CIMA BA1 · Chapter 8
Market failure, externalities and competition policy MCQs with Answers
9 multiple-choice questions on Market failure, externalities and competition policy for CIMA BA1 Fundamentals of Business Economics. Try each one before revealing the answer and explanation.
Practise this chapter interactivelyQuestion 1
A pure public good is characterised by being:
- A) Rival and excludable in consumption
- B) Provided only by the private sector
- C) Supplied free of charge to those on low incomes
- D) Non-rival and non-excludable in consumption
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Answer: D) Non-rival and non-excludable in consumption
A public good is non-rival (one person's consumption does not reduce availability to others) and non-excludable (people cannot be prevented from benefiting). This creates a free-rider problem, so the market tends not to provide it.
Question 2
Where the production of a good creates a negative externality such as pollution, a free market will tend to:
- A) Underproduce the good because marginal private cost exceeds marginal social cost
- B) Produce the socially optimal quantity because firms bear all costs
- C) Overproduce the good because marginal social cost exceeds marginal private cost
- D) Overproduce the good because marginal social benefit exceeds marginal private benefit
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Answer: C) Overproduce the good because marginal social cost exceeds marginal private cost
Firms take account only of their private costs. With a negative externality, the cost to society is higher than the private cost, so output where demand meets private supply is greater than the socially optimal output where marginal social benefit equals marginal social cost.
Question 3
Which of the following is generally treated as a merit good?
- A) Tobacco
- B) Education
- C) Street lighting
- D) Luxury cars
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Answer: B) Education
Merit goods are goods that society judges people should consume more of than they would choose in a free market, often because consumers underestimate the benefits and because of positive externalities. Education and healthcare are common examples. Tobacco is a demerit good and street lighting is a public good.
Question 4
A Pigouvian tax intended to correct a negative production externality should ideally be set equal to:
- A) The marginal external cost at the socially optimal level of output
- B) The firm's average total cost
- C) The total profit earned by the polluting firm
- D) The difference between price and marginal private cost
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Answer: A) The marginal external cost at the socially optimal level of output
A Pigouvian tax internalises the externality by adding the external cost to the firm's private costs. Setting it equal to marginal external cost at the optimum moves the private supply curve to coincide with marginal social cost, so the market produces the socially optimal output.
Question 5
In the market for used cars, sellers know more about the quality of the cars than buyers do. This is an example of:
- A) A public good, leading to free-riding
- B) A positive externality, leading to underproduction
- C) Monopoly power, leading to higher prices
- D) Asymmetric information, which can lead to adverse selection
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Answer: D) Asymmetric information, which can lead to adverse selection
When one party to a transaction has better information than the other, buyers may be unwilling to pay a fair price for good-quality cars. Owners of good cars then withdraw, leaving a higher proportion of poor-quality cars - adverse selection - and the market may fail.
Question 6
In a market, demand (marginal social benefit) is P = 120 - Q and marginal private cost is P = 20 + Q. Production causes a constant marginal external cost of $20 per unit. What is the socially optimal output?
- A) 50 units
- B) 60 units
- C) 40 units
- D) 30 units
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Answer: C) 40 units
Marginal social cost = marginal private cost + external cost = 20 + Q + 20 = 40 + Q. The social optimum is where MSB = MSC: 120 - Q = 40 + Q, so 2Q = 80 and Q = 40 units. The free market output, ignoring the externality, is where 120 - Q = 20 + Q, i.e. 50 units, so the market overproduces by 10 units.
Question 7
Which of the following is a typical function of a national competition authority?
- A) Setting the policy interest rate
- B) Investigating proposed mergers that may substantially lessen competition
- C) Fixing the prices charged by all firms in an industry
- D) Collecting indirect taxes on imported goods
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Answer: B) Investigating proposed mergers that may substantially lessen competition
Competition authorities investigate mergers, cartels and abuse of a dominant position, and can block or impose conditions on mergers that would reduce competition. Interest rates are set by the central bank and tax collection is handled by the tax authority.
Question 8
A natural monopoly is most likely to arise when:
- A) Economies of scale are so large that one firm can supply the whole market at a lower average cost than two or more firms
- B) The government grants a patent to a single firm
- C) A firm owns a well-known brand name
- D) Many small firms produce identical products
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Answer: A) Economies of scale are so large that one firm can supply the whole market at a lower average cost than two or more firms
In a natural monopoly, such as a water or electricity distribution network, average costs keep falling over the whole range of market output. Duplicating the infrastructure would be wasteful, so a single supplier is most efficient. Such firms are usually regulated.
Question 9
Which of the following is an argument AGAINST the privatisation of a state-owned utility?
- A) The profit motive gives managers stronger incentives to control costs
- B) Exposure to competition and capital markets may improve efficiency
- C) Sale proceeds can be used to reduce government borrowing
- D) A privatised natural monopoly may exploit its market power unless it is effectively regulated
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Answer: D) A privatised natural monopoly may exploit its market power unless it is effectively regulated
Privatisation is argued to improve efficiency through the profit motive and capital market discipline, and raises funds for the government. A key argument against is that a natural monopoly transferred to private ownership may raise prices or cut quality unless a regulator controls it.