Unit 5: Market Failure and Government

Answer: C — This is an example of market failure due to negative externalities, as the company's production process has a spillover effect on the rest of the town, which is not accounted for in the market price of water. The company is not considering the social cost of its actions, leading to an inefficient allocation of resources. Option A is incorrect because while the presence of a single supplier may indicate imperfect competition, it is not the primary issue in this scenario. Option B is incorrect because information asymmetry is not the main problem here. Option D is incorrect because the water supply is excludable, as the company can control who has access to it.

Answer: A — The correct answer is A. This scenario describes the classic free rider problem. A public park is a non-excludable good (once built, the city cannot prevent people from using it) and non-rivalrous (one person's use doesn't diminish another's ability to use it). This creates an incentive for individuals to free ride—benefit from the good without paying for it—because they cannot be excluded. This leads to undersupply of the public good since individuals have no private incentive to voluntarily fund it. B is incorrect because negative externalities refer to costs imposed on third parties, not the problem of non-payment for a desired public good. C is incorrect because monopolistic competition is about market structure and product differentiation, not about the non-excludable nature of public goods or payment incentives. D is incorrect because asymmetric information involves one party having more or better information than another, which is not the primary issue here. Residents understand the park's benefits; they simply choose not to pay.

Answer: C — The correct answer is C) Monopoly power because the private company has a monopoly on the town's water supply and is charging a price above the marginal cost of production. This is an example of market failure due to monopoly power, where a single firm has the power to influence the market price. Asymmetric information (A) refers to a situation where one party has more information than the other, which is not relevant to this scenario. Negative externality (B) refers to a situation where a firm's production imposes a cost on others, which is also not relevant to this scenario. Public good (D) refers to a good that is non-rival and non-excludable, which is not relevant to this scenario as the water supply is a private good.

Answer: A — This question tests understanding of the tragedy of the commons and how property rights solve externality problems. The root cause is that fish stocks are common property with no one bearing the full cost of depletion—this is a negative externality of overfishing. Option A is correct because establishing and enforcing property rights (through catch quotas, fishing licenses, or territorial rights) internalizes the externality by making individual fishermen responsible for managing their allocated share. This directly addresses the incentive problem where each fisherman races to catch fish before others do. Option B is incorrect because subsidies would actually encourage more fishing activity and worsen the problem—they don't address the underlying externality. Option C is incorrect because a tax on fish sales addresses demand-side symptoms rather than the root cause of the commons problem; it doesn't solve the incentive misalignment that drives overfishing. Option D is incorrect because developing alternatives is a long-term, indirect approach that doesn't address the immediate market failure of unowned resources. The question requires students to distinguish between treating symptoms of market failure versus addressing the fundamental cause (lack of defined property rights).

Answer: A — The correct answer is A. A corrective (Pigouvian) tax set equal to the marginal external cost ($8) internalizes the externality by making producers bear the full social cost of production. With the tax, the effective marginal cost to society becomes $23 per unit ($15 MPC + $8 tax), which shifts the supply curve upward. At the original price of $40, producers would now be unwilling to supply 10,000 units. The quantity demanded would decrease along the demand curve to a lower equilibrium where marginal social cost equals price. This new quantity (approximately 8,000 units) represents the socially optimal level where marginal social benefit equals marginal social cost, eliminating deadweight loss. Option B is incorrect because while some tax burden falls on consumers through higher prices, the quantity still decreases due to the upward shift in supply. Option C reverses the logic—higher costs make production less profitable, which reduces quantity, not increases it. Option D is incorrect because the tax does shift the supply curve, causing movement along the demand curve and a new equilibrium; the quantity will not remain at 10,000 units.