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2. ‘The existence of externalities is neither a necessary nor a sufficient condition for government
intervention to achieve efficiency in the economy.’ [25]

Externalities are effects on third-parties that is people not directly involved in making a decision. These
effects can be beneficial thus positive externalities or can be harmful thus negative externalities. Private
individuals often ignore the effects of their activities on third parties and thus it is necessary for
government to step up through some corrective actions thus government intervention. However,
government intervention does never sufficient to guarantee efficiency. Efficiency in economics means
that it is not possible to make

someone better-off without make someone worse off thus productive and allocative efficiency.

In case of a negative externality, the market for a demerit good like cigarettes results in
overconsumption and overproduction since consumers ignore external costs such as effects on non-
smokers who smoke passively hence, they overvalue the product.

Also, in case of a merit good, consumers ignore external benefits such as higher GDP hence they
undervalue the product resulting in underproduction and underconsumption.

It is therefore necessary for government to correct this resource misallocation through some measures
like taxation, nudging, prohibition for demerit goods and nudging, subsidies and direct provision in case
of a merit good.

Taxing demerit goods like cigarettes discourage consumption by making them expensive. This may not
be sufficient since consumers may be addicted and their demand will be inelastic or they may opt for
more dangerous substitutes. Also, due to smuggling people evade tax.

Subsidizing merit goods like education encourage schooling by making it affordable. This may not work if
the governments do not have funds and it may need to increase taxes resulting in inefficiencies as
higher income tax is a disincentive to invest or to work.

Nudging influence behavior by persuading and empowering people on the benefits of education and
harmful effects of smoking so that consumers consider the externalities in making their consumption
decisions. And as such the market tends to move towards a socially desirable outcome where MSC =
MSB.
However, nudging may not result in a socially desirable outcome of allocative efficiency (MSC =MSB) as
some people may not be interested in schooling or to quit smoking even if they know the effects thus
willful ignorance.

Therefore, government intervention is a necessary but not sufficient condition to achieve efficiency. To
be specific taxes alone are not enough to discourage consumption of demerit goods due to smuggling as
an example. Subsidies may not be useful due to lack of funds. Also, it is technically difficult to estimate
the size of a tax or subsidy that restore efficiency. Thus, being necessary there is need to support taxes
and subsidies through nudging so as to improve the operation of the price mechanism rather than direct
provision. Also, the extent to which the government can enforce taxation or make funds available
determine how sufficient the intervention is.

Oligopoly refers to a market that is dominated by a few large firms of similar but differentiated products
such as aircraft manufacturers. In some cases, the products can be homogeneous for example oil
producers' case.

4 (a) Consider whether in oligopoly the theory proposes that the market price is rigid. [12]

In non-collusive oligopolies the theory talks of strategic interdependence which results in a kinked
demand curve thus price is rigid at the kink. Strategic interdependence means that a firm anticipate the
reaction of other firms before making a decision on price for example.

In particular, when firms compete for market share to maximize revenue one can neither increase or
decrease price as he anticipates that competitors match a price cut and do not follow a price increase
resulting in a zero-sum game thus rigid market price.

However, in case of oligopoly price rigidity may not hold. Thus, firms may form a cartel thus agree to fix
price and adjust output and, in this case, there is no guarantee of a rigid market price.

Nonetheless in non-collusive oligopoly interdependence may not always hold as price wars are usually
evident. Also, predatory and limiting pricing is evident which means the market price is not always rigid
either way.
(b) ‘Mergers of firms in the same industry are against the public interest. It is better that firms remain
small.’

Discuss this opinion [13]

A merger occurs when two firms agree to operate as one firm thus combine operations. Public interest
means welfare improvement in particular lower price and higher output due to efficiency or lower cost.

Firms usually merge to achieve growth so that they survive price competition as they enjoy economies
of scale and it is against public interest when they grow to an extent of dominating the market thus
exploit customers by charging high prices and restricting output.

In favor of public interest, a merged firm may result in resource sharing which generate efficiency for
example sharing expertise. As such the society benefit from lower prices due to elimination of wastages.
Also, the merged firm may get cheaper loans as its risk profile entice banks. Moreover, the merged and
grown firm get discounts on raw materials resulting in lower costs among other things. These economies
of scale benefits are not enjoyed when a firm remains small.

However, a merged firm may become too big such that its operating costs may increase to an extent
that a firm may need to charge higher prices to survive. For example, coordination becomes a problem.
Communication problems and slow decision making are examples of such problems.

Therefore, a merger is against public interest when it results in welfare loss thus exploitation of
customers due to market power and diseconomies of scale. Otherwise, economies of scale and greater
profits may result in lower prices as research and development becomes more feasible as well.