Chapter 5
When markets fail to meet the conditions for ideal economic efficiency, the problem can generally be traced to one of four sources: absence of competition, externalities, public goods, or poor information. True False
Economic efficiency occurs when (1) all activities generating more benefit than cost are undertaken and (2) no activities for which the cost exceeds the benefit are undertaken. In a simple supply-demand diagram, the economically efficient level of activity is represented by the intersection of the two curves. Quantities to the left of the efficient quantity (where the marginal benefit exceeds the marginal cost) are inefficient because some production that could generate more benefits than costs is not undertaken. Quantities to the right of the efficient quantity (where the marginal cost exceeds the marginal benefit) are also inefficient because some units are produced whose costs exceed the benefits they create. Thus, either too much or too little of an activity will result in inefficiency. When markets fail to meet the conditions for ideal economic efficiency, the problem can generally be traced to one of four sources: absence of competition (which leads to too little production), externalities (which lead to too little or too much production, depending on whether an activity generates a positive or negative externality), public goods (too few of which are produced), or poor information (which may lead to too much or too little production).
Which of the following reduces information costs to consumers by requiring firms to meet certain conditions in order to use a particular brand name? Public goods Franchises Property rights Corporations
Franchises Wendy's is an example of a franchise. Wendy's locations offer a familiar atmosphere and menu of products. Each location is independently owned, but the owner agrees to adhere to certain standards and conditions in order to maintain the right to use the brand name and market Wendy's products. The franchise reduces the information collection costs of consumers by offering them a consistent atmosphere and product at any Wendy's location. Consumers do not have to guess about the quality of the service or the selection of beverages and food.
Which of the following best explains the sources of external costs? The scarcity of clean air Excessive water pollution Poorly defined and imperfectly enforced property rights The great variety of goods and the large numbers of consumers
Poorly defined and imperfectly enforced property rights External costs arise because property rights are poorly defined or imperfectly enforced. Although it makes sense to improve the definition and enforcement of property rights, the nature of some goods renders defining and enforcing property rights extremely difficult. Examples are resources like clean air and many fish species in the ocean. Property owners around a small lake will generally be able to control access to the lake and prevent each other, as well as outsiders, from polluting or overfishing the lake. However, in cases that involve large numbers of people, the transaction costs of arriving at an agreement will often be prohibitively high, so it is unrealistic to expect that private contracts among the parties can address the situation satisfactorily.
A group of university students buys coconuts from a farmers' market. The students consume the meat of the coconuts for food and use the shells to make sculptures. These sculptures are placed in a public park that any student can visit. The park sustains itself through students' donations. Some individuals have no incentive to donate to the park and will instead depend on those who do donate. This is an example of which of the following? Overuse of coconuts The free-rider problem A negative externality Socially efficient allocation of coconuts
The free-rider problem The park is an example of a public good. It is a nonrival in that one additional visitor does not lessen the benefit of another visitor. It is also nonexcludable because any student can visit for free. Public goods suffer from the free-rider problem. Students have no incentive to donate to the park but will instead take a free ride from those who do donate.
In response to the terrorist attacks of September 11, 2001, airline security screening increased dramatically. As a result, the travel time of airline passengers has increased substantially. Evaluate the following statement. True or False: Economics suggests that, at some point, the marginal improvements from dedicating more and more resources to preventing attacks will decline, while the marginal costs will rise.
True Although preventing terrorist attacks is among the most worthwhile goals there is, economists also consider the costs of actually achieving such goals. Economics suggests, that at some point, the marginal improvements from dedicating more and more resources to preventing attacks will become smaller and smaller, while the marginal costs will rise.
True or False: When traveling through an area for the first time, consumers will generally have more accurate information when purchasing from a well-known nationally franchised business rather than from a locally-owned business.
True Compared to tourists, local residents will generally have more accurate information about the quality, price, and service of the local businesses because they will have either patronized them or interacted with other residents who have done so. Franchised businesses and brand names will communicate information to travelers about what to expect from those businesses and products. Franchised owners (e.g. McDonald's, Olive Garden, Holiday Inn, and Best Western) will have an incentive to monitor the quality of the franchised businesses because this will help to maintain the value of the franchises. Therefore the quality, price, and services provided by the franchised business will be similar regardless of its location.
English philosopher John Locke argued that the protection of each individual's person and property (acquired without the use of violence, theft, or fraud) was the primary function of government. Evaluate the following statement. True or False: Locke stressed that individuals are not subservient to governments. On the contrary, the role of governments is to protect the "natural rights" of individuals to their person and property. This view, also reflected in the "unalienable rights" section of the U.S. Declaration of Independence, is the basis for the protective function of government. True False
True The English philosopher John Locke argued that people own themselves and, as a result of this self-ownership, they also own the fruits of their labor. Locke stressed that individuals are not subservient to governments. On the contrary, the role of governments is to protect the "natural rights" of individuals to their person and property. This view, also reflected in the "unalienable rights" section of the U.S. Declaration of Independence, is the basis for the protective function of government.
Apply the economic efficiency criterion to the role of government. When would a government intervention be considered economically inefficient? High interest rates When buyers or sellers are poorly informed When prices are high When political choices lead to outcomes that conflict with the efficient allocation of resources
When political choices lead to outcomes that conflict with the efficient allocation of resources It is tempting to jump to the conclusion that if the market fails to achieve economic efficiency, then the government can intervene and improve the situation. But we must not forget that government directed by political decision-making is merely an alternative form of economic organization. It is not a corrective device that can be counted on to make choices that will promote economic efficiency. There is government failure, as well as market failure. Government failure is present when political choices lead to outcomes that conflict with the efficient allocation of resources.
In response to the terrorist attacks of September 11, 2001, airline security screening increased dramatically. As a result, the travel time of airline passengers has increased substantially. Complete the following statement. Economics suggests, that at some point, the marginal improvements from dedicating more and more resources to preventing attacks will ?? , while the marginal costs will ?? .
decline, rise Although preventing terrorist attacks is among the most worthwhile goals there is, economists also consider the costs of actually achieving such goals. Economics suggests, that at some point, the marginal improvements from dedicating more and more resources to preventing attacks will become smaller and smaller, while the marginal costs will rise.
What is market failure? - A situation in which government must protect individuals and their property against aggression and provide a legal system for the enforcement of contracts and settlement of disputes. - A situation in which the structure of incentives is such that markets will encourage individuals to undertake activities that are inconsistent with economic efficiency. - A situation in which external costs are present and output is too large. - A situation in which the structure of incentives is such that the political process, including democratic political decision-making, will encourage individuals to undertake actions that conflict with economic efficiency.
A situation in which the structure of incentives is such that the political process, including democratic political decision-making, will encourage individuals to undertake actions that conflict with economic efficiency. Market failure is a situation in which the structure of incentives is such that markets will encourage individuals to undertake activities that are inconsistent with economic efficiency, where the latter refers to a situation in which (1) all actions generating more benefit than cost are undertaken and (2) no actions generating more cost than benefit are undertaken. When markets fail to meet the conditions for ideal economic efficiency, the problem can generally be traced to one of four sources: absence of competition, externalities, public goods, or poor information. See section: Market and government failure.
Nonexcludable - It is not possible to prevent an individual from using the good. Rival - Consumption of the good by one person decreases the ability of other people to consume the good.
Explanation: A good is nonexcludable if there is no way to restrict access to it. For example, a concert in a public park is nonexcludable because anyone is allowed to walk through the park and enjoy the music, but a concert in a theater is excludable because the theater management can restrict attendance to only those people who buy a ticket. A good is rival in consumption when consumption by one individual decreases the amount that can be consumed by another individual. For example, if you consume a hamburger, nobody else can consume that same hamburger. However, if you watch a program on television, it doesn't interfere with anyone else's ability to watch the broadcast on a different TV set, so it is nonrival in consumption.
Public goods are sometimes funded voluntarily, but in other cases, they must be provisioned through alternative means. The government approach to providing public goods is usually based on which of the following concepts? Provide the public good directly, paying for it out of tax revenues. Hold a lottery in which one of a number of firms is designated randomly as the only supplier of the public good. Use taxes or regulations to limit production of the public good. Rely on the invisible hand to solve the problem through voluntary trade.
Provide the public good directly, paying for it out of tax revenues. Because of the free-rider problem, governments generally rely on taxation to generate enough revenue to fund the public good. The invisible hand is simply another name for the workings of the market system, which, because of the free-rider problem, will tend to underproduce public goods. A lottery isn't a good solution, because the firm that wins the lottery may be unable to exclude people who don't pay for its services. If it can't, it will never be able to collect sufficient revenue to cover its costs. Finally, using taxes or regulation to limit the production of a public good isn't the right answer because the market failure associated with public goods is underproduction due to the free-rider problem. The government wishes to encourage production, not limit it.
Sharon was willing to contribute $40 this year to her local college radio station. However, after learning that the radio station had already met its goal of raising $200,000, she decides not to contribute, because she knows she can listen to it without contributing. This is an example of which of the following? The free-rider problem An external cost An opportunity cost A deadweight loss
Sharon is free riding. A free rider receives a benefit without paying his or her share of the cost of providing that benefit. An external cost is a cost imposed on a third party not directly involved in the activity in question. A deadweight loss is the reduction in gains from trade due to a deviation from the optimal output. An opportunity cost is the value of the highest-valued forgone choice.
Consumer information problems will be lowest for which of the following products or services? cold medicine Ice sculptures Automobiles Foreign hotel rooms
cold medicine Cold medicine is a repeat-purchase item. Consumers can use past experience to obtain precise information about different cold medicine brands, allowing them to make an informed purchasing decision. Consumers buy all the other products on a more infrequent basis.
Consumer information problems will be lowest for which of the following products or services? International flights Motorcycles shampoo Wedding planning services
shampoo Shampoo is a repeat-purchase item. Consumers can use past experience to obtain precise information about different shampoo brands, allowing them to make an informed purchasing decision. Consumers buy all the other products on a more infrequent basis.
