Tutorial Problem Set 7
Tutorial questions on: Chapter 11 Market successes and failures
Exercise 0. Market failures and externalities
In 2024, over 470,000 flights left from Schiphol Airport in Amsterdam. Consider a single airline
who is deciding how many flights to offer from Schiphol. The Figure 1 below depicts the
marginal social cost, the airline’s marginal private costs, and marginal external costs of flights
leaving from Schiphol.
Figure 1: Marginal costs of flights
a. The market price of flights is equal to $300, depicted by the blue horizontal line in the
figure. Explain:
i. What the shaded green area shows in Figure 1.
ii. How many flights are approximately offered per year in equilibrium, assuming
that the airline is a profit maximizing firm.
iii. Is this equilibrium pareto efficient? If not, what would be the pareto efficient
equilibrium?
In your answer, apply the external cost theory, but first define the concept of market
externalities.
b. If the Dutch government wants to ensure the pareto efficient equilibrium is realized, one
option is to tax flights. How high is the per flight tax approximately? How does it affect
the marginal private cost curve?
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c. From 2025 onwards, the Dutch government has capped the number of flights that are
allowed to leave Schiphol at 478,000 per year to reduce noise pollution. Assume that this
is equivalent to the pareto efficient quantity of 16,000 flights for the airline considered in
the graph. What are the benefits and drawbacks of this quota when compared to the per-
flight tax considered in b?
Exercise 1. Market failure and Pareto inefficiency
Give a current real-world example of a market outcome where the allocation of resources is
Pareto inefficient.
Exercise 2. The problem of adverse selection
In which of the following cases is there an adverse selection problem? Multiple cases can be
correct.
1. A home insurance market, in which the insurers do not know how carefully the insured
people secure their houses.
2. A health insurance market, in which the insurers do not know whether or not the
applicants for insurance are habitual smokers.
3. Sales of old paintings, when consumers cannot verify authenticity as claimed by sellers.
4. A firm that provides take-home laptops to employees, but cannot observe if they comply
with IT security regulations meant to protect the firms’ data.
Exercise 3. Property rights and Contracts
Marcel Fafchamps and Bart Minten, two economists, studied grain markets in Madagascar in
1997, where the legal institutions for enforcing property rights and contracts were weak. Despite
this, they found that theft and breach of contract were rare. The grain traders avoided theft by
keeping their stocks very low, and if necessary, sleeping in the grain stores. They refrained from
employing additional workers for fear of employee-related theft. When transporting their goods,
they paid protection money and traveled in convoy. Most transactions were paid in cash. Trust
was established through repeated interaction with the same traders.
3.1. Do these findings suggest that strong legal institutions are not necessary for markets to
work?
3.2. Consider some market transactions in which you have been involved. Could these markets
work in the absence of a legal framework, and how would they be different if they did?
3.3. Can you think of any examples in which repeated interaction helps to facilitate market
transactions?
3.4. Why might repeated interaction be important even when a legal framework is present?
Exercise 4. Positive external effects and bargaining
Imagine a beekeeper, who produces honey and sells it at a constant price per kilogram. The
diagram below shows the quantity of honey on the horizontal axis, the marginal cost of honey
production as an upward-sloping line, and the price of honey as a horizontal line.
The bees collect pollen for the honey they produce at a nearby apple plantation and thereby
germinate the apple trees. This increases the productivity and profitability of the apple
plantation.
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4.1. Considering the above figure, indicate which of the following answers is correct.
a. The honey production causes a positive external effect which is best characterized as
a public good.
b. The honey production causes a positive external effect that will lead to under provision
of honey and apple tree germination.
c. The honey production causes an external effect that is best solved by the government
subsidizing the apple plantation and taxing the beekeeper.
d. The honey production causes a negative external that is best solved by private
bargaining.
4.2 Have a look at the figure. The amount of honey that the profit-maximizing beekeeper
produces is at point A. As honey production comes with a positive externality to the neighboring
farmer, there is an additional benefit from the beekeeper’s action to society as a whole. This
additional benefit is not taken into account when the beekeeper unilaterally decides about how
much honey to produce. Hence the social marginal benefit is above the price the beekeeper
receives. The socially optimal outcome would be at point B.
By producing quantity B, the beekeeper incurs an additional private cost equal to the triangle
ABC. At the same time, the neighboring farmer has a benefit equal to the blue rectangle. As the
rectangle is larger than the triangle, the farmer would in principle be able to compensate the
beekeeper by more than the additional cost they face (at least the amount ABC, up until
the size of the rectangle) and still benefit from the positive externality.
Why might the beekeeper and farmer be unable to bargain successfully to achieve a Pareto-
efficient outcome in practice? Use the diagram to show how the government might improve the
situation by subsidizing honey production.
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4.3. Describe the distributional effects of this subsidy.
Exercise 5. Market Failure
Construct a table like the one in Figure 11.15 in section 11.13 to analyze the possible market
failures associated with the two decisions below. For each case, identify which markets or
contracts are missing or incomplete.
1. You use money that you borrow from the bank to invest in a highly risky project.
2. A scientist who works to discover basic fundamental research breakthroughs
The How it Cost or Market Possible Terms
decision affects benefit failure remedies applied
others to this type
of
market
failure
1.
2.
Exercise 6. Public goods and common pool resources
Which of the following statements is true? There is one answer correct.
A. Not all public goods are rival.
B. A good cannot be rival and non-excludable.
C. If a good is non-rival, then the cost of an additional person consuming it is zero.
D. A public good must be non-excludable.
Exercise 7. The government as an economic actor
The government is an important economic actor that can adopt policies to address the
inefficiency and unfairness that sometimes results from private economic interactions.
7.1. Which of the below statement(s) is correct?
A. For a policy to be a Pareto improvement, it must be economically, legally, and politically
feasible.
B. Governments are always able to effectively address cases of market failure.
C. The size of most country’s governments has decreased over time.
D. Democratic elections that give citizens the power to dismiss the government are one
way to limit government power.
7.2. Why do you think market failures and unfairness still persist in democracies?