The Limits

of Markets 14
Multiple Choice
1 B* 6 A* 11 C
2 C 7 B 12 B
3 C 8 B 13 D
4 A 9 C 14 D
5 D 10 B* 15 C
*Indicates that an enhanced answer has been provided in the section below.

Enhanced Answers
1 B Government intervention in markets is most likely to aim to improve resource allocation and achieve
economic stability. Governments generally do not want to reduce positive externalities, only
negative externalities, so (A) is not correct. Governments generally aim to redistribute income to
lower income earners rather than higher income earners, so (C) is not correct. Finally, while
governments may want to reduce prices they generally want to increase rather than reduce
competition, so (D) is not correct.

6 A A natural monopoly is a market structure in which goods can only be efficiently provided by one
supplier, usually because the investment in infrastructure required to operate in that market
constitutes a barrier to market entry. This is true for Sydney Water, because of the huge investment
required in water storage and distribution (pipes) to households. This is not true of banks (B), of
which Australia has several; it is not true of internet service providers such as Dodo (C), who each
pay for access to communications networks; and it is not true of Qantas, because although the cost
of airplanes constitutes a barrier to entry in the aviation sector, the industry is still large enough to
support several airlines.

10 B This question asks for an example of an intervention in the market which helps to reduce inequality
in the distribution of income. The best answer is (B), since the imposition of a higher national
minimum wage increases income for workers on the lowest pay rate. This is a better answer than
(A) limiting the abuse of market power, since this is not directly related to the distribution of income
in the economy. It is also a better answer than (C), since a reduction in childcare subsidies may have
a negative impact on lower income earners who need to access childcare in order to balance work
and family responsibilities. It is also a better answer than (D), since policies to reduce negative
externalities are not directly related to the distribution of income in an economy.

Short Answers
Question 1
(a) Governments might use a macroeconomic policy to smooth the business cycle and influence
the level of economic growth if it is either above or below a sustainable rate. This might be
achieved by changing the level of interest rates, government spending or tax rates. These
measures are more effective in influencing the business cycle than microeconomic policies
which are designed to improve allocative, dynamic or technical efficiency in the economy,
such as through competition or trade policy.

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 The Market Economy Eighth Edition Workbook Chapter 14: The Limits of Markets

(b) High levels of economic inequality is sometimes regarded as a market failure, because firms
can use market power to raise prices in goods markets or contain wage levels in labour
markets. This can contribute to lower levels of economic growth, productivity and economic
development. High levels of inequality tend to become entrenched, with multiple forms of
disadvantage resulting in lower levels of social mobility (that is, fewer people are able to move
from lower income to higher income groups). For example, individuals who grow up in poverty
are less likely to be able to access a good quality education, to acquire skills or join networks
where they get opportunities for jobs.

(c) In a modern market economy, the price mechanism determines what goods are to be
produced and in what quality and at what price point. The price mechanism considers only the
private costs and benefits associated with a transaction and does not take into account wider
social costs and benefits of production. This leads to market failure, where the price
mechanism fails to properly reflect the social costs and or benefits of transactions. The costs
and benefits that are not incorporated by the price mechanism are known as externalities as
they are external to the price mechanism. Externalities can take two forms. Positive
externalities are unintended positive outcomes of economic activity while negative externalities
are unintended negative outcomes of economic activity.

(d) A government might intervene in the market economy and place a tax on pollution in order to
reduce the amount of pollution and its negative impact on the environment. By imposing a tax
on the production or use of a particular good, the private costs for the firm increase as does
the price of the good itself. In essence, the government aims to internalise a negative
externality into the price mechanism, to make it reflect the real costs associated with
production. The increase in costs for firms creates an incentive for firms to look to alternative
production methods that might reduce the negative externality of pollution.

Question 2
(a) Exclusive dealing occurs when a firm imposes conditions that prevent a supplier from dealing
with a competitor firm. This is a form of market conduct that is prohibited under the
Competition and Consumer Act 2010.

(b) There are a number of ways in which firms may abuse their market power. In order to
counteract market failure in the abuse of market power, the government could operate its own
monopoly. The government has historically operated many monopolies in Australia in order to
protect consumers from the abuse of monopoly power by private firms. For example, two
industries which are imperative for any functioning society, water and communications, are
both industries in which the Government operates natural monopolies, that is, Sydney Water,
Australia Post and NBN Co. In essence, governments that operate natural monopolies
generally try to set a fair price that ensures consumers cover the costs of providing the good,
but are not subject to exploitation such as when a monopolist uses their market power to
increase prices.

(c) A recession refers to a situation in which an economy experiences two consecutive quarters
of a fall in output, as measured by gross domestic product (GDP). In order to stimulate growth,
the government might intervene through economic stabilisation policies, also known as
macroeconomic policies, such as fiscal policy and monetary policy. The government could use
its fiscal policy to increase economic growth through increased government spending, or
through providing tax cuts. In addition, by lowering interest rates through monetary policy,
individuals may be encouraged to consumer spending, and firms may increase investment.
These measures can help increase growth and end a recession.

(d) The free market distributes income according to the value of each individual’s contribution to
the production process, reflected by his or her wage. Within the free market those with higher
skills and more experience are likely receive a higher share of income compared to those with
low skill levels who will generate less income. With the forces of supply and demand operating,
people who are sick or injured, older people, and people with disabilities would have very low
incomes because they can make limited contributions to the production process. Without
government intervention to improve the distribution of income, inequality would be much
greater. The government can improve the distribution of income by increasing the level of
minimum wages, through progressive income taxation and by providing service and welfare
payments such as the age pension.

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 The Market Economy Eighth Edition Workbook Chapter 14: The Limits of Markets

Question 3
(a) In equilibrium, the free market will provide QE units of the drug at a price of PE per unit.

(b) The government has imposed a price ceiling at Pmax below the equilibrium price PE, with the
effect that the prices for pharmaceutical drugs are artificially lowered and cannot increase
beyond Pmax.

(c) The impact of the government intervention is that the market is now in disequilibrium. Where
the price is below equilibrium (PE), the quantity of pharmaceutical drugs supplied by producers
will contract (to QP) whilst the quantity demanded will expand (to QC). There is likely to be
excess demand in the market and insufficient supply to satisfy the demand.

(d) Pharmaceutical drugs are merit goods, and have positive effects on the population (such as
preventing the spread of infectious diseases). They are also considered to be necessities,
especially in the case of treatments for life-threatening conditions. In some instances
pharmaceutical companies may have a monopoly on an essential medicine, so that without
price regulation they may set a market price that maximises profits but is very high for
consumers. For these reasons, governments may implement policies such as maximum prices
to make them more affordable for a wider range of people, such as the elderly or those
suffering from chronic health conditions.

(e) Governments might provide subsidies for the production of merit goods. A subsidy is where a
government pays money to producers so that they can increase the supply of merit goods,
leading to lower prices. For example, in Australia the Pharmaceutical Benefits Scheme (PBS)
subsidises many medicines. A government might also intervene in the market by producing
the merit good. For example, the government provides many merit goods such as education
and healthcare. This increases the supply of merit goods to the market.

Skills Revision Activity 1

Best government policy in order

Scenario to stabilise the economy (that is,
Fiscal, monetary, microeconomic)
The Reserve Bank is concerned that house prices are overvalued, Monetary Policy
due to borrowers taking out large mortgages at low interest rates

High taxes on wind turbines are preventing business investment Microeconomic policy (changing
in renewable energy and reducing job growth in the renewable industry tax settings to influence the
energy sector allocation of resources is generally
considered microeconomic policy,
even though they will often be
announced in the annual Fiscal
Policy statement – the Budget).
Australia is falling down the league tables of innovation, resulting Microeconomic Policy
in a long-term decline in international competitiveness

An appreciation of the Australian dollar caused by high Monetary Policy

interest rates has placed Australian exporters at a competitive
disadvantage, resulting in a downturn in the business cycle
Due to inadequate broadband capacity in many parts of Microeconomic Policy
Australia, the growth of digital economy businesses has been
slower than in comparable countries
Despite interest rates being close to record low levels, economic Fiscal Policy
growth remains weak with low levels of consumer spending and
business investment

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 The Market Economy Eighth Edition Workbook
Skills Revision Activity 2
A factory releases waste water into
a nearby river
There are no lighthouses to warn
ships of dangerous rocks in a
coastal area
A petrol station retail chain
demands that its suppliers do not
sell fuel to other retailers
A sharp increase in the level of
homelessness
A sharp increase in unemployment
due to a recession
Private companies cannot afford
to provide a national free-to-air
television news service
A sharp increase in the use of
e-cigarettes among younger
consumers is linked to increased
lung disease and several
unexplained deaths.
Two large retailers agree to
coordinate an increase in the price
of milk
Higher train fares encourage people
to drive to work
Two mobile phone companies
agree to submit artificially low bids
in a spectrum auction
As national income rises, higher
consumer spending leads to
inflation
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Type of market failure
Negative externality (pollution)
Because of the ‘free rider’
problem no firm will provide
this good; a public good is
needed
Exclusive dealing
Income inequality
Volatility in the business cycle
Because of the ‘free rider’
problem no firm will provide
this good; a public good is
needed
Demerit goods
Abuse of market power
(collusion)
Negative externality (pollution
and road congestion)
Abuse of market power
(collusion)
Economic fluctuations
Chapter 14: The Limits of Markets
How could the government
respond?
Regulation e.g. by imposing
environmental standards
The government could provide
lighthouses
The ACCC could investigate
and prosecute the firm for
anticompetitive conduct
Progressive income taxation
and transfer payments
Macroeconomic policy to
smooth business cycle
fluctuations
Government to fund a public
broadcasting news channel e.g.
ABC 24
Regulation of e-cigarettes
through measures such as
restricting their sale (e.g. to
over 18-year-olds), imposing
heavy taxation or prohibiting
their sale altogether.
Government agencies to
investigate and prosecute anti-
competitive conduct e.g. ACCC
Government to regulate
increases in train fares
Government agencies to
investigate and prosecute
anticompetitive conduct e.g.
ACCC
Macroeconomic policy to
smooth business cycle
fluctuations
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