CA Foundation P4 · Chapter 7
Public Finance MCQs with Answers
15 multiple-choice questions on Public Finance for CA Foundation P4 Business Economics. Try each one before revealing the answer and explanation.
Practise this chapter interactivelyQuestion 1
According to Richard Musgrave, the three fiscal functions of the government are:
- A) Production, consumption and exchange
- B) Taxation, borrowing and expenditure
- C) Allocation, distribution and stabilisation
- D) Planning, regulation and licensing
Show answer & explanation
Answer: C) Allocation, distribution and stabilisation
Musgrave classified government's fiscal functions as the allocation function (providing goods markets fail to supply efficiently), the distribution function (achieving a fair distribution of income) and the stabilisation function (maintaining employment and price stability).
Question 2
Pure public goods are characterised by:
- A) Rivalry in consumption and excludability
- B) Rivalry in consumption but non-excludability
- C) Non-rivalry in consumption and non-excludability
- D) Non-rivalry in consumption but excludability
Show answer & explanation
Answer: C) Non-rivalry in consumption and non-excludability
A pure public good, such as national defence, can be consumed by one person without reducing availability to others (non-rival), and it is impossible or very costly to exclude non-payers (non-excludable). Rival and excludable goods are private goods.
Question 3
The 'free rider' problem means that:
- A) People can enjoy the benefits of a good without paying for it, so private markets under-provide it
- B) Producers charge excessive prices for public goods
- C) Governments provide goods free of cost to the poor
- D) Consumers buy more than they need of subsidised goods
Show answer & explanation
Answer: A) People can enjoy the benefits of a good without paying for it, so private markets under-provide it
Because of non-excludability, individuals have an incentive to hide their true preferences and let others pay. As private firms cannot collect revenue from free riders, they under-supply such goods, which justifies government provision.
Question 4
When the production of a good generates a negative externality such as pollution, the free market will:
- A) Produce less than the socially optimal quantity
- B) Produce more than the socially optimal quantity, since marginal social cost exceeds marginal private cost
- C) Produce exactly the socially optimal quantity
- D) Charge a price higher than the socially optimal price
Show answer & explanation
Answer: B) Produce more than the socially optimal quantity, since marginal social cost exceeds marginal private cost
The producer considers only private cost, ignoring the external cost borne by others. Since MSC > MPC, the market equates demand with MPC and produces beyond the output where demand equals MSC. The market price is therefore too low and output too high.
Question 5
A tax imposed on a polluting firm equal to the marginal external cost of its activity is known as a:
- A) Progressive tax
- B) Lump-sum tax
- C) Pigouvian tax
- D) Proportional tax
Show answer & explanation
Answer: C) Pigouvian tax
A Pigouvian tax, named after A. C. Pigou, internalises the externality by raising the producer's private cost to equal social cost, reducing output to the socially optimal level.
Question 6
Which of the following is a merit good?
- A) Cigarettes
- B) Liquor
- C) National defence
- D) Primary education
Show answer & explanation
Answer: D) Primary education
Merit goods are goods whose consumption is considered socially desirable and which people tend to under-consume if left to themselves, such as education and health care. Cigarettes and liquor are demerit goods, and national defence is a public good.
Question 7
After buying comprehensive vehicle insurance, a driver becomes careless about locking his car. This is an example of:
- A) Moral hazard
- B) Adverse selection
- C) Free riding
- D) A positive externality
Show answer & explanation
Answer: A) Moral hazard
Moral hazard arises after a transaction, when one party changes behaviour because the other bears the risk and cannot fully monitor actions. Adverse selection arises before a transaction, when hidden information leads to the wrong type of participants entering the market (e.g., only high-risk people buying insurance).
Question 8
Market demand is Qd = 500 - 10P and supply is Qs = 100 + 10P. If the government imposes a price ceiling of Rs. 15, the market will experience:
- A) A surplus of 100 units
- B) A shortage of 100 units
- C) A shortage of 50 units
- D) No effect, since the ceiling is above equilibrium
Show answer & explanation
Answer: B) A shortage of 100 units
Equilibrium: 500 - 10P = 100 + 10P, so P = 20 and Q = 300. The ceiling of Rs. 15 is below equilibrium and therefore binding. At P = 15, Qd = 500 - 150 = 350 and Qs = 100 + 150 = 250. Shortage = 350 - 250 = 100 units.
Question 9
When the government fixes a minimum support price above the market equilibrium price for a crop, the likely result is:
- A) Excess demand and black markets
- B) No change in the market
- C) A fall in the quantity supplied
- D) Excess supply, which the government may have to procure
Show answer & explanation
Answer: D) Excess supply, which the government may have to procure
A minimum support price is a price floor. When set above equilibrium, quantity supplied exceeds quantity demanded, creating a surplus. To make the floor effective, the government often buys the surplus. Excess demand and black markets are associated with price ceilings.
Question 10
Fiscal deficit is defined as:
- A) Revenue expenditure minus revenue receipts
- B) Total expenditure minus total receipts including borrowings
- C) Total expenditure minus revenue receipts and non-debt capital receipts
- D) Revenue deficit minus interest payments
Show answer & explanation
Answer: C) Total expenditure minus revenue receipts and non-debt capital receipts
Fiscal deficit = total expenditure - (revenue receipts + non-debt creating capital receipts such as recovery of loans and disinvestment proceeds). It indicates the government's total borrowing requirement. Revenue expenditure minus revenue receipts is the revenue deficit.
Question 11
A government's budget shows (Rs. crore): revenue receipts 900; non-debt capital receipts 50; total expenditure 1,400, of which interest payments are 300. Fiscal deficit and primary deficit respectively are:
- A) Rs. 500 crore and Rs. 200 crore
- B) Rs. 450 crore and Rs. 150 crore
- C) Rs. 450 crore and Rs. 750 crore
- D) Rs. 1,400 crore and Rs. 1,100 crore
Show answer & explanation
Answer: B) Rs. 450 crore and Rs. 150 crore
Fiscal deficit = 1,400 - (900 + 50) = Rs. 450 crore. Primary deficit = fiscal deficit - interest payments = 450 - 300 = Rs. 150 crore. Rs. 500/200 crore ignores non-debt capital receipts; Rs. 750 crore wrongly adds interest.
Question 12
The 'tragedy of the commons' refers to:
- A) Under-production of public goods due to free riders
- B) Exploitation of consumers by a monopoly
- C) Excessive taxation of the poor
- D) Over-use and depletion of a common-property resource because no one owns it
Show answer & explanation
Answer: D) Over-use and depletion of a common-property resource because no one owns it
Common-property resources such as open fisheries or grazing land are rival but non-excludable. Each user ignores the cost his use imposes on others, leading to over-exploitation and possible depletion. Assigning property rights or regulation can address it.
Question 13
During a deep recession, an appropriate fiscal policy would be to:
- A) Increase government expenditure and reduce taxes
- B) Reduce government expenditure and raise taxes
- C) Aim for a budget surplus
- D) Increase the cash reserve ratio
Show answer & explanation
Answer: A) Increase government expenditure and reduce taxes
Expansionary fiscal policy raises aggregate demand to restore output and employment. Cutting spending, raising taxes and aiming for a surplus are contractionary. The cash reserve ratio is a monetary policy instrument, not fiscal.
Question 14
Which of the following acts as an automatic (built-in) stabiliser?
- A) A one-time increase in road construction approved by Parliament
- B) A discretionary cut in excise duties
- C) A progressive income tax system
- D) An increase in the repo rate
Show answer & explanation
Answer: C) A progressive income tax system
Automatic stabilisers change without new policy action. With a progressive income tax, tax collections rise more than proportionately in a boom and fall in a slump, dampening fluctuations in disposable income. Discretionary changes require deliberate decisions; the repo rate is a monetary tool.
Question 15
'Crowding out' refers to a situation where:
- A) Imports displace domestic production
- B) Increased government borrowing raises interest rates and reduces private investment
- C) Public sector enterprises are privatised
- D) Increased private investment reduces government spending
Show answer & explanation
Answer: B) Increased government borrowing raises interest rates and reduces private investment
When government borrows heavily to finance a deficit, demand for loanable funds rises, pushing up interest rates. Higher rates discourage private investment, partially offsetting the expansionary effect of fiscal policy.