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Chapter 13

Discussion questions
1

What is a market failure? Why do market failures occur?

A market failure is a situation in which the invisible hand pushes in such a way that
individual decisions do not lead to socially desirable outcomes.
2

What are three major sources of market failure?

Three major sources of market failure are externalities, public goods, and imperfect
information.
3

What is a government failure? List four reasons why it might occur.

A government failure occurs when government intervention in the market to improve a


market failure actually makes the situation worse.
The text describes five reasons for government failure:

Governments dont have an incentive to correct the problem.

Governments dont have enough information to deal with the problem.

Intervention in markets is almost always more complicated than it initially seems.

The bureaucratic nature of government intervention does not allow for finetuning.

Government intervention leads to more government intervention.

What is a public good? Give two examples.

A public good is a good that is nonexclusive (no one can be excluded from its benefits)
and nonrivalrous (consumption by one does not preclude consumption by others).
There are many examples of public goods, two of which are national defence and police
protection.
5
What problems are associated with determining how much of a public good
should be provided?

The problems associated with the provision of public goods include the following.
Firstly, it may be difficult to decide what is a public good, since what is and is not a
public good depends on technology. For example, roads used to be privately provided
when the main mode of transport was the horse and cart and toll collection was easy.
But with the advent of the car, toll collection became difficult and roads became more
like public goods. A second problem is that it is difficult to determine how much
consumers are willing to pay for public goods. This is the case because once a public
good is provided to one consumer, all consumers may use it (so there is little incentive
to reveal how much it is worth to you). Surveys may not provide accurate information
because respondents have an incentive to overstate or understate their true willingness
to pay for public goods.

Answers to review questions


1

Non-rival: street lighting on campus; Triple J radio broadcasts. Stephenie Meyer


novels are non-rival except for the fact that it is difficult for more than one
consumer to read a given copy at once. An apple is clearly unavailable to one
consumer if another eats it.

Non-excludable: street lighting on campus; Triple J radio broadcasts.

Rival and non-excludable: fish in the ocean; a busy highway during rush
hour.

Non-rival and excludable: software downloaded from a website (at least for hours
during which the sites server is not operating at full capacity); music in concert
halls (until seats run out).

Non-rival and non-excludable: wildflowers in Western Australia; full moon rising


over the Derwent River; a fairly deserted highway.

A head tax limits the amount of revenue that can be raised to the amount that poor
taxpayers can afford to pay. A wealthy taxpayer might prefer a proportional tax because
the value of the additional public goods made possible by the additional revenue would
outweigh the burden of the additional tax.

True. Activities that generate negative externalities are pursued excessively in the
absence of taxes on them, so a tax would improve resource allocation by making these
activities less attractive. The tax would also raise revenue to pay for public goods.

A not-for-profit biodiversity conservation organisation might well rely on donations to


fund its programs. To the extent that people may be more inclined to donate to preserve
visually attractive or iconic animals, species choice may be biased in their favour.
Species that are valuable from ecosystem and sustainability perspectives may therefore
be underrepresented in species preservation plans.

The direct loss in surplus is an overstatement, because we must also consider the gain
in surplus that results from the public goods and services that are financed by the tax.

Answers to problems
1

The most the guard can charge is $150, to be hired by Jill.

The plan will not be approved because Jack will not vote for it. He would have to
pay a $60 tax for a service worth only $50 to him.

A 1 per cent tax would imply that Jack pays $10 per month and Jill pays
$110. Both Jack and Jill would vote for this tax.

ii

Suppose Jack pays the guard $X and Jill pays him $Y. Then X and Y must
satisfy the equations X + Y = 120 and 150 Y = 50 X. Solving, we get X =
10 and Y = 110, the same as in part a. Jill will agree to the scheme as she
would enjoy a net benefit of $150 $110 = $40 per month.

iii

In order to implement the plan in part b, each party would have to report the
most he or she would be willing to pay for the guard. The problem is that
Jack and Jill each have an incentive to understate that amount in the hope
that the other has a higher willingness to pay and will therefore pay more of
the total.

The pool will not be built; with the requisite lump-sum tax of $6 per voter per
week, voters B and C will vote against it. Not building the pool is a socially
inefficient outcome because the total benefits per week of building the pool ($19)
exceed the total weekly cost ($18).

Since marginal cost is zero, a monopolists profit-maximising price is the price


that maximises total weekly revenue e namely, a price of $12. The result would
be a $6 weekly loss, so no firm will be willing to operate the pool. Again, the
socially efficient outcome is not achieved.

This time, there is a potential economic profit of $1 per week forever. At an


interest rate of 1 per cent per week, the present value of this profit stream is $100,
and this is the price at which the monopoly franchise should sell. The pool will be
built, and the socially efficient outcome achieved.

If all firms spend the same on lobbying, each will have a 25 per cent chance of
winning the franchise, which means an expected profit of 25 cents per week less
the amount spent lobbying. But by spending a cent more than its rivals, any one
of these firms could grab the whole dollar in monopoly profit. As we saw in the
case of the $20 bill auction, the incentives strongly favour escalation of the total
amount spent on lobbying, and total expenditures on lobbying may well exceed
the total value of the prize.

3
a, b
To construct the demand curve, add the two demand curves vertically, as
shown. The socially optimal quantity of broadcast opera on Saturdays occurs where the
marginal cost curve (MC) intersects the total demand curve (D in the top panel). This occurs
at three hours broadcast per Saturday. We get the same result (Q = 3) using algebra by solving
for P = MC, where P = 24 3Q and MC = 15.

$/hr
24

15

MC

6
0
$/hr
12

0
$/hr
12

hours/Sat.

D
Jones

hours/Sat.

D Smith

6
0

12

12

hours/Sat.

The network will choose the programs that generate the most profit. An episode of
The Biggest Loser would attract an audience of 12 million viewers, while one of Global
Village would attract only 8 million. Those audience sizes would generate payments of
$1.2 million and $800 000, respectively, from Colgate. Net of production costs, the
network would thus earn $800 000 for one episode of The Biggest Loser, and only
$400 000 for a Global Village episode.

The network would thus maximise its profit by filling one time slot with The Biggest
Loser and the other with the weight-loss infomercial.

b
The economic surpluses from showing episodes of The Biggest Loser and Global
Village are the areas under their respective demand curves $48 million for The Biggest
Loser, $64 million for Global Village. Since both figures are far larger than the surplus
generated by the infomercial, the socially efficient result would be for the network to fill its
two remaining slots with The Biggest Loser and Global Village.
c

A pay TV network would set price at the point along its demand curve for which
marginal revenue equals marginal cost. Since the marginal cost per viewer is zero, its
profit-maximising price would be $8 per episode. The network would receive $32
million in revenue, and viewers would reap economic surplus of $16 million. In
contrast, showing Global Village free of charge on SBS would result in a viewer
surplus of $64 million. Since production costs of each episode would be the same

under the two arrangements, the total economic surplus per episode would be $16
million larger if broadcast on SBS than if shown on pay TV.

False, because the pay-per-view TV company charges a positive price for a


non-rival good.

False, because the profit-maximising pay-to-view fee will not result in the largest
possible audience (which would have maximised advertising revenue).

False, because the marginal cost to viewers is zero on broadcast TV.

False, because charging a positive price for a non-rival good can cause an even
greater loss in surplus than results from choosing the wrong program.

True, because the pay-to-view scheme allows TV viewers to move away from the
lowest-common-denominator programs favoured and funded by advertisers.

The answer is e. Although the incentive problem described in option c does exist under
the stated circumstances, it is not a cause of the free-rider problem.

The net benefit after tax (column 3 of the table) indicates that Anne, Brad and
Carl would vote for the museum, so the referendum would carry.

Citizen

Marginal benefit Net benefit Single-price


from museum
after tax
monopolists
revenue
($/year)
($/year)

Price-discriminating
monopolists revenue
($/year)

($/year)
Anne

340

140

340

340

Brad

290

90

580

630

Carl

240

40

720

870

Dave

190

10

760

1 060

Ellen

140

60

700

1 200

The maximum revenue a single-price private company could make is $760 per
year, which is accomplished by charging a one-time fee of $190 per year to view
the museum. The total revenues ($760 per year) do not cover the museum costs
($1000 per year), so no private company is willing to build and operate the
museum on a single-fee basis.

A price-discriminating monopolist can make $1200 per year operating the


monument and charging each citizen his or her marginal benefit. The museum
costs $1000 per year to build, so the maximum a private company would bid for
the license to operate the museum as a discriminating monopolist is $200 per year
(= $1200 per year $1000 per year).

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