chapter 8
What type of economy would we expect to have the highest incidence of moral hazard?
A planned economy Explanation: In Marxist societies, most incentives to produce were eliminated. A lack of incentives tend to increase moral hazards in that people are rewarded whether or not they produce.
Which of the following would not be an example of a problem associated with moral hazard?
All of the above are examples of moral hazard. Explanation: Moral hazard provides an incentive to act recklessly at someone else's expense. It involves a party taking an unobservable action to gain advantage over another party.
Which of the following could not cause market failure?
An uneducated person who does not value an education. Explanation: Market failures can occur because of externalities, wealth effects, or natural monopolies. However, only the individual can value the worth of any good.
Which of the following would be considered a solution to automobile air pollution by applying the principle of the second best?
The government sells tradable pollution permits. Explanation: The imposition of a tax, a fine, or a regulation only approximates the cost of the pollution. The problem is not the automobiles but pollution. Tradable pollution permits reduce the information costs and more closely reflect costs.
When positive externalities are in a market, the market
fails, because it underproduces the good that creates the positive externality. Explanation: The market failure occurs because all benefits are not captured by the market. Producers may find some transactions unprofitable, although society would benefit from the transaction.
In a market experiencing a negative externality, quantity should __________ and price should __________.
fall, rise. Explanation: Production creates a negative externality. If all social costs are accounted for, price must rise and quantity must fall until the true social cost equals the social benefit.
In the automobile insurance industry, deductibles are meant to increase the moral hazard associated with a claim.
false Explanation: A deductible forces the insured to pay part of the claim. It makes the insured a co-insurer, thus raising the cost to the insurer of filing a false claim.
A sales tax on all retail sales is a progressive tax system because higher income taxpayers spend more money.
false Explanation: Lower income taxpayers spend a larger percentage of their incomes on retail purchases and a smaller percentage of their incomes on saving. For this reason, a sales tax becomes regressive.
The "principle of second best" is the idea that the best way to internalize a negative externality is to force the producer to correct the effects of the externality after it has occurred.
false Explanation: The "principle of second best" means that the externality should be corrected in a way that most closely corrects the original problem. Correcting after the externality has occurred is usually not a method that closely corrects the original problem.
The Coase theorem suggests that government policy is the most effective way of solving externality problems.
false Explanation: The Coase theorem suggests that the parties involved can often work out a more effective solution than the government solution. Coase suggests that the government should be used when the parties are unable to find a solution.
The impossibility theorem states that we can always achieve consistent results in societal preference ordering if we properly aggregate individual preferences.
false Explanation: The impossibility therorem says that there is no way to aggregate individual choices and achieve consistent results for social choices.
When a per-unit tax is imposed on a polluter, the marginal social cost curve shifts to the right.
false Explanation: The marginal social cost curve is the producers' supply curve. Imposing a tax on a producer shifts it to the left, a decrease in supply.
The true social cost of any transaction is the private cost and the external cost, minus the true social benefits.
false Explanation: The true social cost of a transaction is the sum of the private and external costs only. Subtracting the true social benefit from the true social cost yields the total economic value.
Asymmetric information refers to a situation in which both parties in a transaction have equal information and can calculate the expected value of the outcome of the transaction.
false Explanation: This statement is false. Asymmetric information exists when one party in a transaction has more knowledge about the quality of a product than the other party.
Negative externalities (external costs)that arise from the production of a good
impose unfair costs on parties outside the production. Explanation: Negative externalities are often production costs that a producer successfully passes to third parties, thereby reducing the producers costs.
Market failures are caused by all of the following except
inferior products Explanation: Market failures can occur because of externalities, wealth effects, market power, or asymmetric information. Poor products are not a source of market failure. Poor products may indicate market success if they are eliminated from the market.
One of the main potential problems caused by moral hazards in insurance markets is that
insurance markets may break down. Explanation: Insurance markets could break down completely because insurance companies would be unwilling to take any risk if the incidence of false claims became too high. Insurance companies would move resources to more profitable areas and honest policyholders would be left uninsured.
Which of the following examples describe both risk-averse and risk-loving behavior?
insuring your car and betting on horses Explanation: A risk-averse person would seek a secure situation; a risk lover would be willing to take a chance on transactions. People are capable of both types of behavior in different situations.
The Coase theorem suggests that finding an efficient solution to a negative externality
is not dependent upon the ownership of property rights to the resource. Explanation: The Coase theorem provides a solution, regardless of who owns the property rights. The Coase theorem is based on negotiated prevention of the externality. The property rights will affect who bears the costs, but it does not affect the efficiency of the outcome.
The Coase theorem is important because
it indicates that market externalities can be corrected without resorting to government solutions. Explanation: Coase showed that markets can provide a solution to externalities. The parties may be able to negotiate a market settlement to a market externality.
If third parties are involved in an externality,
it may be less expensive to have the government determine a solution. Explanation: If the transaction costs of getting the groups to the bargaining table are high, the government may be able to negotiate a settlement more cost effectively than the groups.
Assume your neighbor throws trash in his yard. He gets $50 worth of benefit from littering, which imposes a $90 cost to you. According to Coase, you should
offer him between $51 and $90 if he will keep his yard clean. Explanation: You should be willing to pay more than his value and up to yours. Since he already gets $50 benefit from littering, he will not accept less than that to clean the yard. Your cost is $90 so you would be willing to offer up to $90 to clean it. The solution will depend on negotiations.
If your neighbor's barking dog annoys you, a possible Coase solution would be to
offer to train the dog not to bark. Explanation: A Coase solution would involve some negotiation with the neighbor. The outside party must bear part of the cost and offer the owner a solution to which she has an incentive to agree.
Years after the invention of Tang, the space program began using the drink in its heavily advertised space flights. This is an example of a
positive externality Explanation: Years after the invention of Tang by a food maker, the space program used the product in some of its heavily advertised space flights. This is an example of a positive externality because the space program benefited from information or knowledge brought about by the invention of Tang after the drink became more easily accessible.
The effects of an action that increases the well-being of third parties is called a
positive externality (external benefit). Explanation: A positive externality creates unintended benefits to others. The parties receiving these benefits do not pay for them.
You are considering buying a raffle ticket. If you win, you will receive $500. If you lose, you will receive nothing. There is a 1% chance that you will win. If raffle tickets cost $5, which individuals would buy the tickets?
risk neutral individuals and risk lovers Explanation: A risk-averse person would pay less than the expected value. Risk lovers would pay higher than the expected value and risk neutral people would only pay the expected value.
Internalizing a negative externality refers to
the producer bearing the cost of correcting a problem. Explanation: Internalization means that the party producing the externality must bear all private and social costs.
If an externality affects only a few people,
then it is likely that a private solution could occur. Explanation: When only a few parties are affected, negotiations usually become more productive and the likelihood of a successful outcome is enhanced. When many people are affected, the government may have to provide a solution.
The main problem about negative externalities is that
they understate the cost of production. Explanation: Production costs are private costs. The real social cost is the private cost plus the external costs that have to be borne by others. Private production costs understate the true social cost because they do not capture the external cost.
If perfect information were a reality,
transactions would be risk free. Explanation: Perfect information means that everyone has full product knowledge and full knowledge of future payoffs. There would be no risk for either party involved in a transaction based on perfect information.
A method that could be used to internalize an external benefit would be to subsidize the producer of the benefit.
true Explanation: The government could subsidize the production of a good that creates social value but is unprofitable. The subsidy would then induce producers to produce the good.
When externalities are present, the market will not maximize economic value.
true Explanation: The market fails to account for external costs and benefits.
Usually the cost of preventing an external cost is less than the cost of correcting it after it has occurred.
true Explanation: Total economic value is usually greater when incentives are provided to prevent an external cost than if sanctions are imposed after the fact.
If transaction costs in finding a solution are high, a government-imposed solution to an externality may be the most efficient solution.
true Explanation: Transaction costs increase when the number of affected parties increase. If the transaction costs are high, it is often more efficient for the government to find a solution.
Three voters will use a simple majority vote to determine whether a public service will be funded. Each persons share of the tax is $25. Person 1 receives $30 worth of benefits, person 2 receives $26 worth of benefits, and person 3 receives $5 worth of benefits. Therefore ______ person (s)will vote in favor, _____ person(s) will vote against, and the outcome will be ____________.
two; one; inefficient Explanation: Costs exceed benefits. The result is that the project is approved and the outcome is inefficent.
A free rider is a a consumer who consumes
a public good and may be unwilling to pay anything for it. Explanation: Free riders take advantage of the non-exclusive nature of public goods: they can use the good without paying for it.
If you are willing to pay more than the expected value of an opportunity, you are considered
a risk lover. Explanation: The type of risk taker you are depends on your willingness to 'risk' not getting at least what you invested.
If the consumption of a good by one person reduces the amount of the good that can be consumed by others, economists say that the good is
a rival good. Explanation: This defintion is for a rival good. Examples would be a hamburger (exclusive) or a park (non-exclusive).
The auto insurance industry relies on people to
be risk averse. Explanation: The insurance market will break down if people take significantly greater risks. If driver's are risk lovers they will self insure.
Government subsidies of day care can be explained by government's attempt to internalize a _________________ associated with ______________________.
benefit, well-adjusted children. Explanation: The government may subsidize day care because mothers often work. Day care is perceived as a social benefit because children who are cared-for are healthier and better adjusted and in the long run, exhibit fewer anti-social behavior traits.
Negative externalities lead to
inefficiency. Explanation: Markets are most efficient in the absence of externalities. Negative externalities may cause socially undesirable transactions to take place because the producer can pass some costs to others.
A method of correcting air pollution that most closely corrects the original problem is
to tax each firm a per-unit tax for the right to pollute. Explanation: A per-unit tax most closely attacks the original problem, because it taxes the pollution and not the production. Pollution is the problem.
A good is non-exclusive if
it is not possible to prevent people from obtaining the benefits of the good once it has been provided. Explanation: This is the defintion of a public good. Once provided, the good is available to everyone.
You are considering buying a raffle ticket. If you win, you will receive $500. If you lose, you will receive nothing. There is a 1% chance that you will win. If you are risk neutral, which of the following prices would you be willing to pay?
$5 Explanation: To calculate expected value, you multiply the odds of winning by its payoff and the odds of losing by its payoff and sum the two. A risk-neutral person will pay up to the expected value of the payoff. The expected value in this problem is 1% × $500 = $5.00.
Which of the following kinds of monopoly represent a market failure?
All the above are market failures. Explanation: A monopoly of any type is a market failure. The source of the monopoly does not matter.
Which of the following statements is not true?
Internalizing an externality is not the same as inducing the producer of an externality to consider both private and social costs in production decisions. Explanation: An internalization of an externality means that the producer accounts for all costs and benefits, and then produces at the socially optimal level.
Good information is of value to
sellers and buyers. Explanation: Quality of information affects all aspects of a transaction. Transactions based on perfect information would present no risks for either of the groups involved, and markets would operate more efficiently.
All the following are possible methods of correcting a negative externality except
taxing the recipients of the externality and using the revenue to correct the problem. Explanation: The recipients of a negative externality are third parties who are bearing the costs of an externality. To tax the recipients would cause them to bear even more costs of the externality.
An externality refers to
the actions of one person affecting another person. Explanation: An externality is any external cost or benefit that can be passed to others who are not a part to the original transaction.
Producers would be willing to pay for perfect information.
true Explanation: Perfect information would reduce the risk of making a bad decision. Therefore, information has a market and a price in the market.
An external benefit created by a transaction is any benefit that accrues to a party outside that transaction.
true Explanation: The benefit that groups or parties outside the transaction get from the transaction between others is an external benefit.
An example of a positive externality (external benefit) is
vaccinating your dog for rabies. Explanation: A positive externality creates a benefit for another party. Vaccinating your dog protects not only the dog, but also other pets and people who may come into contact with the dog.
Suppose a person has income of $100,000. If this person has a marginal tax rate of 20% on income over $20,000 and a zero tax rate on the first $20,000 of income, what is the person's average tax rate?
16% Explanation: Use the formula [Y-$20,000].20/Y. The result using algebra is .20 -.04 = .16. Multiply .16 by 100 to get a percentage.
Which of the following is least likely to generate an external cost?
Reading a book. Explanation: Reading a book generates only a private benefit and a private cost. The other activities have the potential for generating external costs: many people are allergic to smoke or cologne and using a cell phone in public forces others to hear the conversation.
A taxpayer pays _____________tax rate on additional income if the tax system is progressive, ___________ tax rate on additional income if the tax system is proportional, and ______________ tax rate on additional income if the tax structure is regressive.
a higher; the same; a lower Explanation: Progressive:tax rates increase on matginal income; proportional: tax rates remain the same on marginal income; regressive: tax rates fall on marginal income.
An unintended effect of a action that adversely affects others is called a
a negative externality (external cost). Explanation: A negative externality is an adverse effect on third parties that is caused by the original transaction.
"Lemon laws" are a possible solution to
adverse selection. Explanation: Adverse selection is a problem when a transaction exibits asymmetric information. They allow purchasers to return defective merchandise after a purchase.
A positive externality can be
all of the above Explanation: Positive externalities are the same as external benefits. They can be intentional, unintentional., and are often aesthetic.
All of the following could be reasons that pollution exists except
all of the above could be reasons that pollution exists. Explanation: Pollution is a negative externality but eliminating entails cost. If society chooses lessen pollution, the benefits will have to outweigh the costs. Sometimes society must provide incentives to producers of negative externalities.
It appears that cigarette companies may have had an advantage in information over consumers until recent years. If consumers had had the same information
both a and b. Explanation: If consumers had had complete information about the health effects, the demand curve would have shifted to the left (a decrease in demand), thus decreasing quantity demanded and price.
A risk averse person would not be expected to
buy a lottery ticket. Explanation: A risk-averse person is willing to pay less than his expected return on any gamble. The expected value of a lottery ticket is less than the price of the ticket. A risk averse person would not pay for a lottery ticket.
Because of asymmetric information,
buyers offer low prices to guard against the potential risks. Explanation: Consumers may be reluctant to buy high quality, expensive items because of the increased risk. Therefore, the market for high quality products may disappear.
Assymetric information exists in any transaction when
each party to a trade differ in the amount of knowledge they have of the good being traded. Explanation: Assymetric information means that one party has more information than the other party, and is able to use that information to an advantage.
To obtain a market demand curve for a public good, one has to horizontally sum the demand of individual consumers.
false Explanation: You have to vertically sum the demand for public goods; private goods are horizontally summed.
Coase believes all of the following except
government intervention never effectively deals with externalities. Explanation: Coase believes that if the parties cannot reach a settlement, the government can assist with a solution through taxes or subsidies.
Public choice theory is concerned with
government policy decisions. Explanation: Public choice theory concerns itself with public sector or government choices.
The main feature of a progressive tax system is that the higher one's income, the _______________ one pays.
higher the tax rate one pays. Explanation: A progressive system is one in which the tax rate rises as income rises.
A market failure exists
if an economic outcome fails to maximize economic value. Explanation: Market failure means that the market does not maximize economic value. The solution is often a nonmarket solution.
School lunch programs in which the government pays part of the cost of some students' lunches is an example of how the government attempts to
internalize a benefit. Explanation: When poor children receive a lunch at school, society perceives this as an external benefit because the children perform better in school. To externalize this benefit, the government often subsidizes the cost of the lunch.
If the producer of a negative externality considers the cost to third parties when the producer makes cost-benefit analyses involving the production, the externality is said to be
internalized. Explanation: Internalization means that the producer has in some way borne the costs. If the cost is internalized, the producer will produce the socially optimal level of output.
If property rights for the right to pollute the air were established, there would probably be
less air pollution. Explanation: If a marketwere established with tradeable rights to pollute, there would likely be less airpolllution. Producers would have to consider all costs in their production decisions. An externality is really a missing market.
In a majority voting system, a public project
may be approved even if the total benefits are less than the total costs. Explanation: Simple majority voting fails to account for intensity of preferences. We can use intensity of preferences to sum the total benefits and total costs. Sometimes costs may exceed benefits but when each participant has one vote, the public project may be approved.
If an economic outcome results in a social cost,
negative externalites are probably involved in the production of the good. Explanation: Negative externalities are not reflected in the market supply curve, and producers tend to overproduce. The market supply curve would shift to the left if social costs were included, thus raising the price and decreasing equilibrium output.
Which of the following economic systems could prevent market failure?
none of the above. Explanation: Market failures occur in all societies and in all types of economic organization. The causes of market failures are unrelated to the type of economic organization.
The Coase Theorem suggests that
people working in their own best interest can privately negotiate to solve an externality. Explanation: Coase suggests externalities can be handled among involved parties through negotiation.
Which of the following would create an external benefit?
planting a flower garden Explanation: External benefits provide positive values for others at little or no cost.
Methods used by life insurance companies to avoid the problem of moral hazard include all but
premium discounts for certain age groups. Explanation: Moral hazard refers to situations means that some individuals would take an unobservable action to gain at the expense of the other. Age is an observable trait that policyholders would find difficult to conceal.
If the production of a good results in negative externalities, then
production will be greater than the socially optimal output. Explanation: A negative externality is a cost that the producer does not have to pay. The producer tends to overproduce the good because all costs are not internalized.
In some coastal areas of the country, oceans are being over-fished resulting in rapid depletion of the fish population and a scarcity of certain varieties of fish. The reason for over-fishing is that
the fishing areas are unowned and unregulated. Explanation: The coastal fishing waters demonstrate the tragedy of the commons. When a public area is unowned and open to everyone, there is a tendency to overuse it.
If third parties bear part of the cost of an externality, the Coase theorem corollary says that
the government may have to impose a solution. Explanation: If third parties bear part of the cost of an externality, the negotiation may become too complicated for the original parties to work out. If that is the case, it may be more cost effective for the government to impose a solution on the parties.
The internalization of a negative externality from a particular production process will cause
the market demand curve to stay the same. Explanation: Internalization in production will affect the supply curve. Costs at all levels of output increase and the supply curve shifts inward. The demand curve is unaffected.
A market failure is any economic outcome in which
the market does not provide the optimal outcome for a particular good. Explanation: Economists assume that markets provide the most efficent outcomes. When they do not do this, economists call the situation a market failure.
Public choice theory assumes that those involved in the public sector are generally motivated by
the same factors that motivate them in the private sector. Explanation: Public choice theory assumes that people act in their own self interest no matter what the setting.
You are considering buying a raffle ticket. If you win, you will receive $500. If you lose, you will receive nothing. There is a 1% chance that you will win. If you are risk inclined, how much would you be willing to pay for a ticket?
$6 Explanation: The expected value of the raffle ticket is $5 (1% × $500). A risk-inclined person would pay more than the expected value for the ticket.
