AP Micro Unit 6 study guide (Unit: Market failure and the role of government)

The Ministry of Economics has determined that the production of firebolts creates pollution that costs society $120 per firebolt to clean up. The private benefit of producing firebolts is $80, and each firebolt can be purchased for $80. Currently, 100 firebolts are being produced. If these policymakers want to eliminate the market inefficiency created by the production of firebolts, which of the following should they do?

use cost-benefit analysis to evaluate different policies Policymakers should use cost-benefit analysis to evaluate different policies to eliminate deadweight loss to make sure they fully evaluate the tradeoffs involved with any policy action.

Which of the following best describes something nonrival in consumption?

watching a streaming video service with unlimited bandwidth This best describes something nonrival in consumption because usually more than one person can watch the same show on the same streaming service. For example, you and I could both watch "Hamsterville, Live!" from two different places and two different accounts from the same service.

Basic research is non-excludable and non-rival. However, the government of Hamsterville has noticed that innovators are preferring to go to the beach instead of the lab because it takes time to develop new processes and products, but the innovators do not get any benefit out of it. As a result, the government has created a patent system that gives inventors the right to be the sole producer of anything invented for 15 years. When the government created the patent system, what kind of good did basic research effectively become?

artificially scarce The free-rider problem leads to under-production of basic research because it was a public good. By implementing a patent system, the government made basic research excludable, turning it into an artificially scarce good.

Because no private provider was willing to do so, the city of Montrose has decided to provide emergency room services free of charge. However, a doctor can only see one patient at a time. What kind of good is the emergency room service in Montrose?

common resource Common resources are non-excludable but rival. The emergency room services are free, so they are non-excludable. Because only one patient can be treated by a doctor at a time they are rival.

HamsterCraft is a multiplayer online game. When too many people try to play at the same time the server crashes. There is no charge to play. What kind of good is this game?

common resource Common resources are rival and non-excludable. This game is rival because too many players crash the server and non-excludable because it is free to play.

The problem called the "tragedy of the commons" is associated with what kind of good?

common resources The tragedy of the commons can exist in the absence of excludability. When someone cannot be excluded from consuming a good, they have a private incentive to over-consume it.

When a rational agent is making a decision that is individually rational and individually optimal, what do they do?

equate private marginal benefit to private marginal cost A rational agent makes decisions that are best for themselves, not necessarily what is socially optimal. Unfortunately, this can lead to market inefficiencies.

All of the following result in an efficient allocation of resources EXCEPT

externalities in consumption When agents private costs and benefits do not include external costs and benefits, then markets inefficiently allocate resources.

When an economist says that a good is rival in consumption, what does that mean?

only one agent can consume one unit of the good When a good is rival, if someone uses that good it either prevents or interferes with another person using that same good. For example, when one person eats a candy bar, another person cannot eat that same candy bar, and when a person drives a car on a highway no other car can occupy that same space.

The government of Jacksonia produces and sells cream cheese. Nobody is allowed to consume cream cheese without paying for it, and only one person can consume a given block of cream cheese. What kind of good is cream cheese?

private good Private goods are excludable and rival. Cream cheese is excludable because you have to buy it before making cream cheese toast, and its rival because only one person can consume the same bite of cream cheese at any given time.

Which of the following best describes when an agent manipulates an environment to achieve market power that serves no productive purpose?

rent-seeking Rent-seeking behavior is the pursuit of private actions to exploit market power. For example, if an owner of a piece of land on either side of a river puts a chain across a river to block passing boats unless they pay a fee, the chain adds no value to society. The owner is merely exploiting their environment to extract surplus for themselves.

Priya is conducting research to examine the degree of income inequality in her city. Which of these measures is most relevant to her research?

the Lorenz curve The Lorenz shows the cumulative distribution of income in a society. The distance between the Lorenz curve and the line of equality is an indicator of the degree of income inequality in a population.

What relationship does the Lorenz curve illustrate?

the distribution of income within a population The Lorenz curve shows the cumulative percentage of all income received by different portions of the population. If everyone in a population has the same income, the Lorenz curve follows the line of equality. The degree to which the Lorenz curve sags away from the line of equality represents the degree of income inequality in a population.

This graph shows the marginal social cost (MSC), marginal private benefit (MPB), and the marginal social benefit) associated with the market for snizzles. What is the marginal social benefit of the last unit purchased in this market with no intervention?

$16 The market quantity is the quantity where marginal social cost intersects marginal private benefit, which is 8 units, and people are willing to pay $12 for the 8th unit. However, there is a positive externality in this market, so the social benefit is higher than people's willingness to pay.

This graph shows the marginal social cost (MSC), marginal private benefit (MPB), and the marginal social benefit) associated with the market for snizzles. How much more will be sold in this market if people internalize this externality?

2 units Without intervention 8 units are sold, but with intervention 10 units are sold, so 10-8=2 more units are sold if the externality is internalized.

When snods are produced, one by-product is green toxic sludge. If the market is not regulated, snod producers dump the sludge in a nearby river, which would need cleaning if the water were to be used for household use or recreation. What is being described, and how does the quantity produced in the market compare to the socially optimal quantity?

A negative externality; the market quantity is higher than the socially optimal quantity This situation sounds like the marginal social cost of production is higher than the marginal private cost of production, which makes it a negative externality. The individual firm chooses quantity based on its private costs, not the social costs. As a result, the market quantity will be greater than the socially optimal quantity.

This graph shows the market for flazzles, including the marginal social benefit (MSB), marginal social cost (MSC), and marginal private benefit (MPB). If a government wants to correct the externality shown in this market, which of the following would be the best choice?

A per unit subsidy of $8 to buyers The socially optimal quantity is 28 units, and buyers are only willing to pay $14 at 28 units. It would take a price of $22 to convince sellers to produce 28 units, and a subsidy of $8 would make buyers willing to pay that price.

Which of the following would be most effective at reducing the deadweight loss associated with a negative externality?

A per unit tax equal to the external cost of production. Deadweight loss exists in a market with negative externalities because the producer's marginal cost doesn't reflect the true cost of production. By imposing a per unit tax on the seller, you increase their marginal cost.

The graph below shows the marginal social cost (MSC), marginal private cost (MPC), and marginal social benefit (MSB) in the market for kablams. Which of the following would most likely eliminate the deadweight loss associated with production of kablams?

A per unit tax of Px-Pz If a per unit tax equal to the amount of the externality is imposed on sellers, they internalize the external cost and the MSC curve becomes the sellers MPC curve.

This graph shows the marginal social cost (MSC), marginal private benefit (MPB), and the marginal social benefit (MPB) associated with the market for snizzles. If the government wants to intervene in this market, which of the following policies most likely leads to the optimal quantity being sold in this market?

A per-unit subsidy of $4 per unit. Marginal social benefit is $4 higher than the marginal private benefit for each unit sold, so subsidizing by this amount would be the most likely to lead to the socially optimal quantity being sold.

This graph shows the marginal social cost (MSC), marginal social benefit (MSB), and marginal private benefit (MPB) of a good that is sold in a perfectly competitive market. A government could correct this externality by:

A per-unit subsidy of Pb​−Pd​ The difference between the marginal social benefit and the marginal private benefit is Pb​−Pd. This would lower the cost of buying the socially optimal quantity from Pb​ to Pd, and at Pd, buyers are willing to buy the socially optimal quantity, Q1​.

A government has intervened in the monopoly market shown in this graph. The intervention has caused a change in the firm's marginal cost curve from MC1 to MC2 Which of the following interventions could cause this change, and what is the effect on deadweight loss?

A per-unit tax; deadweight loss increases A per-unit tax increases a firm's marginal costs and shifts the marginal cost curve up. As a result, the profit maximizing quantity decreases from Q2 to Q1, moving it further from the optimal quantity, Q3. This movement increases the deadweight loss generated by the monopoly.

The Lorenz curves for Lincolnland before and after a policy change is shown in this graph. Which of the following policy changes would most likely lead to the change shown?

A switch from a flat tax to a progressive tax system The change in the Lorenz curves shown indicates a decrease in income inequality. A progressive tax structure reduces income inequality.

The marginal social cost (MSC), marginal private cost (MPC), and marginal social benefit (MSB) associated with the production of a good are shown in this graph. If this market is unregulated, what area represents deadweight loss?

ACD The socially optimal quantity is 18, but 30 units will be exchanged, resulting in a deadweight loss equal to the area ACD. This triangle represents deadweight loss because it is the difference between MSC and MSB between the socially optimal quantity and the quantity the market actually generates.

Which of the following must be true to maximize economic surplus in a market?

All social costs and benefits are internalized by agents in the market. When all social benefits and all social costs are reflected in the demand and supply curves, then the economic surplus is maximized at the quantity where supply equals demand. But in any other situation (i.e., with externalities), the market quantity may be inefficient, and an efficient outcome might require a market intervention.

This graph shows the marginal social cost (MSC), marginal private benefit (MPB), and the marginal social benefit (MPB) associated with the market for snizzles. Which of the following best describes what happens if the government imposes a price floor of $14?

Deadweight loss increases There is a deadweight loss in this market because buyers are willing to buy a quantity that is less than is optimal. Raising the market price will decrease the amount bought even further, thereby further increasing deadweight loss.

What must be true about private goods?

Governments sometimes produce them Sometimes governments choose to produce private goods for a variety of reasons. For example, the private sector might provide an inefficient quantity if there are positive externalities, or the government simply wants to provide a good for free.

The Gini coefficients for five countries are shown in this table. Which of the following statements must be true based on these Gini coefficients?

Income inequality is lowest in country A and highest in country E. The Gini coefficient is a common way of comparing income inequality between countries. The higher the Gini coefficient, the more income inequality there is in a country.

The production of good B creates negative externalities, but there are no externalities in the consumption of good B. What must be true at the market equilibrium for good B if the market is not regulated?

Marginal social benefit is less than marginal social cost In a market equilibrium, the amount exchanged is the amount where marginal private cost equals marginal private benefit. If there are no externalities in consumption, marginal social benefit equals marginal private benefit. If there are negative externalities in production, marginal social cost is greater than marginal private cost. Therefore, in equilibrium, marginal social benefit is less than marginal social cost.

The graph shown here illustrates the marginal social cost (MSC), marginal private cost (MPC), and marginal social benefit for graggles. What is the market quantity and price, and what is the socially optimal quantity and price?

Market: Qb Py Socially Optimal: Qa, Px The market price and quantity is where marginal private cost intersects marginal private benefit, and the socially optimal quantity is where marginal social cost intersects marginal social benefit.

The marginal social cost (MSC), marginal private cost (MPC), and marginal social benefit (MSB) associated with the production of a good are shown in this graph. What is the socially optimal price and quantity in this market?

P=$20, Q=20 The socially optimal quantity is where MSB=MSC, which is 20 units, and the marginal social benefit of 20 units is $20, so that is the optimal price.

This graph shows the marginal social cost (MSC), marginal social benefit (MSB), and marginal private benefit (MPB)of a good that is sold in a perfectly competitive market. What kind of externality is this, and what area represents the deadweight loss generated if this market is unregulated?

Positive externality; WYX We can tell that this is a positive externality because the MSB is greater than the MPB. Deadweight loss is the difference between the MSB and the MSC between the socially optimal quantity (Q1) and the privately optimal quantity (Q2):

A per unit tax is placed on a monopoly with a downward sloping demand curve. What happens to the price consumers pay and to deadweight loss?

Price increases; deadweight loss increases When a tax is imposed on a market with a downward sloping demand curve, the price consumers pay increases and the quantity sold decreases. Deadweight loss exists in a monopoly because sellers produce a quantity that is less than the optimal quantity. Since quantity is reduced even further by a tax, deadweight loss increases.

What kinds of goods are excludable?

Private goods and artificially scarce goods Excludability is the ability to keep someone who has not paid for a good or service from using it. Private goods and artificially scarce goods (also called "club goods") are both excludable.

A government gives a lump-sum subsidy to a monopolist. What is the effect on profit, the quantity produced, and deadweight loss?

Profit increases; quantity doesn't change; deadweight loss doesn't change Profit increases because a subsidy lowers the firm's fixed costs, which shifts its average total cost curve down. Quantity doesn't change because a lump-sum subsidy has no effect on the firm's incentives, and if quantity doesn't change, neither does deadweight loss.

The graph shown here illustrates the marginal social cost (MSC), marginal private cost (MPC), demand (D), and marginal revenue (MR) for the only firm producing plastic in a market. What is the socially optimal quantity and price?

Qb​, Pv The socially optimal quantity is the quantity where marginal social cost equals marginal social benefit. Remember: demand is marginal benefit.

Mega-Conglomerate is a monopoly producer of bread in Hamsterville. Citizens are angry about the inefficiency that this firm generates, and have demanded that the government impose a per-unit tax on Mega-Conglomerate to punish the firm. What happens to the quantity produced and deadweight loss as a result of the tax?

Quantity decreases; deadweight loss increases A monopolist produces a quantity less than the allocatively efficient quantity. A tax decreases that quantity even further, putting a larger gap between the marginal cost of producing the good and the marginal benefit of the good.

This graph shows the marginal social cost (MSC), marginal private benefit (MPB), and the marginal social benefit) associated with the market for snizzles. What is the socially optimal quantity and what price would people be willing to pay for that quantity if the externality shown here is internalized?

Socially optimal quantity=10; Willing to pay $14 The socially optimal quantity is the quantity where marginal social cost intersects marginal social benefit, which is 10 units. If people internalize the externality, then their willingness to pay will be the marginal social benefit of 10 units, which is $14.

What happens to the Gini coefficient and the Lorenz curve if an economy implements a progressive tax structure?

The Gini coefficient decreases; the Lorenz curve moves closer to the line of equality. A progressive tax structure increases the marginal tax rate as income increases. Progressive tax structures reduce income inequality.

Which of the following best defines the free rider problem?

When goods are nonexcludable, people have no incentive to pay for their production The free rider problem describes a situation where people have no incentive to pay for the production of goods that are nonexcludable, such as public goods. As a result, private agents have little incentive to produce these goods.

Which of the following situations best describes a positive externality?

You bake a pie that makes the whole neighborhood smell delicious. The private benefit of the pie is your enjoyment from the pie. The social benefit of the pie is your private benefit, plus the benefit the entire neighborhood gets from smelling it. When the social benefit of a good is greater than the private benefit of a good, that is a positive externality.

Which of the following situations best describes a negative externality?

You make a sardine and limburger sandwich that makes your dorm smell terrible. The unbelievable stench caused by this sandwich imposes a cost on your dorm-mates that is not accounted for when you performed a cost benefit analysis on making the sandwich. Had you taken this external cost into account, you might not have made the sandwich at all.

A binding price floor increases inefficiency in all of the following situations EXCEPT

a monopsony labor market When a firm operates in a monopsonistic labor market, it chooses a quantity of labor where the marginal factor cost equals the marginal revenue product of labor, and it then pays a wage lower than the allocatively efficient wage. If the minimum wage in such a market is set at the wage where the supply of labor and the marginal revenue product of labor are equal, deadweight loss is eliminated.

This graph shows the market for vaccines, including the marginal social benefit (MSB), marginal social cost (MSC), and marginal private benefit (MPB). The government can attempt to correct this externality by setting

a per-unit subsidy of Pd-Pb The graph indicates a positive externality, and per-unit subsidies are one way governments can intervene in markets to correct positive externalities. The difference between the MSB and the MPS is Pd-Pb and subsidizing the difference between how people value it and its social value can correct this externality.

Which of the following policy interventions will theoretically reduce the deadweight loss generated by a monopoly?

a per-unit subsidy to the monopolist An effective market intervention to correct, or lessen, a market failure must address the behavior that leads to the market failure. A monopolist produces a quantity that is less than allocatively efficient because its profit-maximizing quantity is less than the allocatively efficient quantity. A per-unit subsidy increases the firm's profit-maximizing quantity by decreasing the firm's marginal cost curve.

The marginal social cost (MSC), marginal private cost (MPC), and marginal social benefit (MSB) associated with the production of a good are shown in this graph. If the government wants to intervene in this market to eliminate deadweight loss, which of the following is the best choice?

a per-unit tax on sellers of $12 Marginal social cost is $12 more than marginal private cost for all units of consumption. A per-unit tax equal to the per-unit externality forces producers to internalize the external cost.

This graph shows the average total cost (ATC), marginal cost (MC), demand (D), and marginal revenue (MR) for a natural monopoly. What is necessary for this firm to be willing to produce the allocatively efficient quantity?

a price ceiling of P6, and a lump-sum subsidy of P4deP6 The allocatively efficient quantity is Q1, and the marginal cost of Q1 is P6. If price equals P6, then the firm's marginal revenue also equals P6, so Q1 is the profit maximizing quantity at P6. However, price is less than average total cost, so this firm is losing money. It would only be willing to produce this quantity if it receives a lump-sum subsidy that earns at least zero economic profit.

This graph shows the Lorenz curves for five countries. Which country has the least income inequality?

Country 1 Country 1's Lorenz curve is identical to the line of equality. Therefore, there is no income inequality at all in country 1.

If a positive externality exists in the consumption of chive butter, which of the following best describes this market?

The marginal social benefit exceeds marginal private benefit. A positive externality in consumption means that the social value of consuming the good is higher than individuals value it at all units of consumption. As a result, the market quantity is less than the optimal quantity.

Which of the following best describes where total surplus is maximized when an externality exists in a market?

The quantity where marginal social cost equals marginal social benefit. The socially optimal quantity is the quantity that maximizes economic surplus. The socially optimal quantity of a good is the quantity where the marginal social benefit of consuming the last unit equals the marginal social cost of producing the last unit.

Which of the following best describes the market quantity that will always maximize total economic surplus?

The quantity where the marginal benefit of the last unit equals the marginal cost of producing the last unit. When the cost of producing the last unit of a good equals how much society values the last unit, that amount of production is optimal, which means economic surplus is maximized.