Unit 6 · 8 to 13% of the exam

Unit 6 practice test: Market Failure and the Role of Government

twelve questions, every option explained

12 exam-style questions from the unit, free, with an explanation for every option. Most are multiple choice, as on the real exam; a few ask for a number or have you shift a curve on a graph, and sets share one data table, graph or scenario. Covers: Socially Efficient and Inefficient Market Outcomes; Externalities; Public and Private Goods; The Effects of Government Intervention in Different Market Structures; Inequality.

Start at question 1

Scenario

Four situations in an invented city

(1) A cement plant's dust settles on cars nearby. (2) Students who get a flu shot also make their classmates less likely to fall ill. (3) A gardener's flower beds, planted for her own business, make the whole street nicer to walk along. (4) Late-night fireworks bought for private parties keep neighbors awake.

1. In the scenario, which situation is a positive consumption externality?

  1. (1) the cement dust
  2. (2) the flu shots
  3. (3) the flower beds
  4. (4) the fireworks
Show the answer

Sort by two questions: does it help or harm others, and does it come from making the good or from using it?

  • (1) the cement dust: That is a cost from production: a negative production externality.
  • Correct: (2) the flu shots: Right: using (consuming) the shot benefits other people.
  • (3) the flower beds: That benefit comes from a firm's production: a positive production externality.
  • (4) the fireworks: That is a cost from consumption: a negative consumption externality.

2. In the scenario, for situation (4), how do MSB and MPB compare, and what does the market do?

  1. MSB is above MPB, so the market buys too few fireworks
  2. MSC is above MPC, so the market buys too many fireworks
  3. MSB equals MPB, so the market is efficient
  4. MSB is below MPB, so the market buys too many fireworks
Show the answer

A negative consumption externality puts MSB below the demand curve (MPB), so the market quantity exceeds the efficient quantity.

  • MSB is above MPB, so the market buys too few fireworks: That would be a benefit to others, not a cost.
  • MSC is above MPC, so the market buys too many fireworks: The cost comes from using the fireworks, not making them, so it is shown on the benefit side.
  • MSB equals MPB, so the market is efficient: The neighbors bear a cost that buyers ignore.
  • Correct: MSB is below MPB, so the market buys too many fireworks: Right: the neighbors' lost sleep is a cost of using the good, so society's benefit is less than the buyers'.

3. In the scenario, which policy is matched to the cause of the market failure in situation (2)?

  1. A per-unit subsidy to people who get the shot
  2. A per-unit tax on flu shots
  3. A lump-sum payment to clinics whatever number of shots they give
  4. A price ceiling on flu shots below the market price
Show the answer

The external benefit comes from consumption, so pay buyers per unit: the subsidy shifts demand to MSB.

  • Correct: A per-unit subsidy to people who get the shot: Right: it raises buyers' benefit to match MSB, so more people get the shot.
  • A per-unit tax on flu shots: A tax would lower the quantity, but the market already makes too few.
  • A lump-sum payment to clinics whatever number of shots they give: A payment that does not depend on the number given does not change the quantity.
  • A price ceiling on flu shots below the market price: A binding ceiling cuts the quantity supplied, moving further from the efficient quantity.

Scenario

Changes on the island of Corrin

On the invented island of Corrin: (1) workers with technical training see their wages rise much faster than other workers' wages; (2) the island starts sending monthly payments to households with very low incomes; (3) a few families pass large fortunes to their children, who earn income from the land and businesses they inherit.

4. In the scenario, which change is a transfer payment?

  1. (1) faster wage growth for trained workers
  2. (2) monthly payments to low-income households
  3. (3) inherited land and businesses
  4. (1) and (3) together, since both change income
Show the answer

Transfer payments, such as cash aid to low-income households, change the distribution of income after taxes and transfers.

  • (1) faster wage growth for trained workers: Wages are payments for labor, earned in a factor market.
  • Correct: (2) monthly payments to low-income households: Right: money paid by the government with no good or service given in return.
  • (3) inherited land and businesses: An inheritance passes wealth within a family; it is not a government payment.
  • (1) and (3) together, since both change income: Neither is a government payment: (1) is earned wages and (3) is inherited wealth.

5. In the scenario, how does change (1) affect Corrin's Lorenz curve, if nothing else changes?

  1. It moves toward the line of equality
  2. It does not change, because wages are not income
  3. It becomes the line of equality
  4. It bows further from the line of equality
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Differences in skills and training (human capital) are a major source of income inequality.

  • It moves toward the line of equality: The gap between trained and other workers grows.
  • It does not change, because wages are not income: Wages are most households' main income.
  • It becomes the line of equality: That would need every household to have the same income.
  • Correct: It bows further from the line of equality: Right: trained workers, already earning more, pull further ahead, so income is less equally shared.

6. In the scenario, change (3) is mainly an example of which difference?

  1. Wealth inequality, which also earns income
  2. A transfer payment from the government
  3. A regressive tax on the families' inheritance
  4. A rise in the wages of trained workers
Show the answer

Income is a flow earned over a period; wealth is a stock of assets. Wealth earns income, so the two inequalities are linked.

  • Correct: Wealth inequality, which also earns income: Right: inherited assets are wealth, and the rent and profit they earn is income.
  • A transfer payment from the government: The fortunes pass within families.
  • A regressive tax on the families' inheritance: Nothing in (3) is a tax, and inheriting is not taxed in the scenario.
  • A rise in the wages of trained workers: That is change (1).

7. Insulating a home also lowers neighbors' shared heating costs. At the efficient quantity of insulation, a unit's marginal social benefit is $13 and its marginal private benefit to the buyer is $10. What per-unit subsidy to buyers corrects the market, in dollars per unit?

Type a number. A four-function calculator is allowed, as on the exam.

Show the answer

A corrective (Pigouvian) subsidy equals the external benefit per unit at the efficient quantity: MSB - MPB = $13 - $10 = $3.

  • Answer: 3

8. Where is the socially efficient quantity of a good?

  1. Where total benefit is largest
  2. Where the price is as low as possible
  3. Where producers earn the most profit
  4. Where marginal social benefit equals marginal social cost
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Below the efficient quantity, each added unit is worth more than it costs; above it, less. Total surplus is largest at MSB = MSC.

  • Where total benefit is largest: Total benefit keeps rising while MSB is positive; the efficient point weighs cost too.
  • Where the price is as low as possible: A low price says nothing about whether each unit is worth its cost.
  • Where producers earn the most profit: Profit is the firm's goal, not society's; a monopoly's profit-maximizing quantity is too small.
  • Correct: Where marginal social benefit equals marginal social cost: Right: MSB = MSC.

9. What is an externality?

  1. A good that is sold to buyers in other countries
  2. A cost that a firm pays to its outside suppliers
  3. A cost or benefit of a deal that falls on people outside it
  4. A benefit a buyer gets from a good she pays for
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Because the third party is not part of the deal, the market ignores the effect, and the quantity is not efficient.

  • A good that is sold to buyers in other countries: That is an export.
  • A cost that a firm pays to its outside suppliers: A cost the firm pays itself is a private cost.
  • Correct: A cost or benefit of a deal that falls on people outside it: Right: a third party gains or loses without paying or being paid.
  • A benefit a buyer gets from a good she pays for: That is a private benefit, already in demand.

10. A good is nonrival when

  1. no one can be kept from using it, paid or not
  2. one person's use leaves no less for others
  3. it is provided by the government
  4. its price is set at zero
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Rival: my use leaves less for you. Nonrival: it does not.

  • no one can be kept from using it, paid or not: That is nonexcludable.
  • Correct: one person's use leaves no less for others: Right: many can use it at once, like a radio broadcast.
  • it is provided by the government: Who provides it does not define rivalry.
  • its price is set at zero: Price does not define rivalry.

11. A binding price ceiling lowers the quantity traded in a perfectly competitive market. Why can a price ceiling raise the quantity a monopoly sells?

  1. The ceiling raises the demand for the monopoly's good
  2. The ceiling lowers the monopoly's marginal cost
  3. A ceiling makes MR flat, so cutting output no longer raises price
  4. Monopolies can ignore price ceilings set below their own price
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A monopoly restricts output because selling more means cutting the price on every unit. A ceiling removes that reason up to the demand curve.

  • The ceiling raises the demand for the monopoly's good: A ceiling does not shift demand.
  • The ceiling lowers the monopoly's marginal cost: Costs do not change; the firm's marginal revenue does.
  • Correct: A ceiling makes MR flat, so cutting output no longer raises price: Right: up to demand, each unit sold earns the ceiling price, so MR = ceiling, and the firm produces where MC meets it.
  • Monopolies can ignore price ceilings set below their own price: The firm must obey the ceiling; it changes the firm's best output.

12. What does a Lorenz curve show?

  1. How one household's income changes over the course of its lifetime
  2. The tax rate paid at each level of income
  3. Cumulative income shares held by cumulative shares of households
  4. The number of households at each level of income
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If every household had the same income, the Lorenz curve would be the diagonal line of equality.

  • How one household's income changes over the course of its lifetime: It is a snapshot across households, not over time for one household.
  • The tax rate paid at each level of income: Tax rates are shown in a tax table; the curve shows shares of income.
  • Correct: Cumulative income shares held by cumulative shares of households: Right: each point says what percent of income the lowest x percent of households hold.
  • The number of households at each level of income: That would be a bar chart of incomes, not cumulative shares.