Principles of Economics

Problem Set 7
Universidad Carlos III de Madrid – Department of Economics

WARMING-UP QUESTIONS

1. Imagine a beekeeper, who produces honey and sells it at a constant price per
kilogram.
a. Draw a diagram with the quantity of honey on the horizontal axis, showing
the marginal cost of honey production as an upward-sloping line, and the
price of honey as a horizontal line. Show the amount of honey that the
profit-maximizing beekeeper will produce.
b. For the beekeeper, the marginal private benefit of producing a kilo of honey
is equal to the price. But since the bees benefit a neighbouring farmer, by
helping to pollinate her crops, honey production has a positive external
effect. Draw a line on your diagram to represent the marginal social benefit
of honey production. Show the quantity of honey that would be Pareto
efficient. How does it compare with the quantity chosen by the beekeeper?
c. Explain how the farmer and beekeeper could both be made better off
through bargaining. What is the equilibrium price, quantity, producer and
consumer surplus in equilibrium?

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2. Construct a table like the one in Figure 12.13 to analyse the possible market
failures associated with the decisions below. In each case, can you identify which
markets or contracts are missing or incomplete?
a. You inoculate your child with a costly vaccination against an infectious
disease.
b. You use money that you borrow from the bank to invest in a highly risky
project.
c. A fishing fleet moves from the overfished coastal waters of its own country
to international waters.
d. A city airport increases its number of passenger flights by allowing
nighttime departures.
e. You contribute to a Wikipedia page.
f. A government invests in research in nuclear fusion.

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MULTIPLE-CHOICE QUESTIONS

3. Read the following statements and choose the correct option(s).

a) Some public goods are rival.
b) A public good must be non-excludable.
c) A good cannot be rival and non-excludable.
d) If a good is non-rival, then the cost of an additional person consuming it is zero.

4. Read the following statements and choose the correct option(s).

a) Market failure occurs in the credit market because loans are given to rich people
with low-quality projects.
b) It is easier for rich people to get loans because they are able to provide equity or
collateral.
c) Hidden action can lead to markets being missing altogether.
d) Full insurance can mitigate the principal–agent problem in insurance markets.

5. In which of the following cases is there an adverse-selection problem?

a) A motor insurance market, in which the insurers do not know how carefully the
insured people drive.
b) A health insurance market, in which the insurers do not know whether or not the
applicants for insurance are habitual smokers.
c) Online sales of nutritional supplements, when consumers cannot tell whether their
contents are as claimed by sellers.
d) A firm that employs home workers, but cannot observe how hard they are working.

6. Consider two countries: CarWise and Haven’tGotAClue. In CarWise, the second-

hand car salesmen know the values of the cars that they are selling, while in
Haven’tGotAClue they only know the distribution of the quality of the cars - how
many cars are of which quality, but not the quality of any particular car. The buyers
only know the quality distribution in both countries. Based on this information,
which of the following statements is correct?

a. In both countries, the second-hand car market suffers from adverse

selection.
b. All cars will be sold in CarWise.
c. No cars will be sold in Haven’tGotAClue.
d. In CarWise, only the worst quality cars will be offered for sale.

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NUMERICAL PROBLEMS

7. A factory is situated next to a dormitory for nurses who work night shifts. The
factory produces 120 units of humanoid robots a day. The production process is
rather noisy, and the nurses often complain that their sleep is disturbed. The
following graph depicts the MPC and MSC of the robot factory production. The
robot market is competitive and the market price is £340. Based on this
information, which of the following statements is/are correct?

a. The factory’s profit-maximising quantity is 80.

b. The efficient level of output is 0, where there is zero marginal external cost to
the nurses.
c. At Q = 120, both the factory and the nurses would benefit from the nurses
paying a fee less than 120 to the factory to reduce output.
d. At Q = 80, both the factory and the nurses would benefit from the factory
paying a fee less than 80 to the nurses to increase output.

8. The graph in the previous question depicts the MPC and MSC of the robot factory
production. The robot market is competitive and the market price is £340. The local
authority has now passed a law that ensures that the nurses have the right to
undisturbed sleep (meaning zero production). Based on this information, which of
the following statements are correct?
a. The Pareto efficient output is 120.
b. The nurses’ minimum acceptable payment from the factory to produce the
efficient outcome is £4,000.
c. The maximum that the factory is willing to pay to increase the output to the
efficient level is £6,400.
d. The net social gain from attaining the efficient output level is £9,600.

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 9. Consider again the factory and the nurses. Instead of a Pigouvian tax, the
government is now considering implementing an enforced compensation from the
factory to the nurses for the costs imposed. Based on this information, which of the
following statements is correct?
a. The factory’s marginal private cost now equals the marginal social cost.
b. The total compensation paid will be £6,400.
c. The nurses are worse off than they would be under the Pigouvian tax.
d. The factory’s profit would be the same as under the Pigouvian tax.

CONCEPTUAL QUESTIONS

Write down a short and concise answer. When you are asked to solve the question in class,
explain the concept clearly and give examples or pieces of evidence.

10. Consider the policy regulation to solve externality problems. Evaluate the strengths
and weaknesses of each policy from the standpoint of Pareto efficiency and fairness.

11. Consider the policy of Pigouvian tax to solve externality problems. Evaluate the
strengths and weaknesses of each policy from the standpoint of Pareto efficiency and
fairness.

12. In two cases described in the book about externality (incinerator, loud music) explain
why the external effects are not (and possibly cannot be) covered by a complete
contract. Explain also what critical piece(s) of information required for a complete
contract are asymmetric or non-verifiable?