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Chapter 08
Market Failure versus Government Failure
True / False Questions
1. Externalities can be either positive or negative.
True False
2. Economists generally prefer direct regulation to incentive-based programs because explicit

regulation tends to be more efficient.
True False
3. Direct regulation means that government sets specific limits on the use of scarce resources.
True False
4. Economists are likely to oppose direct regulation because they do not believe there is any need
for government to take action when negative externalities exist.
True False
5. Economists tend to believe that market incentive plans are generally more efficient than direct
regulation.
True False
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6. An optimal policy is one in which the marginal cost of undertaking a policy is less than the
marginal benefit of that policy.
True False
7. If a program requires people to pay a price that reflects the cost of an externality associated with
their actions that they previously did not pay, it will be in their best interest to change their
behavior.
True False
8. Government provides secondary education because of its private good aspects.
True False
9. Economists believe that free riders often can undermine the social commitment of many in the
society, causing voluntary policies to fail.
True False
10. Adverse selection problems can occur when buyers and sellers have different amounts of
information about a good for sale.
True False
11. Moral hazard problems can occur when insured individuals change their behavior to the detriment
of the insurer.
True False
12. Government attempts to offset market failures can prevent the market from dealing with a
problem more effectively.
True False
13. If government action is likely to do some good, it is always best for government to intervene in the
marketplace.
True False
Multiple Choice Questions
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14. What do economists mean when they say there is "market failure"?
A. Business has introduced a product that consumers did not want.

B. Free markets have led to excessive profits.
C. Markets have surpluses or shortages so that government rationing is necessary.
D. Free markets yield results that economists do not consider socially optimal.
15. Some economists believe that the market will not solve all problems. They are referring to:
A. market failure.
B. market incentive plans.
C. optional policy.
D. the need to balance the good of the individual with the good of society as a whole.
16. All of the following are considered sources of market failure except:
A. public goods.
B. imperfect information.
C. profit-maximizing behavior.
D. externalities.
17. The criterion that no person can be made better off without another being made worse off is
known as the:
A. normative criterion.
B. Pareto criterion.
C. nirvana criticism.
D. second-best criticism.
18. John has 10 apples and six bananas. Jane has two bananas and two apples. If this situation is
Pareto optimal, what mutually beneficial exchange could be made?
A. None; there is no exchange that can help one without hurting the other.
B. Fruit should be taken from John and given to Jane to equalize their holdings.
C. Jane should give up apples to get bananas.
D. Jane should give up bananas to get apples.
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19. The perfectly competitive output level is Pareto optimal because at this output level:
A. the total cost to society equals the total benefit.

B. the marginal cost to society equals the marginal benefit.
C. the marginal cost to society is minimized.
D. the marginal benefit to society is maximized.
20. The economist who mathematically proved that a complete set of competitive markets could yield
a socially (or Pareto) optimal result was:
A. Adam Smith.
B. Kenneth Arrow.
C. Milton Friedman.
D. Ronald Coase.
21. If there is a complete set of markets that are perfectly competitive:
A. the marginal cost of producing goods will exceed their marginal benefit.
B. the marginal cost of producing goods will be less than their marginal benefit.
C. every person's utility function is at a maximum.
D. the invisible hand guides the economy to a Pareto optimal position.
22. If a system has multiple defects but those defects in effect offset each other, curing one defect
may make the system perform more poorly. This possibility is known as:
A. the Hume dictum.

B. the normative criticism of Pareto optimality.
C. the second best criticism of Pareto optimality.
D. the nirvana criticism of Pareto optimality.
23. Can outcomes that are not Pareto optimal be considered better than outcomes that are Pareto
optimal?
A. No; Pareto optimal is defined as the best possible outcome.

B. Yes, if the non-Pareto optimal outcome is more efficient than the Pareto optimal outcome.
C. Yes, if the distribution of wealth in the Pareto optimal outcome is considered undesirable.
D. Yes, if there are too many market failures in the Pareto optimal outcome.
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24. If a market has no externalities, marginal private costs:
A. exceed marginal social costs.

B. equal marginal social costs.
C. are below marginal social costs.
D. intersect marginal social costs.
25. Economists generally call the effect of an agreement on others that is not taken into account by
the parties making the agreement:
A. excess burden.
B. welfare loss.
C. Pareto optimality.
D. an externality.
26. The best example of a positive externality is:
A. roller coaster rides.

B. pollution.
C. alcoholic beverages.
D. education.
27. Alex is playing his music at full volume in his dorm room. The other people living on his floor find
this to be nuisance, but Alex does not care. Alex's music playing is an example of a:
A. negative externality.
B. positive externality.
C. normative externality.
D. Pareto externality.
28. Alex is playing his music at full volume in his dorm room. The other people living on his floor are
enjoying his music, but Alex does not know or care. Alex's music playing is an example of a:
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29. James enjoys gardening in the nude because he says it puts him in touch with nature. His
neighbors find his gardening routine very offensive, but James replies that they should mind their
own business and not watch him. To an economist this situation illustrates the concept of:
A. the tragedy of the commons.

B. a negative externality.
C. a positive externality.
D. adverse selection.
30. Carbon dioxide emissions are thought to contribute to global warming, and there is concern that
changes in climate will be costly. Emitting carbon dioxide is an example of:
A. a public good.
C. an adverse selection problem.
D. an effluent fee.
31. In the Flint Hills area of Kansas, proposals to build wind turbines to generate electricity have
pitted environmentalist against environmentalist. Members of the Kansas Sierra Club support the
turbines as a way to reduce use of fossil fuel, but local chapters of the Nature Conservancy say
they will befoul the landscape. The Sierra Club argues that wind turbines:
A. are a source of negative externalities.

B. reduce negative externalities elsewhere in the economy.
C. create a free rider problem.
D. are a way of solving a free rider problem.
32. Proposals in Flint Hills, Kansas, to build wind turbines to generate electricity have pitted
environmentalist against environmentalist. Members of the Kansas Sierra Club support the
turbines as being a way to reduce use of fossil fuel, but local chapters of the Nature Conservancy
say they will befoul the landscape. The chapters of the Nature Conservancy argue that wind
turbines:

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33. College education provides higher income for the individual but also a more productive and more
educated person who will contribute to society in many ways. Higher education is an example of:
A. a positive externality.
C. a non-excludable service.
34. Richard Vedder argues that the states that have spent the most on higher education in the last 25
years have experienced the least economic growth. One might conclude that higher education:
A. does not have important positive externalities.

B. does not have important negative externalities.
C. is a non-excludable service.
D. has problems of adverse selection.
35. Under the Texas law known as "rule of capture," land owners "get to pump as much of the water
under it as they want. . . . 'This means whoever sucks it out first, it's their water'—even if that
means there isn't enough left for others." Under this law, pumping large amounts of water:
A. imposes a negative externality on others.

B. imposes a positive externality on others.
C. imposes the free rider effect on others.
D. is a private decision with no effects on others.
36. Which of the following is not an example of an externality?
A. Carbon dioxide from energy generation that adds to the worldwide long-term greenhouse
effect
B. Heat from a factory that makes the neighboring tomato patches more productive
C. A defective part that causes an automobile to break down three months after purchase
D. Acidic by-products of fossil fuel combustion that produce acid rain
37. An externality is present in a free market whenever:
A. a monopolist spends funds to keep potential competitors out of the market.

B. an activity generates costs or benefits that are not reflected in market prices.
C. firms hire employees from outside the firm to fill positions normally filled by promotion from
within the firm.
D. a tax is imposed on the supplier of a good.
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38. When negative externalities are present, market failure often occurs because:
A. the cost borne by a third party not involved in the trade is not reflected in the market price.
B. the borne by a third party not involved in the trade is reflected in the market price.
C. the existence of imports from foreign countries takes jobs (and income) away from U.S.
citizens.
D. consumers will consume the good at a level at which their individual marginal benefits exceed
the marginal costs borne by the firm producing the good.
39. The existence of negative externalities:
A. prevents the market from working efficiently.

B. prevents government from intervening in the marketplace.
C. causes the market to work more effectively.
D. necessarily means that government must intervene in the marketplace.
40. An example of a negative externality is the:
A. decrease in your real income that results when photographic equipment you purchase
increases in price because of increased demand by others for these items.
B. cost you bear when your neighbor has a noisy party and does not compensate you for your
discomfort.
C. benefit you receive without paying when your neighbor installs a smoke detector.
D. decrease in income to farmers that results from a drought.
41. If a negative externality is associated with burning firewood:
A. the marginal social cost of burning firewood falls short of its price.
B. the marginal social cost of burning firewood is exactly equal to its price.
C. less than the efficient amount of firewood for burning will be used each year.
D. the marginal social cost of burning firewood exceeds the price of burning firewood.
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42. When negative externalities exist in the production of a good, the marginal social cost of
producing the good:
A. is equal to the marginal benefit received by consumers if competitive markets exist and there is
no government intervention.
B. equals the marginal cost borne by the firm minus marginal cost borne by a third party that
results from the production and consumption of the good.
C. is less than the marginal cost borne by the firm.
D. equals the marginal cost borne by the firm plus the marginal cost borne by third parties from
the production and consumption of the good.
43. The cost of running an electrical utility includes costs for fuel, labor, and capital. In addition, there
are sometimes costs associated with pollution from the utility, such an increased health-care
costs for people living near the utility. To an economist, the costs associated with the pollution
resulting from additional electricity are:
A. marginal private costs.

B. marginal social costs.
C. the difference between marginal social costs and marginal private costs.
D. the sum of marginal social costs and marginal private costs.
44. If a positive externality is associated with the purchase of smoke detectors:
A. the marginal social benefit of smoke detectors exceeds their price.

B. the marginal social benefit of smoke detectors is zero.
C. the marginal social benefit of smoke detectors equals their price.
D. more than the efficient quantity of smoke detectors will be sold.
45. When positive externalities exist in the consumption of a good, the marginal social benefit:
A. equals the marginal benefit received by consumers of the good minus the marginal benefit to
third parties.
B. equals the marginal cost of producing the good plus the marginal cost to third parties.
C. equals the marginal benefit received by consumers of the good plus the marginal benefit to
third parties.
D. could be either greater than or less than the marginal benefit received by consumers of the
good depending on the equilibrium price determined in competitive markets.
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46. If a negative externality exists in the production of paper and paper is sold in a perfectly
competitive market, at the equilibrium output:
A. additional net gains to society are possible by reducing the output of paper.
B. additional net gains to society are possible by increasing the output of paper.
C. the marginal social benefit of paper equals its marginal social cost.
D. additional net gains to society are not possible from either increasing or decreasing the output
of paper.
47. If a positive externality exists in the provision of education when education is provided in a
perfectly competitive market without government intervention, at the market equilibrium level of
education:
A. additional net gains to society are possible by reducing the level of education.
B. additional net gains to society are possible by raising the level of education.
C. the marginal social benefit of education equals the marginal social cost.
D. additional net gains to society are not possible by either increasing or decreasing the level of
education.
48. If a negative externality exists in the market for dirt bikes and that market is perfectly competitive:
A. less than the efficient output of dirt bikes will be produced.

B. the price of dirt bikes exceeds the marginal social cost.
C. the price of dirt bikes equals the marginal social cost.
D. the price of dirt bikes is less than the marginal social cost.
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49.
Refer to the graph shown. There is a $.010 per-gallon marginal cost external to the trade
associated with the use of gasoline. Assuming that gasoline is sold in perfectly competitive
markets, the market equilibrium price will be:
A. $0.95
B. $1.00
C. $1.05.
D. $1.10.
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50.
Refer to the graph shown. If the marginal cost external to the trade associated with the use of
gasoline is $0.10 per gallon, the point on the graph corresponding to the efficient quantity and
price is:
A. G.
B. H.
C. K.
D. L.
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51.
Refer to the graph shown. Assuming a $0.10-per-gallon marginal cost external to the trade that is
associated with gasoline, the market price of gasoline necessary to induce consumers to
purchase the efficient quantity each year is:
A. $1.10.
B. $1.00.
C. $1.05.
D. $0.95.
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52. Refer to the following graph.
Assuming a marginal cost external to the trade equals the tax shown in the graph, the market
price necessary to induce consumers to purchase the efficient quantity each year is:
A. P1.
B. P2.
C. P3.
D. P4.
53. Once vaccinated, a person cannot catch a cold or give a cold to someone else. As a result, the
marginal social benefit resulting from consumption of the vaccine:
A. exceeds the marginal benefit received by consumers of the vaccine.

B. equals the marginal social cost of producing the vaccine in a competitive equilibrium.
C. equals the marginal benefit received by consumers of the vaccine in a competitive equilibrium.
D. is less than the marginal benefit received by consumers of the vaccine.
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54.
Refer to the graph shown, which shows the demand and supply for a new vaccine against the
common cold. Once vaccinated, a person cannot catch a cold or give a cold to someone else. As
a result, the marginal social benefit curve will:
A. coincide with the market demand curve.

B. lie strictly below the market supply curve.
C. lie below the market demand curve.
D. lie above the market demand curve.
55.
common cold. Once vaccinated, a person cannot catch a cold or give a cold to someone else. At
the competitively determined output level, the marginal social benefit will be:
A. equal to P0.
B. less than P0.
C. greater than or less than P0 depending on the income elasticity of demand and the
effectiveness of the vaccine.
D. greater than P0.
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56.
common cold. Once vaccinated, a person cannot catch a cold or give a cold to someone else.
The socially efficient level of output is:
A. less than Q0.

B. greater than or less than Q0 depending on the income elasticity of demand and the
C. greater than Q0.
D. equal to Q0.
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57.
common cold. Once vaccinated, a person cannot catch a cold or give a cold to someone else. If
government does not subsidize the production of this vaccine:
A. the number of workers hired to produce the vaccine will be less than the socially efficient level.
B. the firm producing the vaccine will use too much capital in producing the vaccine.
C. the vaccine will be overproduced because consumers will not take into account the fact that
many of their neighbors and co-workers will consume the vaccine.
D. no positive externality can be created.
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The point on the graph corresponding to the socially optimal output per year and the price sellers
must receive to make that amount available is shown by point:
A. G.
B. H.
C. I.
D. K.
59. If a negative externality is to be internalized to the decision maker, the:
A. producers' marginal costs should be increased by an amount equal to the marginal cost to
those outside the trade that results from production of the good.
B. producers' marginal costs should be reduced by an amount equal to the marginal cost to those
outside the trade that results from production of the good.
C. consumer of the good should receive a subsidy equal to the marginal cost to those outside the
trade that results from production of the good.
D. consumer of the good should pay a tax equal to the marginal benefit to those outside the trade
that results from consuming the good.
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60. If a positive externality is to be taken full advantage of, the:
A. consumer of the good should receive a subsidy equal to the marginal cost imposed on third
parties that results from production (or consumption) of the good.
B. producers' marginal costs should be increased by an amount equal to the marginal benefit to
third parties that results from production of the good.
C. consumer of the good should pay a tax equal to the marginal benefit to third parties that results
from production (or consumption) of the good.
D. producers' marginal costs should be decreased by an amount equal to the marginal cost
imposed on third parties that results from production of the good.
61. If a corrective tax on gasoline results in the efficient output of gasoline by internalizing negative
externalities associated with pollution:
A. pollution from gasoline will increase because people are also harmed by the tax.
B. there will be no effect on pollution from gasoline because the tax is paid by the supplier.
C. pollution from gasoline will be zero because environmental cleanliness is priceless.
D. the tax will generate enough revenue to compensate society for the damages resulting from
the pollution that still occurs.
62.
Refer to the graph shown. Say that there is a negative externality associated with the production
of the good depicted. The marginal social benefit from consuming this good at the competitive
equilibrium output level is:
A. greater than P0.

B. equal to P0.
C. either greater than or less than P0, depending on the elasticities of supply and demand.
D. less than P0.
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63.
Refer to the graph shown. Say that there is a negative externality associated with the production
of the good depicted. The marginal social cost from consuming this good at the competitive
equilibrium output level is:
A. either greater than or less than P0, depending on the elasticities of supply and demand.
B. greater than P0.
C. less than P0.
D. equal to P0.
64.
Refer to the graph shown. There is a negative externality associated with the production of the
good depicted. The socially efficient level of output is:
A. either greater than or less than Q0, depending on the elasticities of supply and demand.
B. less than Q0.
C. equal to Q0.
D. greater than Q0.
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65. The rule for making optimal decisions is that an activity should be increased until:
A. average costs are minimized.

B. total costs are minimized.
C. total benefits are maximized.
D. marginal benefits equal marginal costs.
66. A strategy that achieves a goal at the lowest cost in total resources without consideration of who
pays those costs is:
A. efficient.
B. inefficient.
C. impossible.
D. always the most profitable to the firm.
67. Direct regulation is inefficient because:
A. affected firms ignore regulations, for example, by dumping toxic waste illegally.
B. it does not take into account that the costs of reducing consumption are the same for all
individuals.
C. it does not take into account the fact that the costs of reducing consumption may differ among
individuals.
D. it does not take negative externalities into account.
68. Suppose that government wants a policy that will encourage people to use less oil. For this policy
to be efficient, it must:
A. induce those with the highest cost of conserving to reduce their oil consumption the most.
B. induce those with the lowest cost of conserving to reduce their oil consumption the most.
C. force everyone to reduce oil consumption equally.
D. force rich people to reduce oil consumption proportionally more than poor people.
69. Economists generally oppose direct regulation because:
A. it is unlikely to achieve the desired end as efficiently as possible.

B. it assumes that people behave rationally.
C. it is generally unfair.
D. it does not assume that people behave rationally.
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70. A market incentive plan:
A. regulates the amount of a resource a person can consume through direct limits.
B. requires that people choose to consume until the marginal costs exceed the marginal benefits.
C. makes the price of a resource reflect not only the marginal private costs but also the marginal
social costs of consuming that resource.
D. makes the price of a resource reflect the marginal private costs of consuming that resource.
71. To address the problems created by negative externalities, economists prefer programs that:
A. require government to conserve, using general tax revenues to pay for the program.
B. require all people to reduce consumption equally.
C. make people who have the lowest benefit of reducing consumption choose to undertake the
most reduction.
D. make people who have the lowest cost of reducing consumption choose to undertake the most
reduction.
72. The following table shows four firms, the amount each pollutes, the marginal cost for each firm to
clean up pollution, and the total cost to each firm of eliminating all pollution.
The total discharge of these four companies is 300 tons. Assume there is no one else who
pollutes.
Refer to the table shown. If the goal of the government is to reduce pollution by 50 percent, the
cheapest way would be to have:
A. all four firms cut their discharge by 50 percent

B. have each firm reduce discharge by 37.5 tons.
C. have firms A and D stop discharging and allow B and C to continue.
D. have firms B and C stop discharging and allow A and D to continue.
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pollutes.
Refer to the table shown. Assume that these firms want to maximize profits. If the government
wishes to cut discharge by 50 percent, it could do so by establishing an effluent fee of:
A. $3.00.
B. $4.50.
C. $5.50.
D. $10.00.
pollutes.
Refer to the table shown. If the government establishes an effluent fee of $7.00, how much tax
would firms pay to the government?
A. $660
B. $1,050
C. $1,820
D. $2,100
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pollutes.
Refer to the table shown. If the government establishes an effluent fee of $7.00, how much would
the firms spend on reducing pollution?
A. $660
B. $1,710
C. $1,820
D. $2,100
pollutes.
Refer to the table shown. If the government establishes a regulation requiring each company to
reduce pollution by 50 percent, what will be spent on reducing pollution?
A. $660
B. $910
C. $1,050
D. $1,710
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pollutes.
Refer to the table shown. Suppose that the government gives each company a pollution permit
equal to 50 percent of its present discharge. However, companies are allowed to reduce pollution
more than 50 percent and sell their permit or reduce less than 50 percent and buy a permit from
another company. If firms maximize profits, what would happen?
A. Each firm would reduce pollution by 50 percent.

B. Firms A and D would eliminate pollution and sell their permits to B and C, which would
continue to pollute as before.
C. Firms B and C would eliminate pollution and sell their permits to A and D, which would
D. There is not enough information to answer this question.
78. An effluent fee is an example of:
A. a voluntary approach to pollution.

B. a direct regulation of pollution.
C. a tax incentive policy.
D. a market incentive policy.
79. Based on economic theory, most economists believe market incentive plans are:
A. equitable.
B. efficient.
C. inefficient.
D. unfair.
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80. In a tax incentive program, the person who conserves the most pays:
A. relatively less tax.

B. relatively more tax.
C. no tax.
D. no penalties.
81. Which of the following methods of reducing the amount of trash society generates is most likely to
be efficient?
A. A mandatory recycling program

B. A completely voluntary recycling program
C. A "trash tax"
D. Landfills and incinerators
82. Which policy is likely to be the most efficient in dealing with automobile emission pollution?
A. A mandatory requirement to reduce pollution

B. Voluntary emission control guidelines
C. Subsidizing research and development for alternative forms of transportation
D. An emission tax
83. A policy that requires all the people to certify that they have reduced total consumption, not
necessarily their own individual consumption, by a specified amount, is a(n):
A. external incentive plan.

B. internal incentive plan.
C. tax incentive plan.
D. market incentive plan.
84. Suppose Mary finds it easier to conserve than Jim does. The difference between a tax incentive
program and a marketable certificate plan in this case is that:
A. Mary undertakes most of the conservation in the case of a tax incentive program and least in
the marketable certificate program.
B. Mary undertakes least of the conservation in the case of a tax incentive program and most in
the marketable certificate program.
C. Mary takes on most of the conservation in both cases but is paid by Jim in the marketable
certificate program.
D. Jim takes on most of the conservation in both cases but is paid by Mary in the marketable
8-26
85. If markets are perfectly competitive and production of a good results in water pollution, the
imposition of a tax on that good will:
A. increase the price of that good and increase pollution.

B. reduce the price of that good and increase pollution.
C. reduce the price of that good and decrease pollution.
D. increase the price of that good and reduce pollution.
imposition of a tax on the good will:
A. reduce the number of firms producing that good in the long run.
B. increase the number of firms producing that good in the long run.
C. reduce the number of firms producing that good in the short run.
D. increase the number of firms producing that good in the short run.
87. An individual with a highly elastic demand for gasoline will:
A. cut consumption more than an individual with a highly inelastic demand when price goes up.
B. cut consumption less than an individual with a highly inelastic demand when price goes up.
C. refuse to cut consumption for any reason.
D. stop using gasoline entirely if a tax is imposed.
88. A firm with a highly inelastic demand for coal will:
A. cut consumption more than a firm with a highly elastic demand when price goes up.
B. cut consumption less than a firm with a highly elastic demand when price goes up.
89. A policy is considered optimal if it:
A. is supported by a majority of voters.

B. equates total costs with total benefits.
C. equates marginal costs with marginal benefits.
D. forces people to conserve on scarce resources.
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90. An optimal corrective tax levied on polluters will:
A. be equal to the marginal cost of their actions imposed on third parties.

B. not generate enough revenue to pay for the cost of the damage resulting from pollution that
occurs at the efficient output of the good.
C. decrease pollution to zero.
D. increase the supply of polluting goods.
91. A policy in which the marginal costs of undertaking the policy equal the marginal benefits of that
policy is best called an:
A. equality policy.
B. incentive policy.
C. optimal policy.
D. opportunity policy.
92. An efficient policy to reduce pollution would reduce pollution to the point where:
A. the marginal costs of reducing pollution equal the marginal benefits of reducing pollution.
B. it is eliminated.
C. the marginal costs of reducing pollution are greater than the marginal benefits of reducing
pollution.
D. the marginal costs of reducing pollution are less than the marginal benefits of reducing
pollution.
93. The efficient amount of pollution control is:
A. the amount for which the total social benefit equals the total social cost of pollution.
B. the amount for which the marginal social benefit equals the marginal social cost of pollution.
C. always zero.
D. always a 100 percent abatement.
94. The optimal quantity of pollution control occurs at the point where the:
A. level of pollution is reduced to zero.

B. marginal social benefit is at its maximum.
C. marginal social cost equals the marginal social benefit of pollution.
D. total benefit equals the total cost of pollution.
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95. Economists' attitude toward voluntary programs causes them to:
A. actively oppose them on the grounds that they will do more harm than good.
B. actively oppose them on the grounds that they are unfair.
C. be skeptical of the potential success of such programs
D. favor these programs over alternative solutions.
96. Economists tend to distrust voluntary approaches as a way to deal with externalities. What is their
most common concern?
A. Voluntary approaches do not make people develop an awareness of the problem that would
lead them to make good lifestyle changes.
B. Voluntary approaches often are perceived as unfair, imposing a heavy burden on the poor.
C. Voluntary approaches usually require people to ignore their self-interest, and economists do
not think people do that well.
D. Voluntary approaches are often too effective and lead to excessive reduction in the externality.
97. Public television periodically runs pledge drives to raise money. Only a small percentage of the
people who benefit from public television are willing to pay. What do economists call the people
who do not pay?
A. Free riders
B. Excludables
C. Adverse selectors
D. Thieves
98. Public television periodically runs pledge drives to raise money. Only a small percentage of the
people who benefit from public television are willing to pay. This low percentage of people willing
to contribute illustrates a difficulty with:
A. government regulation.
B. voluntary programs.
C. tax incentive policies.
D. market incentive programs.
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99. Economists are most likely to suggest that societies address the inefficiencies created by
negative externalities by:
A. direct regulation.
B. voluntary conservation.
C. making the price people pay reflect the cost of the externality.
D. leaving environmental problems alone so that the market can deal effectively with them.
100.In 1990, the Clean Air Act was amended to place a national cap on sulfur dioxide emissions,
giving electric utilities an allowance of a set amount of emissions and allowing the utilities to trade
their allowances. This type of plan is:
A. more efficient than direct regulation because utilities that receive a high marginal benefit from
emissions can gain additional allowances through trade.
B. more efficient than direct regulation because it forces each utility company to reduce sulfur
dioxide emissions by the same amount.
C. less efficient than direct regulation because utilities that receive a high marginal benefit from
emissions can gain additional allowances through trade.
D. less efficient than direct regulation because it forces each utility company to reduce sulfur
101.If government undertakes to reduce water usage by using a market incentive plan:
A. each consumer will have to reduce his or her water usage by an equal amount.
B. consumers who reduce water usage by more than the required amount can sell marketable
certificates to consumers who seek to reduce usage by less than the required amount.
C. consumers who do not reduce usage by the required amount will have to pay taxes on the
extra water usage.
D. consumers will be asked to reduce water usage voluntarily.
102.Since trash generation involves an externality, the way economists might address the problem of
trash generation that is most likely to be optimal is by:
A. integrating the cost of the externality into the initial price of the good.
B. having the government require mandatory sorting and recycling of trash.
C. having the cost of the externality be paid by the government.
D. not allowing persons to throw away more trash than is acceptable as a maximum.
8-30
103.An economist is most likely to support all of the following methods to address the negative
externalities created by the waste from newspapers except:
A. requiring publishers to cut the volume of newspapers generated but allowing them to sell
certificates so that others can meet those requirements for them.
B. taxing the suppliers of newspaper by the pound.
D. ensuring that the social cost of buying a newspaper is reflected in its price.
104.The inefficiency associated with negative externalities is most likely the result of:
A. special interest groups.

B. the fallacy of composition.
C. government intervention.
D. poorly specified property rights.
105.A per-unit tax designed to internalize the costs of production imposed on third parties is called:
A. an excise tax.
B. an effluent fee.
C. a sin tax.
D. a tariff.
106.The Environment Ministry in Japan proposed a new carbon tax to meet Japan's obligations to
reduce carbon dioxide emissions under the Kyoto Treaty. The tax would be levied on producers
and importers of fossil fuels, and the expectation is that it would be largely passed on to
consumers. This proposal is an example of a:
A. progressive tax.
B. voluntary program.
C. tax incentive policy.
D. free rider problem.
8-31
and importers of fossil fuels, and the expectation is that it would be largely passed on to
consumers. The rationale for this tax is that it will:
A. reduce a negative externality.

B. reduce a positive externality.
C. turn a private good into a public good.
D. turn a public good into a private good.
and importers of fossil fuels and raise the cost of using fossil fuels. How do most economists
view a tax such as this?
A. They prefer direct regulation to taxes because taxes create deadweight loss.
B. They prefer voluntary programs to taxes because they reduce the role of compulsion.
C. They do not believe any government intervention is necessary because the invisible hand of
the market will correct the problem.
D. They support taxes on pollution as a way of making decision makers consider all costs.
109.
Refer to the graph shown. The price and quantity that would prevail if all social costs and benefits
were taken into account is:
A. $5 and 2,600 units.

B. $3.50 and 2,000 units.
C. $3.95 and 6,800 units.
D. $1.80 and 2,000 units.
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110.
Refer to the graph shown. The amount of a tax sufficient to reduce quantity supplied to the level
that individuals would have supplied had they included the cost in their decision on third parties
is:
A. $2.50.
B. $1.70.
C. $1.00.
D. $0.80.
111.
Refer to the graph shown. The free market equilibrium in the graph is at a price and quantity of:

B. $3.50 and 2,000 units.
C. $2.50 and 2,600 units.
D. $3.50 and 3,100 units.
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112.A good that if supplied to one person is supplied to all and whose consumption by one individual
does not prevent its consumption by another individual is known as:
A. a private good.
B. a public good.
C. an external good.
D. an internal good.
113.Public television periodically runs pledge drives to raise money. Only a small percentage of the
people who benefit from public television are willing to pay. Why does public television have a
problem in collecting money from its viewers?
A. Broadcast television has public good aspects.

B. Public television has problems of adverse selection.
C. Public television is an example of government failure.
D. Broadcast television has problems of informational problems.
114.When you purchase and eat a hamburger, no one else can eat the same hamburger. When you
download a file on the Internet, the file is still available for others to download. Economists
explain this difference between hamburgers and computer files by saying that the hamburger is:
A. excludable whereas the computer file is not.

B. non-excludable whereas the computer file is not.
C. rival in consumption whereas the computer file is not.
D. nonrival in consumption whereas the computer file is not.
115.Television broadcasts are often given as examples of a public good. However, it is possible to
code a broadcast so that only people who pay for the decoder box can view it. The use of a
coded signal does what to a television broadcast?
A. Makes it rival
B. Makes it nonrival
C. Makes it excludable
D. Makes it non-excludable
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116.A meeting of the United Nations Convention on International Trade in Endangered Species
ended with greater protection given to great white sharks. Why should sharks need special
protection?
A. There is an informational problem in the market; people do not understand the full
consequences of their actions.
B. Sharks are not privately owned and can be subject to a tragedy of the commons problem.
C. Sharks are what economists call a public good, and hence there are no incentives to produce
or protect them.
D. Sharks are subject to adverse selection problems.
117.A system in which power plants buy and sell the right to pollute in the form of emission credits is
known as:
A. a voluntary program.
B. direct regulation.
C. a tax incentive program.
D. a market incentive program.
118.Do economists tend to favor a system in which power plants buy and sell the right to pollute in
the form of emission credits?
A. No; these programs are ineffective because they encourage major polluters to free ride on the
efforts of others.
B. No; it is possible for some firms to do nothing if they simply buy enough credits.
C. Yes; they encourage all firms to cut pollution by the same percentage.
D. Yes; they believe that such a proposal would achieve a level of pollution reduction with the
lowest cost to society.
119.Suppose there are only two firms that pollute, A and B, and each emits 10 tons of waste into the
air. Firm A can reduce its pollution at a cost of $100 per ton, and Firm B can reduce its pollution
at a cost of $500 per ton. Each has been given an emission credit that allows it to pollute 6 tons.
If firms maximize profits, what will happen?
A. Each firm will clean up 4 tons and pollute 6 tons.

B. Firm B will buy four credits from A; B will emit 10 tons, and A 2 tons.
C. Firm A will buy four credits from B; A will emit 10 tons, and B 2 tons.
D. Firm B will buy one credit from A; it will cut pollution to 7 tons, and firm A will cut it to 5 tons.
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120.Which of the following does not illustrate the free rider problem?
A. Amy does not contribute to public television, but she watches it every day.
B. Roger refuses to help pay for the private security officer who patrols his neighborhood.
C. Amanda, a taxpayer, prefers to check out books from her local library rather than purchasing
them herself.
D. Frank enjoys the fireworks from his lawn and does not purchase a ticket to view the display
from the stadium.
121.The unwillingness of individuals to share in the cost of a public good is called the:
A. free rider problem.

B. social conscience problem.
C. volunteer problem.
D. public choice problem.
122.Which of the following is not a characteristic of a public good?
A. Non-exclusivity
B. Available to nonbuyers
C. Nonrivalry in consumption
D. Can be consumed only once
123.Since consumption of a public good by one person does not preclude consumption by others,
public goods are said to be:
A. non-exclusive.
B. nonrival.
C. exclusive.
D. rival.
124.Once a public good is provided, those who do not pay cannot be denied the benefits. For this
reason, public goods are said to be:
A. non-exclusive.
B. nonrival.
C. exclusive.
D. rival.
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125.If air pollution control is a public good, it follows that:
A. the efficient output of air pollution control is zero.

B. additional persons can benefit from a given amount of air pollution control without reducing the
benefits enjoyed by others.
C. the efficient output of air pollution control can be attained by selling it by the unit in a market.
D. the more air pollution control enjoyed by any one person, the less is available to others.
126.The free rider problem:
A. can never prevent pure public goods from being supplied.

B. results because people act unselfishly.
C. results because people behave irrationally.
D. prevents voluntary cost sharing from achieving the efficient output of a public good.
127.The best example of a public good is:
A. competition.
B. government-subsidized lunches.
C. pollution.
D. national defense.
128.In economic terminology, a free rider is someone who:
A. does not pay for his or her own consumption of a public good.
B. chooses not to consume a public good.
C. is earning economic profit.
D. raises his or her prices because all other prices are rising.
129.In the case of a public good, a demand curve that shows the marginal benefit of the good is:
A. nonexistent.
B. the horizontal sum of individual demand curves.
C. the vertical sum of individual demand curves.
D. perfectly inelastic.
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130.If the marginal benefit of one more unit of a public good is $500 for Sam and $800 for Alex, the
social benefit of one more unit of a public good is:
A. $500 since the benefit will go to the person who values it least.
B. $800 since the benefit will go to the person who values it most.
C. $1,300 since the benefit of one more unit goes to both individuals.
D. more than $1,300 since the benefits to society exceed the sum of individual benefits.
131.This table shows the marginal benefits from widgets obtained by the only three people who value
them.
Refer to the table shown. Suppose widgets cost $8.50 to produce. If widgets are a private good,
how many will be produced by market incentives, and is that the right (efficient) number?
A. Zero will be produced, and this is below the socially optimal amount.
B. One will be produced, and this is the socially optimal amount.
C. One will be produced, and this is below the socially optimal amount.
D. Two will be produced, and this is the socially optimal amount.
132.This table shows the marginal benefits from widgets obtained by the only three people who value
them.
Refer to the table shown. Suppose widgets cost $8.50 to produce. If widgets are a public good,
how many will be produced by market incentives, and is that the right (efficient) number?
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133.Basic research is more likely to be funded by the federal than by state and local government
because basic research:
A. is usually conducted by oligopoly, the market structure that is most conducive to preliminary
research.
B. has negative externalities that are passed on to those who live outside the state.
C. is largely a public good; benefits flow to the whole world, not just the state.
D. has information problems that cause adverse selection.
134.Music spreads easily and cheaply on computer networks. As a result, music has become more
like:
A. a private good.
B. a public good.
C. a merit good.
D. an inferior good.
135.The Apple iPod is able to play digital music that has a special encoding that makes pirating music
more difficult. In economic terms, this encoding is an attempt to:
A. make digital music more like a private good and less like a public good.
B. reduce the negative externalities of digital music.
C. reduce the adverse selection problem of digital music.
D. increase the marginal social benefit of digital music.
136.If the benefit of a public good is small to each individual in a society of millions of individuals:
A. it will never be efficient for government to provide the public good.

B. the total benefit will be large since social benefit is the sum of all individual benefits.
C. the total benefit will be small since individuals cannot share the benefits of public goods.
D. it cannot really be a public good since the benefit of public goods is always large.
137.With regard to a public good provided by the government:
A. individuals reveal their demand when they buy the good.

B. a free rider problem is unlikely.
C. individuals have an incentive to conceal their willingness to buy the good.
D. individuals have an incentive to exaggerate their willingness to buy the good.
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138.Real-world markets:
A. often involve deception, cheating, and inaccurate information.

B. ensure that sellers will always be honest and provide accurate information because those who
are dishonest or provide inaccurate information go out of business.
C. can operate efficiently only if government takes steps to correct informational problems.
D. provide no mechanism for solving informational problems.
139.If a consumer is willing to pay $100 for a used Blu-ray player that is a "cherry" and $30 for a used
Blu-ray player that is a "lemon," the consumer will offer:
A. $30 for any used Blu-ray player even if the probability that it is a "lemon" is 50 percent.
B. $100 for any used Blu-ray player even if the probability that is a "cherry" is 50 percent.
C. $65 for any used Blu-ray player if the probability that it is a "lemon" is 50 percent.
D. $130 for any used Blu-ray player if the probability that it is a "cherry" is 50 percent.
140.Adverse selection is most likely to be a problem when:
A. one side of the market, either buyer or seller, has better information than the other side.
B. there are public goods involved.
C. the good being exchanged has negative externalities.
D. the good being exchanged has free rider problems.
141.In economics, the term "signaling" refers to a way of lessening the problem of:
A. free riders.
B. negative externalities.
C. bad information by all market participants.
D. unequal information between buyers and sellers.
142.At one time many economists were suspicious of brand names. They saw them as a barrier to
entry with no benefits to consumers. In the 1970s economists began to see a possible benefit of
brand names to consumers. They discovered that brand names were a way to:
A. signal quality.
B. market public goods.
C. overcome negative externalities.
D. overcome the free rider effect.
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143.John and Jack are both trying to sell a used car to Jim. John's car is a lemon, a car that has a
serious but nonobvious problem. Jack's car is a cherry, a car that has no problems. Jim cannot
tell the difference between the cars. Economists say this information problem might be solved
with signaling. Who has an incentive to find a way to signal quality?
A. Both Jack and John

B. Jack but not John
C. John but not Jack
D. Jim
144.A lawyer who drives a beat-up car and wears frumpy clothes may have a hard time getting
clients. Potential clients may conclude from his appearance that he is poor, and if he is poor, he
probably is not very good. If this is true for a lawyer, dressing in expensive and stylish clothing is
a way of:
A. internalizing externalities.
B. changing a nonrival good into a rival good.
C. changing a non-excludable good into an excludable good.
D. signaling quality.
145.In the early days of the Internet, selling and buying from other individuals were dangerous
because one never knew if the person on the other side of the transaction was honest. eBay.com
became successful because it lessened that problem with its feedback rating system that let
buyers and sellers develop a reputation. eBay.com's innovation is an example of overcoming:
A. the free rider effect.

C. positive externalities.
D. an information problem.
146.How do economists explain the value firms and consumers place on brand names?
A. Brand names show that firms can easily manipulate consumers.

B. Brand names are a way firms can provide information about quality to consumers.
C. Brand names are a way of turning private goods into public goods, increasing their value to
both seller and buyer.
D. Brand names are an example of adverse selection, by which producers advertise the options
to consumers.
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147.The Consumer Product Safety Commission (CPSC) is charged with protecting the public from
unreasonable risks of serious injury or death from more than 15,000 types of consumer products.
The CPSC is designed to overcome:
A. information problems.
B. positive externalities.
C. negative externalities.
D. direct regulation.
148.Which of the following is an argument an economist would use to argue against market
regulation designed to protect consumers?
A. Information is costless and readily available, and so it is up to consumers to beware.

B. When a brand name product is found unsafe, the value of the brand is reduced, which gives
companies with brand names an incentive to produce high-quality products.
C. Manufacturers have no incentive to stop the sale of counterfeit products.
D. Government is more likely to have consumers' interest in mind than does the market.
149.If a consumer is willing to pay $5,000 for a used car that is a free of mechanical problems and
$1,000 for a used car that will require extensive repairs, the consumer will offer:
A. $1,000 for a used car if the probability that it is free of mechanical problems is 50 percent.
B. $3,000 for a used car if the probability that it is free of mechanical problems is 50 percent.
C. $5,000 for a used car if the probability that it is free of mechanical problems is 50 percent.
D. $6,000 for a used car if the probability that it is free of mechanical problems is 50 percent.
150.If buyers cannot distinguish between "lemons" and "cherries" in the used car market but sellers
can, the price buyers are willing to pay for used cars will be:
A. high enough to guarantee that at least 50 percent of the used cars offered for sale are
"cherries."
B. so low that sellers with "cherries" will be unwilling to sell.
C. so low that sellers with "lemons" will be unwilling to sell.
D. equal to zero since no one will take the chance of purchasing a "lemon" even if the value of a
car known to be a lemon is greater than zero.
8-42
151.If medical insurers could use information contained in DNA to predict the likelihood of major
medical illnesses, the most likely outcome is that:
A. there would be an adverse selection problem and average insurance rates would rise.
B. there would be an adverse selection problem and average insurance rates would fall.
C. the adverse selection problem would be decreased and average insurance rates would rise.
D. the adverse selection problem would be decreased and average insurance rates would fall.
152.The reason the Federal Trade Commission regulates advertising to prevent false and misleading
claims is:
A. that firms that make false and misleading claims would earn lower profit, resulting in many
firms being forced to shut down and many workers losing their jobs.
B. to create a market for information.
C. to prevent a market failure caused by inaccurate information.
D. to eliminate persuasive advertising.
153.Economists believe that if government provides information about product quality:
A. there will be less incentive for consumers to pay extra for quality guarantees supplied by firms.
B. consumers will be forced to pay for information when otherwise it would have been available
for free.
C. the overall quality of products sold will increase substantially, eliminating the information
problem.
D. the cost of providing information will be zero.
154.A market for information is more likely to develop even in the absence of government regulation
of information as long as the marginal:
A. cost of information is zero.

B. benefit of information is zero.
C. cost of information exceeds the marginal benefit.
D. benefit of information exceeds the marginal cost.
8-43
155.The basis of the argument favoring government intervention to correct informational and
rationality problems is that:
A. if information is not perfect or if one trader is not rational, a trade can result in one party
benefiting and the other losing.
B. entry into certain markets may be restricted so that excess profits cannot be eliminated by the
forces of competition.
C. people cannot possibly know how well off they will be as a result of a trade until after the trade
has occurred.
D. if individuals are free to produce whatever goods they want, when excess profit is being made,
more people will enter into the production of that good and consumers will benefit as the price
is pushed down.
156.Milton Friedman argues that medical licensure benefits doctors because it:
A. allows them to restrict supply, increase prices, and significantly increase their incomes.
B. protects them from malpractice suits.
C. ensures that they will not have to compete against one another for patients.
D. prevents other doctors from advertising and stealing their patients.
157.Which of the following is not a question raised by critics of medical licensure?
A. Why, if licensed medical treatment is so great, do we even need formal restrictions to keep
other types of medicine from being practiced?
B. Whom do these restrictions benefit: the general public or the doctors who practice mainstream
medicine?
C. What have the long-run effects of licensure been?
D. Why does the public need to have accurate information about a doctor's competency?
158.Which of the following is the best example of an adverse selection problem?
A. Once individuals are insured, they are less likely to take efficient precautions.
B. Individuals are unlikely to pay for something if they can receive the benefits for free.
C. When a firm pollutes the air, families living nearby suffer the consequences.
D. Individuals who seek to purchase health insurance have better information about their health
than do insurance companies.
8-44
159.If employers were made responsible for injuries suffered by employees while working at home:
A. there might be an adverse selection problem since employees have better information about
the safety conditions of their own homes than employers do.
B. employers would never permit employees to work at home.
C. more employees would be able to work safely at home.
D. there might be an adverse selection problem since employers have better information about
the safety conditions of their employees than the employees have themselves.
160.The problem that arises when people don't have to bear the negative consequence of their
actions is known as:
A. adverse selection.
B. externality.
C. moral hazard.
D. signaling.
161.A person who has auto insurance is likely to drive a little less safely and to take less care in
parking the car in a safe place off the street. This is an example of a problem called:
A. signaling.
B. moral hazard.
C. externality.
162.A life insurance company is likely to require a health examination of a person applying for
insurance. This helps reduce the informational problem through the process of:
A. signaling.
B. screening.
C. creating an externality.
D. government regulation.
163.A person buying a used car could ask the seller for permission to take the car to a mechanic for
an inspection. If the seller says no, the prospective buyer has gained information about the car.
This process is known as:
A. screening.
B. signaling.
C. licensing.
D. internalizing the externality.
8-45
164.Which of the following is an example of screening?
A. Selling pollution permits to polluters to induce the lowest-cost pollution reducers to cut back on
pollution
B. Reducing pollution to the point at which the marginal cost of the pollution equals the marginal
benefit
C. A car buyer asking the seller if the car is a lemon
D. An employer requiring job applicants to provide references
165.Opponents of government intervention in the economy argue that government's attempts to

correct informational problems:
A. are justified in most cases though politically difficult to implement.

B. are not necessary since an efficiently operating market system ensures that adequate
information will be provided.
C. often create greater problems, such as FDA restrictions on experimental drugs for AIDS which
could save lives.
D. will make market transactions much more efficient.
166.Opponents of government intervention in the economy argue that externalities:
A. do not create problems for the model.

B. are themselves the inevitable result of government policies.
C. should be corrected with regulations rather than subsidies.
D. may not be effectively corrected by the government.
167.Suppose that a negative externality creates $1 billion worth of costs to third parties. The
government attacks the problem with regulations that cut the cost of the externality to $500
million but cost business and consumers $1.5 billion. This situation illustrates the idea that:
A. regulations are an effective way to curb externalities.

B. externalities can never be corrected.
C. correcting market failure can result in government failure.
D. getting rid of externalities requires a great deal of necessary sacrifice for all of us.
168.Opponents of government intervention argue that government makes decisions based on:
A. marginal social costs and marginal social benefits.

B. marginal political costs and marginal political benefits.
C. irrational choices.
D. total costs and total benefits.
8-46
169.Both opponents of and proponents of government intervention most likely would agree with which
of the following?
A. Government can and does create proper incentives to correct for externalities.
B. Property rights eliminate the need for government.
C. The market is inherently fair.
D. Property rights must exist for a market to operate.
170.Government failure occurs when:
A. government fails to implement policy designed to correct a market failure.

B. government intervention in the market to improve a market failure succeeds.
C. government intervention in the market to correct a market failure makes things worse.
D. there is no need for government intervention into the market because there is no market
failure.
171.Suppose a public good that is worth $1 billion is not produced by the market, and so the
government provides it, but at a cost of $3 billion. This attempt to correct a market failure has:
A. been successful since the public good is now produced.

B. given rise to the problem of free riders.
C. resulted in a government failure since use of resources is now less efficient.
D. resulted in an information asymmetry for the government.
172.A European Union official, Mr. McGreevey, claims a portion of EU law involves overregulation.
McGreevey is suggesting the EU suffers in part from:
A. market failure
B. fairness.
C. government failure.
D. the rule of law.
173.All of the following are justifications for government intervention except:
A. too much competition.

B. informational problems.
C. externalities.
D. public goods.
8-47
174.Government may not have an incentive to correct a market failure because:
A. government doesn't have the information it needs to correct the market failure.
B. government reflects politics, which reflects individuals' interests in trying to gain more for
themselves.
C. policy makers fear that intervention will lead to a Pareto optimal outcome.
D. the benefit of correcting the market failure might exceed the cost of correcting the market
failure.
175.Government failure is likely to occur for all of the following reasons except:
A. special interest groups might lobby government to the detriment of the public good.
B. individuals have better information about a situation that affects them than does government.
C. intervention in markets is always simpler than it initially seems.
D. the bureaucratic nature of government intervention does not allow fine-tuning.
8-48
Chapter 08 Market Failure versus Government Failure Answer Key
True / False Questions
1. Externalities can be either positive or negative.
TRUE
Positive externalities have positive effects on third parties, and negative externalities have
negative effects.
AACSB: Analytic
Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 08-01 Explain what an externality is and show how it affects the market outcome.
Topic: Externalities
2. Economists generally prefer direct regulation to incentive-based programs because explicit

regulation tends to be more efficient.
FALSE
Direct regulation is not generally as efficient as incentive-based programs.
AACSB: Analytic
Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 08-02 Describe three methods of dealing with externalities.
Topic: Direct Regulation
3. Direct regulation means that government sets specific limits on the use of scarce resources.
TRUE
See the definition of direct regulation in the textbook.
AACSB: Analytic
Blooms: Understand
Difficulty: 1 Easy
8-49
4. Economists are likely to oppose direct regulation because they do not believe there is any
need for government to take action when negative externalities exist.
FALSE
Economists' opposition to direct regulation generally is based on their findings that direct
regulation doesn't accomplish a given goal as efficiently as possible.
AACSB: Analytic
Blooms: Understand
Difficulty: 2 Medium
5. Economists tend to believe that market incentive plans are generally more efficient than direct
regulation.
TRUE
Market incentive plans are more likely to make marginal costs equal marginal benefits and
thus are likely to be more efficient.
AACSB: Analytic
Blooms: Understand
Topic: Tradable Permits
6. An optimal policy is one in which the marginal cost of undertaking a policy is less than the
marginal benefit of that policy.
FALSE
An optimal policy is one in which the marginal cost of undertaking a policy equals the marginal
benefit of that policy.
AACSB: Analytic
Blooms: Understand
Difficulty: 3 Hard
Topic: Marginal Costs and Marginal Benefits
8-50
7. If a program requires people to pay a price that reflects the cost of an externality associated
with their actions that they previously did not pay, it will be in their best interest to change their
behavior.
TRUE
If a person were required to pay the higher price that reflects the cost of an externality, that
person would reduce quantity demanded (law of demand).
AACSB: Analytic
Blooms: Understand
Topic: Tax and Subsidy Programs
8. Government provides secondary education because of its private good aspects.
FALSE
Education has public good aspects, and that is one reason government provides it.
AACSB: Analytic
Blooms: Apply
Difficulty: 1 Easy
Learning Objective: 08-03 Define public good and explain the problem with determining the value of a public good to society.
Topic: Public Goods
9. Economists believe that free riders often can undermine the social commitment of many in the
society, causing voluntary policies to fail.
TRUE
Economists believe that the incentive facing individuals is to maximize individual utility. This
would lead to an individual cheating (free riding) to reduce marginal cost while enjoying the
benefits of others' actions.
AACSB: Analytic
Blooms: Understand
Topic: Voluntary Programs
8-51
10. Adverse selection problems can occur when buyers and sellers have different amounts of
information about a good for sale.
TRUE
This is the way in which adverse selection problems are defined.
AACSB: Analytic
Blooms: Understand
Learning Objective: 08-04 Explain how informational and moral hazard problems can lead to market failure.
Topic: Informational Problems
11. Moral hazard problems can occur when insured individuals change their behavior to the
detriment of the insurer.
TRUE
Moral hazard is a problem that arises when people don't have to bear the negative
consequences of their actions. In this case, the insurer bears the consequences.
AACSB: Analytic
Blooms: Understand
12. Government attempts to offset market failures can prevent the market from dealing with a
problem more effectively.
TRUE
The market's way of dealing with problems generally works only in the long run. If government
deals with the problems in the short run, it may eliminate incentives that would have brought
about a long-run market solution.
AACSB: Analytic
Blooms: Understand
Learning Objective: 08-05 Explain why market failure is not necessarily a reason for government intervention.
Topic: Government Failure
8-52
13. If government action is likely to do some good, it is always best for government to intervene in
the marketplace.
FALSE
Even in those cases in which government action might do some good, it could lead to
additional intervention in cases in which it could make the situation worse.
AACSB: Analytic
Blooms: Understand
Multiple Choice Questions
14. What do economists mean when they say there is "market failure"?
A. Business has introduced a product that consumers did not want.

B. Free markets have led to excessive profits.
C. Markets have surpluses or shortages so that government rationing is necessary.
D. Free markets yield results that economists do not consider socially optimal.
Economists define socially optimal in terms of economic efficiency. Market failure means that
there is lost value—it is at least theoretically possible to change something to increase end
value.
AACSB: Analytic
Blooms: Understand
Topic: Market Failure
8-53
15. Some economists believe that the market will not solve all problems. They are referring to:
A. market failure.
B. market incentive plans.
C. optional policy.
D. the need to balance the good of the individual with the good of society as a whole.
Market failures are market results that are less than optimal.
AACSB: Analytic
Blooms: Understand
Difficulty: 1 Easy
16. All of the following are considered sources of market failure except:
A. public goods.
B. imperfect information.
C. profit-maximizing behavior.
D. externalities.
Profit-maximizing behavior is assumed in the competitive market model; it is not itself a source
of market failure.
AACSB: Analytic
Blooms: Understand
17. The criterion that no person can be made better off without another being made worse off is
known as the:
A. normative criterion.
B. Pareto criterion.
C. nirvana criticism.
D. second-best criticism.
Refer to Added Dimension: Pareto Optimality and the Perfectly Competitive Benchmark in the
text.
AACSB: Analytic
Blooms: Understand
8-54
Topic: Pareto Optimality
18. John has 10 apples and six bananas. Jane has two bananas and two apples. If this situation is
Pareto optimal, what mutually beneficial exchange could be made?
A. None; there is no exchange that can help one without hurting the other.
B. Fruit should be taken from John and given to Jane to equalize their holdings.
C. Jane should give up apples to get bananas.
D. Jane should give up bananas to get apples.
No voluntary exchange will take place if the start is Pareto optimal.
AACSB: Analytic
Blooms: Understand
19. The perfectly competitive output level is Pareto optimal because at this output level:
A. the total cost to society equals the total benefit.

B. the marginal cost to society equals the marginal benefit.
C. the marginal cost to society is minimized.
D. the marginal benefit to society is maximized.
text.
AACSB: Analytic
Blooms: Understand
8-55
20. The economist who mathematically proved that a complete set of competitive markets could
yield a socially (or Pareto) optimal result was:
A. Adam Smith.
B. Kenneth Arrow.
C. Milton Friedman.
D. Ronald Coase.
text.
AACSB: Analytic
Blooms: Understand
21. If there is a complete set of markets that are perfectly competitive:
A. the marginal cost of producing goods will exceed their marginal benefit.
B. the marginal cost of producing goods will be less than their marginal benefit.
C. every person's utility function is at a maximum.
D. the invisible hand guides the economy to a Pareto optimal position.
text.
AACSB: Analytic
Blooms: Understand
Difficulty: 3 Hard
8-56
22. If a system has multiple defects but those defects in effect offset each other, curing one defect
may make the system perform more poorly. This possibility is known as:
A. the Hume dictum.

B. the normative criticism of Pareto optimality.
C. the second best criticism of Pareto optimality.
D. the nirvana criticism of Pareto optimality.
For example, a firm that is a monopolist and a polluter causes two market failures. Monopoly
makes it produce too little; the externalities make it produce too much. Curing one problem
could move the system further from efficiency. See Added Dimension: Pareto Optimality and
the Perfectly Competitive Benchmark in the text.
AACSB: Analytic
Blooms: Understand
Difficulty: 3 Hard
23. Can outcomes that are not Pareto optimal be considered better than outcomes that are Pareto
optimal?
A. No; Pareto optimal is defined as the best possible outcome.

B. Yes, if the non-Pareto optimal outcome is more efficient than the Pareto optimal outcome.
C. Yes, if the distribution of wealth in the Pareto optimal outcome is considered undesirable.
D. Yes, if there are too many market failures in the Pareto optimal outcome.
Pareto optimality is defined without consideration to the distribution of wealth. A situation in

which one person has everything may be Pareto optimal, but few would consider it a good
outcome. Note that this requires reading the box, "Pareto Optimality and the Perfectly
Competitive Benchmark."
AACSB: Analytic
Blooms: Understand
Difficulty: 3 Hard
8-57
24. If a market has no externalities, marginal private costs:
A. exceed marginal social costs.

B. equal marginal social costs.
C. are below marginal social costs.
D. intersect marginal social costs.
The difference between marginal social costs and marginal private costs is due to
externalities.
AACSB: Analytic
Blooms: Understand
Difficulty: 3 Hard
25. Economists generally call the effect of an agreement on others that is not taken into account
by the parties making the agreement:
A. excess burden.
B. welfare loss.
C. Pareto optimality.
D. an externality.
The effects on third parties not taken into account by the parties making the agreement.
AACSB: Analytic
Blooms: Understand
Difficulty: 1 Easy
26. The best example of a positive externality is:
A. roller coaster rides.

B. pollution.
C. alcoholic beverages.
D. education.
Pollution is an example of a negative externality. Roller coaster rides and alcoholic beverages
are private goods.
AACSB: Analytic
Blooms: Apply
8-58
27. Alex is playing his music at full volume in his dorm room. The other people living on his floor
find this to be nuisance, but Alex does not care. Alex's music playing is an example of a:
A negative externality is a spillover effect that harms third parties.
AACSB: Analytic
Blooms: Understand
Difficulty: 1 Easy
28. Alex is playing his music at full volume in his dorm room. The other people living on his floor
are enjoying his music, but Alex does not know or care. Alex's music playing is an example of
a:
A positive externality is a spillover effect that benefits third parties.
AACSB: Analytic
Blooms: Understand
Difficulty: 1 Easy
8-59
29. James enjoys gardening in the nude because he says it puts him in touch with nature. His
neighbors find his gardening routine very offensive, but James replies that they should mind
their own business and not watch him. To an economist this situation illustrates the concept
of:
A. the tragedy of the commons.

C. a positive externality.
A negative externality is a spillover effect that harms third parties.
AACSB: Analytic
Blooms: Understand
Difficulty: 1 Easy
30. Carbon dioxide emissions are thought to contribute to global warming, and there is concern
that changes in climate will be costly. Emitting carbon dioxide is an example of:
A. a public good.
C. an adverse selection problem.
D. an effluent fee.
If climate-changing emissions of carbon dioxide impose costs on society, it is an example of a

negative externality.
AACSB: Analytic
Blooms: Apply
8-60
31. In the Flint Hills area of Kansas, proposals to build wind turbines to generate electricity have
pitted environmentalist against environmentalist. Members of the Kansas Sierra Club support
the turbines as a way to reduce use of fossil fuel, but local chapters of the Nature
Conservancy say they will befoul the landscape. The Sierra Club argues that wind turbines:

Burning fossil fuels creates a variety of types of air pollution, a negative externality. The
attraction of wind power to many is that it reduces that negative externality. The Nature
Conservancy is pointing out another negative externality created by the windmills.
AACSB: Analytic
Blooms: Apply
32. Proposals in Flint Hills, Kansas, to build wind turbines to generate electricity have pitted
environmentalist against environmentalist. Members of the Kansas Sierra Club support the
turbines as being a way to reduce use of fossil fuel, but local chapters of the Nature
Conservancy say they will befoul the landscape. The chapters of the Nature Conservancy
argue that wind turbines:

If the windmills are an eyesore, they are creating a negative externality.
AACSB: Analytic
Blooms: Apply
8-61
33. College education provides higher income for the individual but also a more productive and
more educated person who will contribute to society in many ways. Higher education is an
example of:
A. a positive externality.
C. a non-excludable service.
The spillover effect of a person who is educated making others around him more productive is
a positive externality. It is a primary justification for the state subsidizing higher education.
AACSB: Analytic
Blooms: Apply
34. Richard Vedder argues that the states that have spent the most on higher education in the last
25 years have experienced the least economic growth. One might conclude that higher
education:
A. does not have important positive externalities.

B. does not have important negative externalities.
C. is a non-excludable service.
D. has problems of adverse selection.
The spillover effects of a person who is educated—making others around her more
productive—is a positive externality. It is a primary justification for the state subsidizing higher
education. Vedder's findings indicate that these positive externalities do not exist or at least
that they are outweighed by other costs.
AACSB: Reflective Thinking

Blooms: Apply
8-62
35. Under the Texas law known as "rule of capture," land owners "get to pump as much of the
water under it as they want. . . . 'This means whoever sucks it out first, it's their water'—even if
that means there isn't enough left for others." Under this law, pumping large amounts of
water:
A. imposes a negative externality on others.

B. imposes a positive externality on others.
C. imposes the free rider effect on others.
D. is a private decision with no effects on others.
When property rights are poorly allocated, there can be effects on third parties not involved in
the trade, as in this case.
AACSB: Analytic
Blooms: Understand
36. Which of the following is not an example of an externality?
A. Carbon dioxide from energy generation that adds to the worldwide long-term greenhouse
effect
B. Heat from a factory that makes the neighboring tomato patches more productive
C. A defective part that causes an automobile to break down three months after purchase
D. Acidic by-products of fossil fuel combustion that produce acid rain
An externality is the effect of a decision on a third party not taken into account by the decision
makers. The defective part is affecting one of the decision makers, not a third party.
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
8-63
37. An externality is present in a free market whenever:
A. a monopolist spends funds to keep potential competitors out of the market.

B. an activity generates costs or benefits that are not reflected in market prices.
C. firms hire employees from outside the firm to fill positions normally filled by promotion from
within the firm.
D. a tax is imposed on the supplier of a good.
Externalities cause marginal social costs and benefits and marginal private costs and benefits
to differ. Thus, marginal costs and benefits are not reflected in market prices.
AACSB: Analytic
Blooms: Understand
38. When negative externalities are present, market failure often occurs because:
A. the cost borne by a third party not involved in the trade is not reflected in the market price.
B. the borne by a third party not involved in the trade is reflected in the market price.
C. the existence of imports from foreign countries takes jobs (and income) away from U.S.
citizens.
D. consumers will consume the good at a level at which their individual marginal benefits
exceed the marginal costs borne by the firm producing the good.
Externalities cause marginal social costs and marginal private costs to differ. Thus, costs and
benefits are not reflected in market prices.
AACSB: Analytic
Blooms: Understand
8-64
39. The existence of negative externalities:
A. prevents the market from working efficiently.

B. prevents government from intervening in the marketplace.
C. causes the market to work more effectively.
D. necessarily means that government must intervene in the marketplace.
Externalities are one type of market failure. As the text later shows, it is not always beneficial
to have government intervention.
AACSB: Analytic
Blooms: Understand
40. An example of a negative externality is the:
A. decrease in your real income that results when photographic equipment you purchase
increases in price because of increased demand by others for these items.
B. cost you bear when your neighbor has a noisy party and does not compensate you for your
discomfort.
C. benefit you receive without paying when your neighbor installs a smoke detector.
D. decrease in income to farmers that results from a drought.
Negative externalities are negative effects of trades not taken into account by the decision
makers. The smoke detector has a positive effect on a third party and is an example of a
positive externality. The decrease in your real income from higher photographic equipment
prices is a monetary externality that does not generate a net cost to society. It is not a
negative externality.
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
8-65
41. If a negative externality is associated with burning firewood:
A. the marginal social cost of burning firewood falls short of its price.
B. the marginal social cost of burning firewood is exactly equal to its price.
C. less than the efficient amount of firewood for burning will be used each year.
D. the marginal social cost of burning firewood exceeds the price of burning firewood.
A negative externality causes the marginal social cost to exceed the marginal private cost (the
market price).
AACSB: Analytic
Blooms: Apply
42. When negative externalities exist in the production of a good, the marginal social cost of
producing the good:
A. is equal to the marginal benefit received by consumers if competitive markets exist and
there is no government intervention.
B. equals the marginal cost borne by the firm minus marginal cost borne by a third party that
results from the production and consumption of the good.
C. is less than the marginal cost borne by the firm.
D. equals the marginal cost borne by the firm plus the marginal cost borne by third parties
from the production and consumption of the good.
A negative externality causes the marginal social cost to exceed the marginal private cost. The
difference between the two is the cost borne by third parties.
AACSB: Analytic
Blooms: Understand
8-66
43. The cost of running an electrical utility includes costs for fuel, labor, and capital. In addition,
there are sometimes costs associated with pollution from the utility, such an increased health-
care costs for people living near the utility. To an economist, the costs associated with the
pollution resulting from additional electricity are:
A. marginal private costs.

B. marginal social costs.
C. the difference between marginal social costs and marginal private costs.
D. the sum of marginal social costs and marginal private costs.
The costs the producer bears (the marginal private costs) plus the costs imposed on third
parties equal the marginal social costs. The cost associated with the pollution is marginal
social cost minus marginal private cost.
AACSB: Analytic
Blooms: Understand
44. If a positive externality is associated with the purchase of smoke detectors:
A. the marginal social benefit of smoke detectors exceeds their price.

B. the marginal social benefit of smoke detectors is zero.
C. the marginal social benefit of smoke detectors equals their price.
D. more than the efficient quantity of smoke detectors will be sold.
A positive externality causes the marginal social benefit to exceed the marginal private benefit
(and marginal private cost, or price).
AACSB: Analytic
Blooms: Apply
8-67
45. When positive externalities exist in the consumption of a good, the marginal social benefit:
A. equals the marginal benefit received by consumers of the good minus the marginal benefit
to third parties.
B. equals the marginal cost of producing the good plus the marginal cost to third parties.
C. equals the marginal benefit received by consumers of the good plus the marginal benefit to
third parties.
D. could be either greater than or less than the marginal benefit received by consumers of the
good depending on the equilibrium price determined in competitive markets.
Positive externalities are not included in the marginal benefit to those involved in the trade.
The marginal social benefit is the benefit to the trader plus the benefit to third parties.
AACSB: Analytic
Blooms: Understand
46. If a negative externality exists in the production of paper and paper is sold in a perfectly
competitive market, at the equilibrium output:
A. additional net gains to society are possible by reducing the output of paper.
B. additional net gains to society are possible by increasing the output of paper.
C. the marginal social benefit of paper equals its marginal social cost.
D. additional net gains to society are not possible from either increasing or decreasing the
output of paper.
If negative externalities exist, the marginal social cost exceeds the marginal private cost and
too much of the good is produced. Net social gains are possible by reducing production.
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
8-68
47. If a positive externality exists in the provision of education when education is provided in a
perfectly competitive market without government intervention, at the market equilibrium level
of education:
A. additional net gains to society are possible by reducing the level of education.
B. additional net gains to society are possible by raising the level of education.
C. the marginal social benefit of education equals the marginal social cost.
D. additional net gains to society are not possible by either increasing or decreasing the level
of education.
Since there is a positive externality, marginal social benefit exceeds marginal private benefit.
The market equilibrium occurs where marginal private benefit equals marginal private cost, but
the socially optimal level is where marginal social benefit equals marginal private cost.
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
48. If a negative externality exists in the market for dirt bikes and that market is perfectly
competitive:
A. less than the efficient output of dirt bikes will be produced.

B. the price of dirt bikes exceeds the marginal social cost.
C. the price of dirt bikes equals the marginal social cost.
D. the price of dirt bikes is less than the marginal social cost.
A negative externality causes the marginal social cost to exceed the marginal social benefit.
Too much of the good is produced, and too low a price is charged consumers.
AACSB: Analytic
Blooms: Understand
8-69
49.
Refer to the graph shown. There is a $.010 per-gallon marginal cost external to the trade
associated with the use of gasoline. Assuming that gasoline is sold in perfectly competitive
markets, the market equilibrium price will be:
A. $0.95
B. $1.00
C. $1.05.
D. $1.10.
Equilibrium is where MC = MB, point G.
AACSB: Analytic
Blooms: Apply
8-70
50.
Refer to the graph shown. If the marginal cost external to the trade associated with the use of
gasoline is $0.10 per gallon, the point on the graph corresponding to the efficient quantity and
price is:
A. G.
B. H.
C. K.
D. L.
The efficient point is where MSC = MSB, point K.
AACSB: Analytic
Blooms: Apply
8-71
51.
Refer to the graph shown. Assuming a $0.10-per-gallon marginal cost external to the trade
that is associated with gasoline, the market price of gasoline necessary to induce consumers
to purchase the efficient quantity each year is:
A. $1.10.
B. $1.00.
C. $1.05.
D. $0.95.
The externality, $0.10 per gallon, must be internalized by a tax to result in an efficient point, K.
Some of the tax burden is borne by producers.
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
Topic: Tax and Subsidy Incentives
8-72
Assuming a marginal cost external to the trade equals the tax shown in the graph, the market
price necessary to induce consumers to purchase the efficient quantity each year is:
A. P1.
B. P2.
C. P3.
D. P4.
The efficient price is where MSC = MSB, or P2.
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
53. Once vaccinated, a person cannot catch a cold or give a cold to someone else. As a result,
the marginal social benefit resulting from consumption of the vaccine:
A. exceeds the marginal benefit received by consumers of the vaccine.

B. equals the marginal social cost of producing the vaccine in a competitive equilibrium.
C. equals the marginal benefit received by consumers of the vaccine in a competitive
equilibrium.
D. is less than the marginal benefit received by consumers of the vaccine.
There is a positive externality associated with the vaccine. The MSB curve is to the right of the
demand curve for the vaccinated person.
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
8-73
54.
As a result, the marginal social benefit curve will:
A. coincide with the market demand curve.

B. lie strictly below the market supply curve.
C. lie below the market demand curve.
D. lie above the market demand curve.
There is a positive externality associated with the vaccine. The MSB curve is to the right of
(above) the demand curve shown.
AACSB: Analytic
Blooms: Apply
8-74
55.
At the competitively determined output level, the marginal social benefit will be:
A. equal to P0.
B. less than P0.
C. greater than or less than P0 depending on the income elasticity of demand and the
D. greater than P0.
demand curve shown. Without intervention, equilibrium price (MB) is P0. Thus, MSB is greater
than P0 at Q0.
AACSB: Analytic
Blooms: Apply
8-75
56.
The socially efficient level of output is:
A. less than Q0.

B. greater than or less than Q0 depending on the income elasticity of demand and the
C. greater than Q0.
D. equal to Q0.
demand curve shown. Without intervention, the equilibrium quantity is Q0. The efficient level of
output is where MSB = MC, greater than Q0.
AACSB: Analytic
Blooms: Apply
8-76
57.
If government does not subsidize the production of this vaccine:
A. the number of workers hired to produce the vaccine will be less than the socially efficient
level.
B. the firm producing the vaccine will use too much capital in producing the vaccine.
C. the vaccine will be overproduced because consumers will not take into account the fact
that many of their neighbors and co-workers will consume the vaccine.
D. no positive externality can be created.
demand curve shown. Without intervention, too little vaccine will be produced to equate
marginal social benefits and marginal social costs.
AACSB: Analytic
Blooms: Apply
8-77
The point on the graph corresponding to the socially optimal output per year and the price
sellers must receive to make that amount available is shown by point:
A. G.
B. H.
C. I.
D. K.
The efficient output is where MSC = MSB.
AACSB: Analytic
Blooms: Apply
8-78
59. If a negative externality is to be internalized to the decision maker, the:
A. producers' marginal costs should be increased by an amount equal to the marginal cost to
B. producers' marginal costs should be reduced by an amount equal to the marginal cost to
C. consumer of the good should receive a subsidy equal to the marginal cost to those outside
the trade that results from production of the good.
D. consumer of the good should pay a tax equal to the marginal benefit to those outside the
trade that results from consuming the good.
To internalize a negative externality, MC must be increased by the amount of the externality.
AACSB: Analytic
Blooms: Understand
60. If a positive externality is to be taken full advantage of, the:
A. consumer of the good should receive a subsidy equal to the marginal cost imposed on third
parties that results from production (or consumption) of the good.
B. producers' marginal costs should be increased by an amount equal to the marginal benefit
to third parties that results from production of the good.
C. consumer of the good should pay a tax equal to the marginal benefit to third parties that
results from production (or consumption) of the good.
D. producers' marginal costs should be decreased by an amount equal to the marginal cost
imposed on third parties that results from production of the good.
To internalize a positive externality, the marginal benefit must be increased by the amount of
the externality. That is, consumers must be subsidized.
AACSB: Analytic
Blooms: Understand
8-79
61. If a corrective tax on gasoline results in the efficient output of gasoline by internalizing
negative externalities associated with pollution:
A. pollution from gasoline will increase because people are also harmed by the tax.
B. there will be no effect on pollution from gasoline because the tax is paid by the supplier.
C. pollution from gasoline will be zero because environmental cleanliness is priceless.
D. the tax will generate enough revenue to compensate society for the damages resulting
from the pollution that still occurs.
Since the tax is equal to the marginal cost of the consumption of gasoline imposed on third
parties, the revenue generated by the tax equals the total cost of the pollution to society.
AACSB: Analytic
Blooms: Understand
Difficulty: 3 Hard
62.
Refer to the graph shown. Say that there is a negative externality associated with the
production of the good depicted. The marginal social benefit from consuming this good at the
competitive equilibrium output level is:
A. greater than P0.

B. equal to P0.
C. either greater than or less than P0, depending on the elasticities of supply and demand.
D. less than P0.
If there is a negative externality, the marginal social cost is to the left of the supply curve.
However, the competitive equilibrium remains at Q0, P0. Since the marginal social benefit is
still given by the demand curve and the externality is not charged for, the competitive
equilibrium remains at P0 and Q0.
AACSB: Analytic
8-80
Blooms: Apply
Difficulty: 3 Hard
63.
Refer to the graph shown. Say that there is a negative externality associated with the
production of the good depicted. The marginal social cost from consuming this good at the
competitive equilibrium output level is:
A. either greater than or less than P0, depending on the elasticities of supply and demand.
B. greater than P0.
C. less than P0.
D. equal to P0.
If there is a negative externality, the marginal social cost is to the left of the supply curve. The
competitive equilibrium remains at Q0, P0, where MSC > MC = P0.
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
8-81
64.
Refer to the graph shown. There is a negative externality associated with the production of the
good depicted. The socially efficient level of output is:
A. either greater than or less than Q0, depending on the elasticities of supply and demand.
B. less than Q0.
C. equal to Q0.
D. greater than Q0.
If there is a negative externality, the marginal social cost is to the left of the supply curve. The
efficient level of output is to the left of the competitive equilibrium.
AACSB: Analytic
Blooms: Apply
65. The rule for making optimal decisions is that an activity should be increased until:
A. average costs are minimized.

B. total costs are minimized.
C. total benefits are maximized.
D. marginal benefits equal marginal costs.
We want to maximize net benefits, the excess of total benefits over total costs. This happens
when marginal benefits equal marginal costs.
AACSB: Analytic
Blooms: Understand
Difficulty: 3 Hard
8-82
66. A strategy that achieves a goal at the lowest cost in total resources without consideration of
who pays those costs is:
A. efficient.
B. inefficient.
C. impossible.
D. always the most profitable to the firm.
See the definition of efficient in the textbook.
AACSB: Analytic
Blooms: Understand
67. Direct regulation is inefficient because:
A. affected firms ignore regulations, for example, by dumping toxic waste illegally.
B. it does not take into account that the costs of reducing consumption are the same for all
individuals.
C. it does not take into account the fact that the costs of reducing consumption may differ
among individuals.
D. it does not take negative externalities into account.
The purpose of regulation is to correct for negative externalities by reducing consumption to

the socially optimal level, but the costs of reducing consumption differ among individuals, and
so an optimal policy would not require the same reduction for everyone.
AACSB: Analytic
Blooms: Understand
Difficulty: 3 Hard
8-83
68. Suppose that government wants a policy that will encourage people to use less oil. For this
policy to be efficient, it must:
A. induce those with the highest cost of conserving to reduce their oil consumption the most.
B. induce those with the lowest cost of conserving to reduce their oil consumption the most.
C. force everyone to reduce oil consumption equally.
D. force rich people to reduce oil consumption proportionally more than poor people.
Efficiency means that marginal costs equal marginal benefits. If the marginal cost of reducing
consumption is less for some individuals, it is efficient that they reduce consumption the most.
AACSB: Analytic
Blooms: Understand
Difficulty: 3 Hard
69. Economists generally oppose direct regulation because:
A. it is unlikely to achieve the desired end as efficiently as possible.

B. it assumes that people behave rationally.
C. it is generally unfair.
D. it does not assume that people behave rationally.
Because direct regulation is less likely to make marginal costs equal marginal benefits, it is not
as efficient as market incentive plans.
AACSB: Analytic
Blooms: Understand
8-84
70. A market incentive plan:
A. regulates the amount of a resource a person can consume through direct limits.
B. requires that people choose to consume until the marginal costs exceed the marginal
benefits.
C. makes the price of a resource reflect not only the marginal private costs but also the
marginal social costs of consuming that resource.
D. makes the price of a resource reflect the marginal private costs of consuming that
resource.
See the definition of market incentive plan in the textbook.
AACSB: Analytic
Blooms: Understand
Difficulty: 3 Hard
71. To address the problems created by negative externalities, economists prefer programs that:
A. require government to conserve, using general tax revenues to pay for the program.
B. require all people to reduce consumption equally.
C. make people who have the lowest benefit of reducing consumption choose to undertake
the most reduction.
D. make people who have the lowest cost of reducing consumption choose to undertake the
most reduction.
Economists prefer efficient programs, that is, those which require that individuals equate
marginal costs and marginal benefits. This means that those people for whom reducing
consumption is less costly will undertake the greatest reduction.
AACSB: Analytic
Blooms: Understand
8-85
72. The following table shows four firms, the amount each pollutes, the marginal cost for each firm
to clean up pollution, and the total cost to each firm of eliminating all pollution.
pollutes.
Refer to the table shown. If the goal of the government is to reduce pollution by 50 percent,
the cheapest way would be to have:
A. all four firms cut their discharge by 50 percent

B. have each firm reduce discharge by 37.5 tons.
C. have firms A and D stop discharging and allow B and C to continue.
D. have firms B and C stop discharging and allow A and D to continue.
A and D have the lowest per unit cost of cleanup. If we want to use the fewest resources to get
a 50 percent reduction in pollution, this is the low-cost way to do it.
AACSB: Analytic
Blooms: Apply
8-86
pollutes.
Refer to the table shown. Assume that these firms want to maximize profits. If the government
wishes to cut discharge by 50 percent, it could do so by establishing an effluent fee of:
A. $3.00.
B. $4.50.
C. $5.50.
D. $10.00.
A and D would find it cheaper to clean up their pollution than pay the tax, whereas firms B and
C would find it cheaper to pay the tax than clean up.
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
8-87
pollutes.
Refer to the table shown. If the government establishes an effluent fee of $7.00, how much tax
would firms pay to the government?
A. $660
B. $1,050
C. $1,820
D. $2,100
A and D clean up for a cost of $660. B and C pay the tax for a cost of $1,050.
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
8-88
pollutes.
Refer to the table shown. If the government establishes an effluent fee of $7.00, how much
would the firms spend on reducing pollution?
A. $660
B. $1,710
C. $1,820
D. $2,100
A and D clean up for a cost of $660. B and C pay the tax for a cost of $1,050, but this is not
part of the cost of cleanup.
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
8-89
pollutes.
Refer to the table shown. If the government establishes a regulation requiring each company
to reduce pollution by 50 percent, what will be spent on reducing pollution?
A. $660
B. $910
C. $1,050
D. $1,710
If all the firms clean up completely, the total cost will be $1,820. If each has to pay half of that,
the total is $910. The difference between $910 and $660, the least-cost way of reducing
pollution by 50 percent, is the efficiency cost of this regulation.
AACSB: Analytic
Blooms: Apply
8-90
pollutes.
Refer to the table shown. Suppose that the government gives each company a pollution permit
equal to 50 percent of its present discharge. However, companies are allowed to reduce
pollution more than 50 percent and sell their permit or reduce less than 50 percent and buy a
permit from another company. If firms maximize profits, what would happen?
A. Each firm would reduce pollution by 50 percent.

B. Firms A and D would eliminate pollution and sell their permits to B and C, which would
C. Firms B and C would eliminate pollution and sell their permits to A and D, which would
D. There is not enough information to answer this question.
The market price of the permits should be between $5.00 and $7.50. At that price, A and D will
find it profitable to clean up and sell their permits, and B and C will find it profitable to buy the
permits and continue polluting. Any other solution results in less profit, which violates the
assumption in the question that firms are maximizing profits.

Blooms: Apply
Difficulty: 3 Hard
8-91
78. An effluent fee is an example of:
A. a voluntary approach to pollution.

B. a direct regulation of pollution.
C. a tax incentive policy.
D. a market incentive policy.
An effluent fee is a tax on pollution. The more one pollutes, the more one pays. Hence, there
is an incentive to reduce pollution in order to reduce the tax.
AACSB: Analytic
Blooms: Understand
Difficulty: 1 Easy
79. Based on economic theory, most economists believe market incentive plans are:
A. equitable.
B. efficient.
C. inefficient.
D. unfair.
Economic theory tells us that the plans are efficient; it says nothing about equity or fairness.
AACSB: Analytic
Blooms: Understand
Difficulty: 3 Hard
80. In a tax incentive program, the person who conserves the most pays:
A. relatively less tax.

B. relatively more tax.
C. no tax.
D. no penalties.
Tax incentive programs impose a tax on the consumption of a good. Those who consume the
least pay the least tax.
AACSB: Analytic
Blooms: Understand
8-92
81. Which of the following methods of reducing the amount of trash society generates is most
likely to be efficient?
A. A mandatory recycling program

B. A completely voluntary recycling program
C. A "trash tax"
D. Landfills and incinerators
Market-based programs such as a trash tax are more likely to equate marginal benefit and
marginal cost.
AACSB: Analytic
Blooms: Understand
82. Which policy is likely to be the most efficient in dealing with automobile emission pollution?
A. A mandatory requirement to reduce pollution

B. Voluntary emission control guidelines
C. Subsidizing research and development for alternative forms of transportation
D. An emission tax
Taxes are more likely to equate marginal benefit and marginal cost.
AACSB: Analytic
Blooms: Understand
8-93
83. A policy that requires all the people to certify that they have reduced total consumption, not
necessarily their own individual consumption, by a specified amount, is a(n):
A. external incentive plan.

B. internal incentive plan.
C. tax incentive plan.
D. market incentive plan.
See the definition of market incentive plan in the textbook.
AACSB: Analytic
Blooms: Understand
Difficulty: 1 Easy
84. Suppose Mary finds it easier to conserve than Jim does. The difference between a tax
incentive program and a marketable certificate plan in this case is that:
A. Mary undertakes most of the conservation in the case of a tax incentive program and least
in the marketable certificate program.
B. Mary undertakes least of the conservation in the case of a tax incentive program and most
in the marketable certificate program.
C. Mary takes on most of the conservation in both cases but is paid by Jim in the marketable
D. Jim takes on most of the conservation in both cases but is paid by Mary in the marketable
Since Mary finds it easier to conserve, she conserves the most in both cases. In the market
incentive plan, however, Jim pays Mary to conserve for him. Thus, she gains financially.
AACSB: Analytic
Blooms: Understand
8-94
imposition of a tax on that good will:
A. increase the price of that good and increase pollution.

B. reduce the price of that good and increase pollution.
C. reduce the price of that good and decrease pollution.
D. increase the price of that good and reduce pollution.
Market supply shifts to the left, and so equilibrium price rises and equilibrium quantity falls,
thereby reducing pollution.
AACSB: Analytic
Blooms: Understand
Difficulty: 3 Hard
imposition of a tax on the good will:
A. reduce the number of firms producing that good in the long run.
B. increase the number of firms producing that good in the long run.
C. reduce the number of firms producing that good in the short run.
D. increase the number of firms producing that good in the short run.
By assumption, the number of firms in a perfectly competitive industry can change only in the
long run.
AACSB: Analytic
Blooms: Understand
Difficulty: 3 Hard
8-95
87. An individual with a highly elastic demand for gasoline will:
A. cut consumption more than an individual with a highly inelastic demand when price goes
up.
B. cut consumption less than an individual with a highly inelastic demand when price goes up.
Since that person finds it easy to conserve gasoline, he or she will reduce consumption of
gasoline by a lot.
AACSB: Analytic
Blooms: Understand
Difficulty: 3 Hard
88. A firm with a highly inelastic demand for coal will:
A. cut consumption more than a firm with a highly elastic demand when price goes up.
B. cut consumption less than a firm with a highly elastic demand when price goes up.
Since that firm finds it difficult to conserve gasoline, it will reduce consumption of gasoline by
comparatively less.
AACSB: Analytic
Blooms: Understand
Difficulty: 3 Hard
89. A policy is considered optimal if it:
A. is supported by a majority of voters.

B. equates total costs with total benefits.
C. equates marginal costs with marginal benefits.
D. forces people to conserve on scarce resources.
See the definition of optimal policy.
AACSB: Analytic
Blooms: Understand
8-96
90. An optimal corrective tax levied on polluters will:
A. be equal to the marginal cost of their actions imposed on third parties.

B. not generate enough revenue to pay for the cost of the damage resulting from pollution that
occurs at the efficient output of the good.
C. decrease pollution to zero.
D. increase the supply of polluting goods.
An optimal policy equates marginal costs (including costs imposed on third parties) with
marginal benefits. Because the amount of the tax equals the total cost of the pollution imposed
on third parties, it equals the cost of the pollution to society.
AACSB: Analytic
Blooms: Understand
Difficulty: 1 Easy
91. A policy in which the marginal costs of undertaking the policy equal the marginal benefits of
that policy is best called an:
A. equality policy.
B. incentive policy.
C. optimal policy.
D. opportunity policy.
See the definition of optimal policy in the textbook.
AACSB: Analytic
Blooms: Understand
Difficulty: 1 Easy
8-97
92. An efficient policy to reduce pollution would reduce pollution to the point where:
A. the marginal costs of reducing pollution equal the marginal benefits of reducing pollution.
B. it is eliminated.
C. the marginal costs of reducing pollution are greater than the marginal benefits of reducing
pollution.
D. the marginal costs of reducing pollution are less than the marginal benefits of reducing
pollution.
Economists believe in efficient policies, that is, policies that equate marginal costs and
marginal benefits.
AACSB: Analytic
Blooms: Understand
93. The efficient amount of pollution control is:
A. the amount for which the total social benefit equals the total social cost of pollution.
B. the amount for which the marginal social benefit equals the marginal social cost of
pollution.
C. always zero.
D. always a 100 percent abatement.
The efficient amount of pollution control is where MC = MB.
AACSB: Analytic
Blooms: Understand
94. The optimal quantity of pollution control occurs at the point where the:
A. level of pollution is reduced to zero.

B. marginal social benefit is at its maximum.
C. marginal social cost equals the marginal social benefit of pollution.
D. total benefit equals the total cost of pollution.
The optimal amount of pollution control is where MC = MB.
AACSB: Analytic
8-98
Blooms: Understand
95. Economists' attitude toward voluntary programs causes them to:
A. actively oppose them on the grounds that they will do more harm than good.
B. actively oppose them on the grounds that they are unfair.
C. be skeptical of the potential success of such programs
D. favor these programs over alternative solutions.
The worst that can happen is that people will not alter their behavior.
AACSB: Analytic
Blooms: Understand
Difficulty: 1 Easy
96. Economists tend to distrust voluntary approaches as a way to deal with externalities. What is
their most common concern?
A. Voluntary approaches do not make people develop an awareness of the problem that
would lead them to make good lifestyle changes.
B. Voluntary approaches often are perceived as unfair, imposing a heavy burden on the poor.
C. Voluntary approaches usually require people to ignore their self-interest, and economists
do not think people do that well.
D. Voluntary approaches are often too effective and lead to excessive reduction in the
externality.
Voluntary programs ignore self-interest and often work against it. Economists are specialists in
understanding the role of self-interest.
AACSB: Analytic
Blooms: Understand
8-99
97. Public television periodically runs pledge drives to raise money. Only a small percentage of
the people who benefit from public television are willing to pay. What do economists call the
people who do not pay?
A. Free riders
B. Excludables
C. Adverse selectors
D. Thieves
Free riders enjoy public goods for free because they are non-excludable.
AACSB: Analytic
Blooms: Understand
Difficulty: 1 Easy
Topic: Public Goods
the people who benefit from public television are willing to pay. This low percentage of people
willing to contribute illustrates a difficulty with:
A. government regulation.
B. voluntary programs.
C. tax incentive policies.
D. market incentive programs.
Pledge drives by public television are an illustration of a voluntary program. Few public
television stations are able to obtain enough donations to operate; usually the subscription
drives supplement other, larger sources of revenue.
AACSB: Analytic
Blooms: Understand
Difficulty: 1 Easy
8-100
99. Economists are most likely to suggest that societies address the inefficiencies created by
negative externalities by:
A. direct regulation.
B. voluntary conservation.
C. making the price people pay reflect the cost of the externality.
D. leaving environmental problems alone so that the market can deal effectively with them.
Economists prefer programs that are market-based. An unregulated market with negative
externalities will not lead to an efficient solution.
AACSB: Analytic
Blooms: Understand
100. In 1990, the Clean Air Act was amended to place a national cap on sulfur dioxide emissions,
giving electric utilities an allowance of a set amount of emissions and allowing the utilities to
trade their allowances. This type of plan is:
A. more efficient than direct regulation because utilities that receive a high marginal benefit
from emissions can gain additional allowances through trade.
B. more efficient than direct regulation because it forces each utility company to reduce sulfur
C. less efficient than direct regulation because utilities that receive a high marginal benefit
from emissions can gain additional allowances through trade.
D. less efficient than direct regulation because it forces each utility company to reduce sulfur
A market incentive plan is more efficient than direct regulation because it allows for variation in
emissions reduction.

Blooms: Apply
Difficulty: 3 Hard
8-101
101. If government undertakes to reduce water usage by using a market incentive plan:
A. each consumer will have to reduce his or her water usage by an equal amount.
B. consumers who reduce water usage by more than the required amount can sell marketable
certificates to consumers who seek to reduce usage by less than the required amount.
C. consumers who do not reduce usage by the required amount will have to pay taxes on the
extra water usage.
D. consumers will be asked to reduce water usage voluntarily.
Market incentive plans result in reduced total consumption but allow those for whom the cost
of reduction is lowest to reap financial rewards by selling marketable certificates to those for
whom the cost of reduction is greatest.
AACSB: Analytic
Blooms: Understand
102. Since trash generation involves an externality, the way economists might address the problem
of trash generation that is most likely to be optimal is by:
A. integrating the cost of the externality into the initial price of the good.
B. having the government require mandatory sorting and recycling of trash.
D. not allowing persons to throw away more trash than is acceptable as a maximum.
When people must pay a price that reflects the true cost to society, they will alter their
behavior so that the optimal level of the good is consumed. In the case of an externality, the
social cost must be added to the private cost.
AACSB: Analytic
Blooms: Understand
Difficulty: 3 Hard
8-102
103. An economist is most likely to support all of the following methods to address the negative
externalities created by the waste from newspapers except:
A. requiring publishers to cut the volume of newspapers generated but allowing them to sell
certificates so that others can meet those requirements for them.
B. taxing the suppliers of newspaper by the pound.
D. ensuring that the social cost of buying a newspaper is reflected in its price.
Economists tend to favor market-based programs. Requiring government to pay the cost of an
externality is not such a program.
AACSB: Analytic
Blooms: Understand
Difficulty: 3 Hard
104. The inefficiency associated with negative externalities is most likely the result of:
A. special interest groups.

B. the fallacy of composition.
C. government intervention.
D. poorly specified property rights.
Poorly specified property rights result in effects of decisions not taken into account by decision
makers. No one owns the right and cannot control the effect on those not involved in the trade.
Refer to Applying the Tools: Common Resources and the Tragedy of the Commons in the text.
AACSB: Analytic
Blooms: Understand
8-103
105. A per-unit tax designed to internalize the costs of production imposed on third parties is
called:
A. an excise tax.
B. an effluent fee.
C. a sin tax.
D. a tariff.
See the definition of effluent fee in the textbook.
AACSB: Analytic
Blooms: Understand
Difficulty: 1 Easy
106. The Environment Ministry in Japan proposed a new carbon tax to meet Japan's obligations to
reduce carbon dioxide emissions under the Kyoto Treaty. The tax would be levied on
producers and importers of fossil fuels, and the expectation is that it would be largely passed
on to consumers. This proposal is an example of a:
A. progressive tax.
B. voluntary program.
C. tax incentive policy.
D. free rider problem.
A carbon tax is an example of a tax incentive program. See the textbook.
AACSB: Analytic
Blooms: Apply
8-104
producers and importers of fossil fuels, and the expectation is that it would be largely passed
on to consumers. The rationale for this tax is that it will:
A. reduce a negative externality.

B. reduce a positive externality.
C. turn a private good into a public good.
D. turn a public good into a private good.
A pollution tax has long been a proposal made by economists; it usually is opposed by
business and sometimes by environmentalists who either do not understand it or oppose it on
philosophical grounds.
AACSB: Analytic
Blooms: Apply
producers and importers of fossil fuels and raise the cost of using fossil fuels. How do most
economists view a tax such as this?
A. They prefer direct regulation to taxes because taxes create deadweight loss.
B. They prefer voluntary programs to taxes because they reduce the role of compulsion.
C. They do not believe any government intervention is necessary because the invisible hand
of the market will correct the problem.
D. They support taxes on pollution as a way of making decision makers consider all costs.
Economists prefer policies that internalize the externality. A tax on pollution is one way;
another is tradable pollution permits. They dislike direct regulation and voluntary programs
because the first uses too many resources to get any level of reduction and the second often
works poorly.
AACSB: Analytic
Blooms: Apply
8-105
109.
Refer to the graph shown. The price and quantity that would prevail if all social costs and
benefits were taken into account is:

B. $3.50 and 2,000 units.
C. $3.95 and 6,800 units.
D. $1.80 and 2,000 units.
Equilibrium would be where marginal social cost intersects marginal social benefit.
AACSB: Analytic
Blooms: Apply
8-106
110.
Refer to the graph shown. The amount of a tax sufficient to reduce quantity supplied to the
level that individuals would have supplied had they included the cost in their decision on third
parties is:
A. $2.50.
B. $1.70.
C. $1.00.
D. $0.80.
Evaluated at the socially optimal output (2,000), the tax would need to shift the supply curve
upward by $1.70 to move equilibrium to where MSC = MSB.
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
8-107
111.
Refer to the graph shown. The free market equilibrium in the graph is at a price and quantity
of:

B. $3.50 and 2,000 units.
C. $2.50 and 2,600 units.
D. $3.50 and 3,100 units.
Free market equilibrium is where marginal private costs equal marginal private benefits.
AACSB: Analytic
Blooms: Apply
112. A good that if supplied to one person is supplied to all and whose consumption by one
individual does not prevent its consumption by another individual is known as:
A. a private good.
B. a public good.
C. an external good.
D. an internal good.
This is the textbook definition of a public good.
AACSB: Analytic
Blooms: Understand
Topic: Public Goods
8-108
the people who benefit from public television are willing to pay. Why does public television
have a problem in collecting money from its viewers?
A. Broadcast television has public good aspects.

B. Public television has problems of adverse selection.
C. Public television is an example of government failure.
D. Broadcast television has problems of informational problems.
There is no penalty for not contributing because broadcast television is a public good.
AACSB: Analytic
Blooms: Understand
Difficulty: 1 Easy
Topic: Public Goods
114. When you purchase and eat a hamburger, no one else can eat the same hamburger. When
you download a file on the Internet, the file is still available for others to download. Economists
explain this difference between hamburgers and computer files by saying that the hamburger
is:
A. excludable whereas the computer file is not.

B. non-excludable whereas the computer file is not.
C. rival in consumption whereas the computer file is not.
D. nonrival in consumption whereas the computer file is not.
Public goods are nonrival in consumption, which means everyone can use them. Private
goods are rival, which means that if one person uses a private good, another cannot.
AACSB: Analytic
Blooms: Understand
Topic: Public Goods
8-109
115. Television broadcasts are often given as examples of a public good. However, it is possible to
code a broadcast so that only people who pay for the decoder box can view it. The use of a
coded signal does what to a television broadcast?
A. Makes it rival
B. Makes it nonrival
C. Makes it excludable
D. Makes it non-excludable
It is still nonrival because lots of people can get the signal without affecting others, but now
those who do not pay can be excluded.
AACSB: Analytic
Blooms: Understand
Difficulty: 1 Easy
Topic: Public Goods
116. A meeting of the United Nations Convention on International Trade in Endangered Species
ended with greater protection given to great white sharks. Why should sharks need special
protection?
A. There is an informational problem in the market; people do not understand the full
consequences of their actions.
B. Sharks are not privately owned and can be subject to a tragedy of the commons problem.
C. Sharks are what economists call a public good, and hence there are no incentives to
produce or protect them.
D. Sharks are subject to adverse selection problems.
Things that are not owned but available to all can be overused. Economists argue that the
development of property rights can be seen as a way of overcoming this problem. The tragedy
of the commons was discussed in Added Dimension: Common Resources and the Tragedy of
the Commons in the text.
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
8-110
117. A system in which power plants buy and sell the right to pollute in the form of emission credits
is known as:
A. a voluntary program.
B. direct regulation.
C. a tax incentive program.
D. a market incentive program.
See the textbook. Trading emission credits is something a market incentive program does.
AACSB: Analytic
Blooms: Apply
118. Do economists tend to favor a system in which power plants buy and sell the right to pollute in
the form of emission credits?
A. No; these programs are ineffective because they encourage major polluters to free ride on
the efforts of others.
B. No; it is possible for some firms to do nothing if they simply buy enough credits.
C. Yes; they encourage all firms to cut pollution by the same percentage.
D. Yes; they believe that such a proposal would achieve a level of pollution reduction with the
lowest cost to society.
Economists like tradable emissions credits because they achieve any level of pollution
reduction by using the least costly method. Some environmentalists do not like them because
they do not understand economics, and others because they consider factors such as fairness
that are outside economists' normal range of consideration.
AACSB: Analytic
Blooms: Apply
8-111
119. Suppose there are only two firms that pollute, A and B, and each emits 10 tons of waste into
the air. Firm A can reduce its pollution at a cost of $100 per ton, and Firm B can reduce its
pollution at a cost of $500 per ton. Each has been given an emission credit that allows it to
pollute 6 tons. If firms maximize profits, what will happen?
A. Each firm will clean up 4 tons and pollute 6 tons.

B. Firm B will buy four credits from A; B will emit 10 tons, and A 2 tons.
C. Firm A will buy four credits from B; A will emit 10 tons, and B 2 tons.
D. Firm B will buy one credit from A; it will cut pollution to 7 tons, and firm A will cut it to 5
tons.
The credits are more valuable to B than to A, so Firm B will buy all of Firm A's credits. Both
firms benefit from the trade.
AACSB: Analytic
Blooms: Apply
120. Which of the following does not illustrate the free rider problem?
A. Amy does not contribute to public television, but she watches it every day.
B. Roger refuses to help pay for the private security officer who patrols his neighborhood.
C. Amanda, a taxpayer, prefers to check out books from her local library rather than
purchasing them herself.
D. Frank enjoys the fireworks from his lawn and does not purchase a ticket to view the display
from the stadium.
Since public funds are used to purchase books for the library, Amanda is not enjoying
something for free that others have paid for (assuming she pays her taxes). In the other cases,
the person described is enjoying a benefit that others have paid for.
AACSB: Analytic
Blooms: Apply
Topic: Public Goods
8-112
121. The unwillingness of individuals to share in the cost of a public good is called the:
A. free rider problem.

B. social conscience problem.
C. volunteer problem.
D. public choice problem.
See the definition of the free rider problem.
AACSB: Analytic
Blooms: Understand
Difficulty: 1 Easy
Topic: Public Goods
122. Which of the following is not a characteristic of a public good?
A. Non-exclusivity
B. Available to nonbuyers
C. Nonrivalry in consumption
D. Can be consumed only once
Public goods are nonexclusive and nonrival by definition. Since they are nonexclusive, they
are available to nonbuyers (which is what creates the possibility of a free rider problem).
AACSB: Analytic
Blooms: Understand
Difficulty: 1 Easy
Topic: Public Goods
123. Since consumption of a public good by one person does not preclude consumption by others,
public goods are said to be:
A. non-exclusive.
B. nonrival.
C. exclusive.
D. rival.
It is possible for a good to be nonrival without being nonexclusive. For example, nonpayers
could be excluded from a national park, but enjoyment of the scenery by one person does not
preclude enjoyment by another.
AACSB: Analytic
8-113
Blooms: Understand
Difficulty: 1 Easy
Topic: Public Goods
124. Once a public good is provided, those who do not pay cannot be denied the benefits. For this
reason, public goods are said to be:
A. non-exclusive.
B. nonrival.
C. exclusive.
D. rival.
It is possible for a good to be nonexclusive without being nonrival. For example, once a
freeway has been provided (without a tollbooth or computer sensors), nonpayers cannot be
excluded, but if there is heavy traffic, consumption is rival.
AACSB: Analytic
Blooms: Understand
Difficulty: 1 Easy
Topic: Public Goods
125. If air pollution control is a public good, it follows that:
A. the efficient output of air pollution control is zero.

B. additional persons can benefit from a given amount of air pollution control without reducing
the benefits enjoyed by others.
C. the efficient output of air pollution control can be attained by selling it by the unit in a
market.
D. the more air pollution control enjoyed by any one person, the less is available to others.
See the definition of a public good in the textbook.
AACSB: Analytic
Blooms: Understand
Topic: Public Goods
8-114
126. The free rider problem:
A. can never prevent pure public goods from being supplied.

B. results because people act unselfishly.
C. results because people behave irrationally.
D. prevents voluntary cost sharing from achieving the efficient output of a public good.
The free rider problem is an individual's unwillingness to share in the cost of a public good. It
prevents cost sharing.
AACSB: Analytic
Blooms: Understand
Difficulty: 3 Hard
Topic: Public Goods
127. The best example of a public good is:
A. competition.
B. government-subsidized lunches.
C. pollution.
D. national defense.
A public good is one that when consumed by one individual does not prevent its consumption
by others. National defense protects all individuals in a country. If it is provided for some, it
must also be provided for all.
AACSB: Analytic
Blooms: Apply
Difficulty: 1 Easy
Topic: Public Goods
128. In economic terminology, a free rider is someone who:
A. does not pay for his or her own consumption of a public good.
B. chooses not to consume a public good.
C. is earning economic profit.
D. raises his or her prices because all other prices are rising.
A free rider is a person who participates in something for free because others have paid for it.
AACSB: Analytic
Blooms: Understand
8-115
Difficulty: 1 Easy
Topic: Public Goods
129. In the case of a public good, a demand curve that shows the marginal benefit of the good is:
A. nonexistent.
B. the horizontal sum of individual demand curves.
C. the vertical sum of individual demand curves.
D. perfectly inelastic.
This is the case because the full benefit of the total output is received by everyone.
AACSB: Analytic
Blooms: Understand
Difficulty: 1 Easy
Topic: Public Goods
130. If the marginal benefit of one more unit of a public good is $500 for Sam and $800 for Alex, the
social benefit of one more unit of a public good is:
A. $500 since the benefit will go to the person who values it least.
B. $800 since the benefit will go to the person who values it most.
C. $1,300 since the benefit of one more unit goes to both individuals.
D. more than $1,300 since the benefits to society exceed the sum of individual benefits.
The social benefit in the case of a public good is the sum of the individual benefits since each
individual gets the benefit of the good.
AACSB: Analytic
Blooms: Apply
Topic: Public Goods
8-116
131. This table shows the marginal benefits from widgets obtained by the only three people who
value them.
Refer to the table shown. Suppose widgets cost $8.50 to produce. If widgets are a private
good, how many will be produced by market incentives, and is that the right (efficient)
number?
Helen will buy one because she gets more value than it costs to produce. The second is not
worth producing because it costs $8.50 but provides value of only $8.
AACSB: Analytic
Blooms: Apply
Topic: Public Goods
8-117
132. This table shows the marginal benefits from widgets obtained by the only three people who
value them.
Refer to the table shown. Suppose widgets cost $8.50 to produce. If widgets are a public
good, how many will be produced by market incentives, and is that the right (efficient)
number?
Helen will buy one because she gets more value than it costs to produce. However, a second
also is worth producing because it provides value of $9, which is more than the cost of
production.
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
Topic: Public Goods
8-118
133. Basic research is more likely to be funded by the federal than by state and local government
because basic research:
A. is usually conducted by oligopoly, the market structure that is most conducive to

preliminary research.
B. has negative externalities that are passed on to those who live outside the state.
C. is largely a public good; benefits flow to the whole world, not just the state.
D. has information problems that cause adverse selection.
Basic research usually is funded by the federal government because it is often a public good.
For this research to pass a cost/benefit test for California, the benefits must be much greater
than the cost because most of them will flow out of the state. If the research results in a private
good, more of the benefits could be captured by California, but if the prospect of arriving at a
private good, that is, something protected by patent, were high enough, private firms would be
conducting it.
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
Topic: Public Goods
134. Music spreads easily and cheaply on computer networks. As a result, music has become more
like:
A. a private good.
B. a public good.
C. a merit good.
D. an inferior good.
A public good is nonrival and non-exclusive. So is digital music.
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
Topic: Public Goods
8-119
135. The Apple iPod is able to play digital music that has a special encoding that makes pirating
music more difficult. In economic terms, this encoding is an attempt to:
A. make digital music more like a private good and less like a public good.
B. reduce the negative externalities of digital music.
C. reduce the adverse selection problem of digital music.
D. increase the marginal social benefit of digital music.
Encoding is an attempt to make digital music excludable, that is, to exclude those who do not
pay. Hence, digital music would become more like a private good and less like a public good.
AACSB: Analytic
Blooms: Apply
Topic: Public Goods
136. If the benefit of a public good is small to each individual in a society of millions of individuals:
A. it will never be efficient for government to provide the public good.

B. the total benefit will be large since social benefit is the sum of all individual benefits.
C. the total benefit will be small since individuals cannot share the benefits of public goods.
D. it cannot really be a public good since the benefit of public goods is always large.
Since there are millions of individuals, summing each person's benefit will result in a large
amount of total or social benefit.
AACSB: Analytic
Blooms: Understand
Topic: Public Goods
137. With regard to a public good provided by the government:
A. individuals reveal their demand when they buy the good.

B. a free rider problem is unlikely.
C. individuals have an incentive to conceal their willingness to buy the good.
D. individuals have an incentive to exaggerate their willingness to buy the good.
Public goods are nonrival and non-exclusive, and so there is an incentive to exaggerate
willingness to buy because people can free ride.
AACSB: Analytic
8-120
Blooms: Understand
Topic: Public Goods
138. Real-world markets:
A. often involve deception, cheating, and inaccurate information.

B. ensure that sellers will always be honest and provide accurate information because those
who are dishonest or provide inaccurate information go out of business.
C. can operate efficiently only if government takes steps to correct informational problems.
D. provide no mechanism for solving informational problems.
Deception, cheating, and inaccurate information characterize real-world markets, but

informational problems can be solved either through government intervention or through
markets. For example, a consumer can hire a mechanic to check out a used car before
purchasing it.
AACSB: Analytic
Blooms: Understand
Difficulty: 1 Easy
139. If a consumer is willing to pay $100 for a used Blu-ray player that is a "cherry" and $30 for a
used Blu-ray player that is a "lemon," the consumer will offer:
A. $30 for any used Blu-ray player even if the probability that it is a "lemon" is 50 percent.
B. $100 for any used Blu-ray player even if the probability that is a "cherry" is 50 percent.
C. $65 for any used Blu-ray player if the probability that it is a "lemon" is 50 percent.
D. $130 for any used Blu-ray player if the probability that it is a "cherry" is 50 percent.
The expected value of a used Blu-ray player is equal to the probability that it is a lemon
multiplied by the value if it is a lemon plus the probability that it is a cherry multiplied by the
value if it is a cherry.
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
8-121
140. Adverse selection is most likely to be a problem when:
A. one side of the market, either buyer or seller, has better information than the other side.
B. there are public goods involved.
C. the good being exchanged has negative externalities.
D. the good being exchanged has free rider problems.
Adverse selection is a problem in markets with informational problems.
AACSB: Analytic
Blooms: Understand
141. In economics, the term "signaling" refers to a way of lessening the problem of:
A. free riders.
C. bad information by all market participants.
D. unequal information between buyers and sellers.
Signaling, or transmitting information about quality in a way that is hard to fake, is a way of
overcoming the problem of informational problems.
AACSB: Analytic
Blooms: Understand
8-122
142. At one time many economists were suspicious of brand names. They saw them as a barrier to
entry with no benefits to consumers. In the 1970s economists began to see a possible benefit
of brand names to consumers. They discovered that brand names were a way to:
A. signal quality.
B. market public goods.
C. overcome negative externalities.
D. overcome the free rider effect.
Brand names were a form of signaling, of transmitting information about quality in a way that is
hard to fake, and thus a way of overcoming the problem of informational problems. When a
company has invested a large amount of money creating a meaningful brand name, it is very
costly to produce poor-quality products under that brand name because it will ruin the brand.
Usually a company that has a valuable brand will market lower-quality products under a
different name. The beer market has a lot of examples.
AACSB: Analytic
Blooms: Understand
143. John and Jack are both trying to sell a used car to Jim. John's car is a lemon, a car that has a
serious but nonobvious problem. Jack's car is a cherry, a car that has no problems. Jim cannot
tell the difference between the cars. Economists say this information problem might be solved
with signaling. Who has an incentive to find a way to signal quality?
A. Both Jack and John

B. Jack but not John
C. John but not Jack
D. Jim
John has an incentive to communicate the truth about the condition of his car in a way that
Jack cannot duplicate. If he can find a way to do it, he will sell his car at a fair price. If he
cannot, he will have to take a price that reflects the risk that Jim faces. In many markets
manufacturers use some sort of guarantee or warranty to signal quality.
AACSB: Analytic
Blooms: Apply
8-123
144. A lawyer who drives a beat-up car and wears frumpy clothes may have a hard time getting
clients. Potential clients may conclude from his appearance that he is poor, and if he is poor,
he probably is not very good. If this is true for a lawyer, dressing in expensive and stylish
clothing is a way of:
A. internalizing externalities.
B. changing a nonrival good into a rival good.
C. changing a non-excludable good into an excludable good.
D. signaling quality.
Signaling is an attempt to communicate attributes in a way that is difficult to do for those who
do not have the attributes, though in this case, it can be faked to some extent.
AACSB: Analytic
Blooms: Understand
145. In the early days of the Internet, selling and buying from other individuals were dangerous
because one never knew if the person on the other side of the transaction was honest.
eBay.com became successful because it lessened that problem with its feedback rating
system that let buyers and sellers develop a reputation. eBay.com's innovation is an example
of overcoming:
A. the free rider effect.

C. positive externalities.
D. an information problem.
Transactions between complete strangers are hard because either side may cheat—there is
nothing to lose. eBay's innovation gave cheating a cost and honesty a benefit.
AACSB: Analytic
Blooms: Apply
8-124
146. How do economists explain the value firms and consumers place on brand names?
A. Brand names show that firms can easily manipulate consumers.

B. Brand names are a way firms can provide information about quality to consumers.
C. Brand names are a way of turning private goods into public goods, increasing their value to
both seller and buyer.
D. Brand names are an example of adverse selection, by which producers advertise the
options to consumers.
Brand names are one of the ways in which markets overcome the problem of informational
problems.
AACSB: Analytic
Blooms: Apply
147. The Consumer Product Safety Commission (CPSC) is charged with protecting the public from
unreasonable risks of serious injury or death from more than 15,000 types of consumer
products. The CPSC is designed to overcome:
A. information problems.
B. positive externalities.
C. negative externalities.
D. direct regulation.
Presumably, the problem is that consumers are not well informed and need more information.
AACSB: Analytic
Blooms: Apply
8-125
148. Which of the following is an argument an economist would use to argue against market
regulation designed to protect consumers?
A. Information is costless and readily available, and so it is up to consumers to beware.

B. When a brand name product is found unsafe, the value of the brand is reduced, which
gives companies with brand names an incentive to produce high-quality products.
C. Manufacturers have no incentive to stop the sale of counterfeit products.
D. Government is more likely to have consumers' interest in mind than does the market.
Firms do have an incentive to produce safe products. Those which do not will go out of
business or at least suffer loss of sales. Information is not costless.
AACSB: Analytic
Blooms: Apply
149. If a consumer is willing to pay $5,000 for a used car that is a free of mechanical problems and
$1,000 for a used car that will require extensive repairs, the consumer will offer:
A. $1,000 for a used car if the probability that it is free of mechanical problems is 50 percent.
B. $3,000 for a used car if the probability that it is free of mechanical problems is 50 percent.
C. $5,000 for a used car if the probability that it is free of mechanical problems is 50 percent.
D. $6,000 for a used car if the probability that it is free of mechanical problems is 50 percent.
The expected value of a used car is equal to the probability that it is free of mechanical
problems multiplied by the value if it is free of mechanical problems plus the probability that it
will require extensive repairs multiplied by the value if it will require extensive repairs. A risk-
neutral consumer will offer that expected value.
AACSB: Analytic
Blooms: Apply
8-126
150. If buyers cannot distinguish between "lemons" and "cherries" in the used car market but
sellers can, the price buyers are willing to pay for used cars will be:
A. high enough to guarantee that at least 50 percent of the used cars offered for sale are
"cherries."
B. so low that sellers with "cherries" will be unwilling to sell.
C. so low that sellers with "lemons" will be unwilling to sell.
D. equal to zero since no one will take the chance of purchasing a "lemon" even if the value of
a car known to be a lemon is greater than zero.
With uncertainty, buyers would not offer a price high enough to induce the owner of a "cherry"
used car to sell. Eventually, buyers would realize that all the used cars offered for sale must
be "lemons," and so the price would fall even more, but not to zero unless the value of a car
known to be a "lemon" is zero.
AACSB: Analytic
Blooms: Apply
151. If medical insurers could use information contained in DNA to predict the likelihood of major
medical illnesses, the most likely outcome is that:
A. there would be an adverse selection problem and average insurance rates would rise.
B. there would be an adverse selection problem and average insurance rates would fall.
C. the adverse selection problem would be decreased and average insurance rates would
rise.
D. the adverse selection problem would be decreased and average insurance rates would fall.
Rates probably would fall on average because those with a very low likelihood of having a
major medical illness could purchase insurance at a much lower rate. Currently, an adverse
selection problem exists because individuals have better information about their health than do
insurance providers.

Blooms: Apply
Difficulty: 3 Hard
8-127
152. The reason the Federal Trade Commission regulates advertising to prevent false and
misleading claims is:
A. that firms that make false and misleading claims would earn lower profit, resulting in many
firms being forced to shut down and many workers losing their jobs.
B. to create a market for information.
C. to prevent a market failure caused by inaccurate information.
D. to eliminate persuasive advertising.
If sellers are allowed to make false and misleading claims about their products, consumers
may end up assuming that all advertising information is false. When advertising information is
accurate, consumers can make more efficient choices. Sellers engage in persuasive
advertising because this is not considered false or misleading.
AACSB: Analytic
Blooms: Understand
153. Economists believe that if government provides information about product quality:
A. there will be less incentive for consumers to pay extra for quality guarantees supplied by
firms.
B. consumers will be forced to pay for information when otherwise it would have been
available for free.
C. the overall quality of products sold will increase substantially, eliminating the information
problem.
D. the cost of providing information will be zero.
Left on their own, without government regulation, information markets will develop to provide
the information that people need and are willing to pay for. The market solution is likely to be
more efficient (less costly) than government regulation.
AACSB: Analytic
Blooms: Understand
8-128
154. A market for information is more likely to develop even in the absence of government
regulation of information as long as the marginal:
A. cost of information is zero.

B. benefit of information is zero.
C. cost of information exceeds the marginal benefit.
D. benefit of information exceeds the marginal cost.
Consumers will pay for information if it makes them better off.
AACSB: Analytic
Blooms: Understand
155. The basis of the argument favoring government intervention to correct informational and
rationality problems is that:
A. if information is not perfect or if one trader is not rational, a trade can result in one party
benefiting and the other losing.
B. entry into certain markets may be restricted so that excess profits cannot be eliminated by
the forces of competition.
C. people cannot possibly know how well off they will be as a result of a trade until after the
trade has occurred.
D. if individuals are free to produce whatever goods they want, when excess profit is being
made, more people will enter into the production of that good and consumers will benefit as
the price is pushed down.
The usual case for the market assumes good information and rationality.
AACSB: Analytic
Blooms: Understand
8-129
156. Milton Friedman argues that medical licensure benefits doctors because it:
A. allows them to restrict supply, increase prices, and significantly increase their incomes.
B. protects them from malpractice suits.
C. ensures that they will not have to compete against one another for patients.
D. prevents other doctors from advertising and stealing their patients.
Licensure reduces the supply of doctors, raising the price for their services. They still have to
compete against other licensed doctors.
AACSB: Analytic
Blooms: Understand
157. Which of the following is not a question raised by critics of medical licensure?
A. Why, if licensed medical treatment is so great, do we even need formal restrictions to keep
other types of medicine from being practiced?
B. Whom do these restrictions benefit: the general public or the doctors who practice
mainstream medicine?
C. What have the long-run effects of licensure been?
D. Why does the public need to have accurate information about a doctor's competency?
Problems with information is one reason licensing is supported. Refer to Added Dimension:
Licensure and Surgery in the text.
AACSB: Analytic
Blooms: Understand
8-130
158. Which of the following is the best example of an adverse selection problem?
A. Once individuals are insured, they are less likely to take efficient precautions.
B. Individuals are unlikely to pay for something if they can receive the benefits for free.
C. When a firm pollutes the air, families living nearby suffer the consequences.
D. Individuals who seek to purchase health insurance have better information about their
health than do insurance companies.
The text uses the example of health insurance to illustrate the adverse selection problem. The
incorrect responses illustrate moral hazard, the free rider problem, and negative externalities.
AACSB: Analytic
Blooms: Understand
Difficulty: 1 Easy
159. If employers were made responsible for injuries suffered by employees while working at
home:
A. there might be an adverse selection problem since employees have better information
about the safety conditions of their own homes than employers do.
B. employers would never permit employees to work at home.
C. more employees would be able to work safely at home.
D. there might be an adverse selection problem since employers have better information
about the safety conditions of their employees than the employees have themselves.
Although such a policy was recently considered, the plan was rejected because of a likely
adverse selection problem. Making employers responsible for injuries suffered by employees
working at home probably would reduce the incidence of at-home work but would not eliminate
it entirely.
AACSB: Analytic
Blooms: Apply
8-131
160. The problem that arises when people don't have to bear the negative consequence of their
actions is known as:
A. adverse selection.
B. externality.
C. moral hazard.
D. signaling.
See the definition of moral hazard in the text.
AACSB: Analytic
Blooms: Apply
161. A person who has auto insurance is likely to drive a little less safely and to take less care in
parking the car in a safe place off the street. This is an example of a problem called:
A. signaling.
B. moral hazard.
C. externality.
Moral hazard occurs when an insured individual changes his or her behavior to the detriment
of the insurer.
AACSB: Analytic
Blooms: Apply
8-132
162. A life insurance company is likely to require a health examination of a person applying for
insurance. This helps reduce the informational problem through the process of:
A. signaling.
B. screening.
C. creating an externality.
D. government regulation.
Screening is an action taken by the uninformed party that induces the informed party to reveal
information.
AACSB: Analytic
Blooms: Apply
Difficulty: 1 Easy
163. A person buying a used car could ask the seller for permission to take the car to a mechanic
for an inspection. If the seller says no, the prospective buyer has gained information about the
car. This process is known as:
A. screening.
B. signaling.
C. licensing.
D. internalizing the externality.
information.
AACSB: Analytic
Blooms: Apply
8-133
164. Which of the following is an example of screening?
A. Selling pollution permits to polluters to induce the lowest-cost pollution reducers to cut back
on pollution
B. Reducing pollution to the point at which the marginal cost of the pollution equals the
marginal benefit
C. A car buyer asking the seller if the car is a lemon
D. An employer requiring job applicants to provide references
information.
AACSB: Analytic
Blooms: Apply
165. Opponents of government intervention in the economy argue that government's attempts to
correct informational problems:
A. are justified in most cases though politically difficult to implement.

B. are not necessary since an efficiently operating market system ensures that adequate
information will be provided.
C. often create greater problems, such as FDA restrictions on experimental drugs for AIDS
which could save lives.
D. will make market transactions much more efficient.
Opponents argue that correcting informational problems creates other problems.
AACSB: Analytic
Blooms: Understand
8-134
166. Opponents of government intervention in the economy argue that externalities:
A. do not create problems for the model.

B. are themselves the inevitable result of government policies.
C. should be corrected with regulations rather than subsidies.
D. may not be effectively corrected by the government.
Opponents argue that government is too cumbersome to make the fine-tuning choices to
correct them and that because of politics, they may not be effectively corrected.
AACSB: Analytic
Blooms: Understand
Difficulty: 3 Hard
167. Suppose that a negative externality creates $1 billion worth of costs to third parties. The
government attacks the problem with regulations that cut the cost of the externality to $500
million but cost business and consumers $1.5 billion. This situation illustrates the idea that:
A. regulations are an effective way to curb externalities.

B. externalities can never be corrected.
C. correcting market failure can result in government failure.
D. getting rid of externalities requires a great deal of necessary sacrifice for all of us.
In this example the cure is worse than the disease. Government failure is a policy that causes
more harm than the problem it was intended to remedy.
AACSB: Analytic
Blooms: Understand
8-135
168. Opponents of government intervention argue that government makes decisions based on:
A. marginal social costs and marginal social benefits.

B. marginal political costs and marginal political benefits.
C. irrational choices.
D. total costs and total benefits.
Economists focus on incentives of decision makers. In the case of government, it is the

marginal political costs and marginal political benefits.
AACSB: Analytic
Blooms: Understand
169. Both opponents of and proponents of government intervention most likely would agree with
which of the following?
A. Government can and does create proper incentives to correct for externalities.
B. Property rights eliminate the need for government.
C. The market is inherently fair.
D. Property rights must exist for a market to operate.
Property rights must exist for markets to function. Whether those property rights are fair or
need correction is a matter of debate.
AACSB: Analytic
Blooms: Understand
Difficulty: 3 Hard
8-136
170. Government failure occurs when:
A. government fails to implement policy designed to correct a market failure.

B. government intervention in the market to improve a market failure succeeds.
C. government intervention in the market to correct a market failure makes things worse.
D. there is no need for government intervention into the market because there is no market
failure.
The text provides five reasons that explain government failure.
AACSB: Analytic
Blooms: Understand
Difficulty: 1 Easy
171. Suppose a public good that is worth $1 billion is not produced by the market, and so the
government provides it, but at a cost of $3 billion. This attempt to correct a market failure has:
A. been successful since the public good is now produced.

B. given rise to the problem of free riders.
C. resulted in a government failure since use of resources is now less efficient.
D. resulted in an information asymmetry for the government.
Instead of losing value of $1 billion, the economy now has lost value of $2 billion. The
allocation of resources is now inferior to what it was at the start.
AACSB: Analytic
Blooms: Understand
8-137
172. A European Union official, Mr. McGreevey, claims a portion of EU law involves overregulation.
McGreevey is suggesting the EU suffers in part from:
A. market failure
B. fairness.
C. government failure.
D. the rule of law.
Government policy may not only fail to correct a problem but make it worse. This is
government failure.
AACSB: Analytic
Blooms: Understand
Difficulty: 1 Easy
173. All of the following are justifications for government intervention except:
A. too much competition.

B. informational problems.
C. externalities.
D. public goods.
It is true that everyone likes competition except when it affects him or her; however, too much
competition is not a justification for government intervention.
AACSB: Analytic
Blooms: Understand
Difficulty: 1 Easy
8-138
174. Government may not have an incentive to correct a market failure because:
A. government doesn't have the information it needs to correct the market failure.
B. government reflects politics, which reflects individuals' interests in trying to gain more for
themselves.
C. policy makers fear that intervention will lead to a Pareto optimal outcome.
D. the benefit of correcting the market failure might exceed the cost of correcting the market
failure.
Lack of information is a reason for government failure different from incentives. The lack of
incentive to correct market failure stems from political pressures to benefit special interest
groups.
AACSB: Analytic
Blooms: Understand
Difficulty: 3 Hard
175. Government failure is likely to occur for all of the following reasons except:
A. special interest groups might lobby government to the detriment of the public good.
B. individuals have better information about a situation that affects them than does
government.
C. intervention in markets is always simpler than it initially seems.
D. the bureaucratic nature of government intervention does not allow fine-tuning.
Intervention is almost always more complicated than it initially seems.
AACSB: Analytic
Blooms: Understand
Difficulty: 1 Easy
8-139

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Market Failure versus Government Failure

True / False Questions

1. Externalities can be either positive or negative.

2. Economists generally prefer direct regulation to incentive-based programs because explicit

8. Government provides secondary education because of its private good aspects.

Multiple Choice Questions

A. Business has introduced a product that consumers did not want.

A. the total cost to society equals the total benefit.

21. If there is a complete set of markets that are perfectly competitive:

A. the Hume dictum.

A. No; Pareto optimal is defined as the best possible outcome.

A. exceed marginal social costs.

26. The best example of a positive externality is:

A. roller coaster rides.

A. the tragedy of the commons.

A. are a source of negative externalities.

A. are a source of negative externalities.

A. does not have important positive externalities.

A. imposes a negative externality on others.

36. Which of the following is not an example of an externality?

37. An externality is present in a free market whenever:

A. a monopolist spends funds to keep potential competitors out of the market.

39. The existence of negative externalities:

A. prevents the market from working efficiently.

40. An example of a negative externality is the:

41. If a negative externality is associated with burning firewood:

A. marginal private costs.

44. If a positive externality is associated with the purchase of smoke detectors:

A. the marginal social benefit of smoke detectors exceeds their price.

A. less than the efficient output of dirt bikes will be produced.

A. exceeds the marginal benefit received by consumers of the vaccine.

A. coincide with the market demand curve.

A. less than Q0.

59. If a negative externality is to be internalized to the decision maker, the:

A. greater than P0.

A. average costs are minimized.

67. Direct regulation is inefficient because:

69. Economists generally oppose direct regulation because:

A. it is unlikely to achieve the desired end as efficiently as possible.

A. all four firms cut their discharge by 50 percent

A. Each firm would reduce pollution by 50 percent.

78. An effluent fee is an example of:

A. a voluntary approach to pollution.

A. relatively less tax.

A. A mandatory recycling program

A. A mandatory requirement to reduce pollution

A. external incentive plan.

A. increase the price of that good and increase pollution.

87. An individual with a highly elastic demand for gasoline will:

88. A firm with a highly inelastic demand for coal will:

89. A policy is considered optimal if it:

A. is supported by a majority of voters.

A. be equal to the marginal cost of their actions imposed on third parties.

93. The efficient amount of pollution control is:

A. level of pollution is reduced to zero.

A. special interest groups.

A. reduce a negative externality.

A. $5 and 2,600 units.

A. $5 and 2,600 units.

A. Broadcast television has public good aspects.

A. excludable whereas the computer file is not.

A. Each firm will clean up 4 tons and pollute 6 tons.