Practice Questions Tutorial 4

Question 1

The baby bonus was a form of government intervention. Which market failure do you think the government was trying to correct with this bonus when they first introduced it, and how?

Answer 1

Babies have positive production externalities: Private cost to parents higher than cost to society, baby bonus is a corrective subsidy; Merit good: Government thinks people ought to have babies; Inequality: The poor need help?

Question 2

The demand curve for fire extinguishers slopes downward and the supply curve for fire extinguishers slopes upward. The production of the 500th fire extinguisher entails the following:
• a private cost of $10; 
• an external cost of $0; 
• a private value of $9; 
• an external benefit of $3.

(a) Does the production of fire extinguishers convey a positive externality, a negative externality, or neither?

Answer 2

The social value exceeds the private value, so the production of fire extinguishers conveys a positive externality. The social cost is equal to the private cost, so there is no negative externality.

Question 3

The demand curve for fire extinguishers slopes downward and the supply curve for fire extinguishers slopes upward. The production of the 500th fire extinguisher entails the following:
• a private cost of $10; 
• an external cost of $0; 
• a private value of $9; 
• an external benefit of $3.

(b) What is the social value of the 500th fire extinguisher?

Answer 3

The social value is equal to the private value plus the external benefit, so the social value of the 500 th fire extinguisher is $12.

Question 4

The demand curve for fire extinguishers slopes downward and the supply curve for fire extinguishers slopes upward. The production of the 500th fire extinguisher entails the following:
• a private cost of $10; 
• an external cost of $0; 
• a private value of $9; 
• an external benefit of $3.

(c) In order to reach the social optimum, should fire extinguishers be taxed or subsidised? What is the appropriate amount of the tax or subsidy on each fire extinguisher?

Answer 4

Each fire extinguisher should be subsidised by $3, which is the amount of the external benefit.

Tax or Subsidy should always equal externality

Question 5

The demand curve for fire extinguishers slopes downward and the supply curve for fire extinguishers slopes upward. The production of the 500th fire extinguisher entails the following:
• a private cost of $10; 
• an external cost of $0; 
• a private value of $9; 
• an external benefit of $3.

(d) Is the market-equilibrium quantity of fire extinguishers less than, equal to, or greater than 500? Explain.

Answer 5

For the 500th fire extinguisher, the private cost ($10) exceeds the private value ($9), so the market-equilibrium quantity is less than 500.

Question 6

The demand curve for fire extinguishers slopes downward and the supply curve for fire extinguishers slopes upward. The production of the 500th fire extinguisher entails the following:
• a private cost of $10; 
• an external cost of $0; 
• a private value of $9; 
• an external benefit of $3.

(e) Is the socially-optimal quantity of fire extinguishers less than, equal to, or greater than 500? Explain.

Answer 6

For the 500th fire extinguisher, the social value ($12) exceeds the social cost ($10), so the socially-optimal quantity is greater than 500.

Question 7

The demand curve for fire extinguishers slopes downward and the supply curve for fire extinguishers slopes upward. The production of the 500th fire extinguisher entails the following:
• a private cost of $10; 
• an external cost of $0; 
• a private value of $9; 
• an external benefit of $3.

(f) In order to maximise the total benefit of fire extinguishers to society as a whole, should the number of fire extinguishers produced be less than, equal to, or greater than 500? Explain.

Answer 7

For the 500th fire extinguisher, the social value ($12) exceeds the social cost ($10), so the socially-optimal quantity is greater than 500. The total benefit to society as a whole is maximised at the social optimum, so more than 500 fire extinguishers should be produced.

Question 8

The demand curve for fire extinguishers slopes downward and the supply curve for fire extinguishers slopes upward. The production of the 500th fire extinguisher entails the following:
• a private cost of $10; 
• an external cost of $0; 
• a private value of $9; 
• an external benefit of $3.

(g) Sketch a supply-demand diagram to demonstrate how the externality above leads to market inefficiency.

Answer 8

Photo in favourites 19/8/18

Question 9

Q3: Why are tradeable pollution permits considered to be a more efficient way to reduce pollution than Government regulation?

Answer 9

With regulations:
• no incentive for low abatement cost firms to reduce pollution if they are meeting the regulation;
• more firms can enter the industry and pollute within the regulations.

With tradeable permits:
• there is an incentive for low abatement cost firms to reduce their pollution and sell their permits to high abatement cost firms;
• the number of permits is fixed, pollution cannot increase with the entry of new firms.

Question 10

Should government always intervene when market failure exists? What are the general obstacles to successful intervention?

Answer 10

No - not necessarily.

Obstacles:
• government not informed enough to determine the correct amount and type of intervention needed;
• government may not always act in the public interest;
• the cost of appropriate and effective intervention may outweigh the benefit of correcting the failure;
• government may be accused of paternalism.