the price were raised to include externalities, quantity supplied would decline in response to declining demand.
Chapter 17 ― Question 6
Define asymmetric information
* The parties to a contract do not have the same amount of information.
Chapter 17 ― Question 7
Define adverse selection.
* It stands for a decision that is adverse to the interests of the people taking the decision.
Chapter 17 ― Question 8
Explain the famous lemon example of adverse selection.
* The lemon is a one-year old car. Compared with new cars, one-year old cars are relatively cheap. But people are reluctant to buy them. They fear that the cars are sold so early because they have some hidden defects.
Chapter 17 ― Question 9
What can the government do to internalise external costs generated by an industry whose firms produce negative externalities?
- It can grant subsidies to firms
- It can set a price ceiling for the firms' products
- It can set a price floor for the firms' products
- it can correct the overallocation of resources to this industry by imposing a tax on firms
*D. Answer C is wrong because price floors are set to protect suppliers, not to penalise them.
Chapter 17 ― Question 10
Describe the consequences of the following for insurance markets
- asymmetric information
- adverse selection
- moral hazard
*1) People who buy insurance tend to misinform insurance companies about their problems and risks.
*2) Ultimately this behaviour drives up the price of insurance. As a result, other people buy less insurance than they should.
*3) The insurance company is seen as a principal suffering from moral hazard. People who have bought insurance are less cautious to avoid damages.
Chapter 17 ― Question 11
Moral hazard is in the main due to the fact that
- all people have a propensity to cheat
- complete control is never possible
- a principal is more likely to pursue his self-interest than an agent
- an agent is more likely to pursue his self-interest than a principal
*B.
Chapter 17 ― Question 12
The price of installing airbags is $1,000. A buyer of a car supposes airbags to reduce the risk of dying in an accident by 1/600. What value does he place on life if he has the airbag installed?
* $1,000 x 600 = $600,000. The rule is multiply the amount by the inverse of the reduction in risk.
If you like, print this page for offline comparison or studying.