Market failure: externalities and common pool resources practice questions.

A merit good is best described as one that is

• over-consumed and yields external costs
• under-consumed, yielding external benefits
• always provided free by the government
• non-rival and non-excludable in consumption

Answer: under-consumed, yielding external benefits

Merit goods (e.g. education, healthcare) generate positive externalities and are under-consumed by the free market; governments often subsidise or provide them.

When a negative production externality exists, at the market equilibrium

• marginal social cost exceeds marginal private cost
• marginal private cost exceeds marginal social cost
• marginal social benefit exceeds marginal private benefit
• the market produces less than the social optimum

Answer: marginal social cost exceeds marginal private cost

Third-party costs (e.g. pollution) mean MSC = MPC + external cost, so MSC lies above MPC and the market over-produces.

A firm's staff-training programme creates skills that also benefit other employers — a positive production externality. At the free-market equilibrium:

• Marginal social cost exceeds marginal private cost, so output is too high
• The market quantity equals the socially optimal quantity
• Marginal social cost lies below marginal private cost, so output is too low
• Marginal private benefit exceeds marginal social benefit, so consumers buy too much

Answer: Marginal social cost lies below marginal private cost, so output is too low

With a positive production externality, MSC = MPC − external benefit, so MSC lies below MPC and the market under-produces relative to the social optimum.

A government wants to set a Pigouvian (corrective) tax on a polluting industry so that the socially optimal output is produced. The tax per unit should be equal to:

• the marginal external cost at the socially optimal level of output
• the total external cost of all units produced
• the marginal private cost at the current market equilibrium
• the difference between the market price and average total cost

Answer: the marginal external cost at the socially optimal level of output

A corrective tax internalises the externality when it equals the marginal external cost at the optimum, making MPC + tax coincide with MSC at that output.

Which of the following goods is a common pool resource?

• National defence
• A subscription video-streaming service
• A privately owned apple orchard
• Fish stocks in international waters

Answer: Fish stocks in international waters

Open-ocean fish stocks are rivalrous (one boat's catch leaves fewer fish) but non-excludable, the defining combination of a common pool resource.

Under a tradable emissions permit (cap and trade) scheme:

• the government fixes the price of pollution and lets the total quantity of emissions adjust
• the government fixes the total quantity of emissions; the permit price is set by the market
• every firm is required to cut its emissions by the same percentage
• firms receive a government subsidy for each unit of pollution they abate

Answer: the government fixes the total quantity of emissions; the permit price is set by the market

Cap and trade controls the quantity of pollution directly: the cap sets total permits, and trading lets the market discover the price, so abatement happens where it is cheapest.