VERY BRIEF ANSWERS TO SAMPLE TEST **IMPORTANT NOTE** These answers will do you no bloody good if you haven't spent a lot of time studying for the exam and have not completed the sample test. If you are in this category, go study hard now, take the sample test, look at these answers, and figure out what GENERAL things you need to review and get better on before taking the last exam. Match the market on the left with the most likely form of market failure on the right. Do not use an answer more than once. Highways at rush hour -----------> Negative Externality Market for high quality used appliances ----> Incomplete Market Low-emission cars -------------> Positive Externality Each of the following statements is wrong in some way. Provide a counter-argument based on economic rationale. Taxes always lead to a dead weight loss. No, as we saw in the case of negative externalities, taxes can actually lead to a gain in economic efficiency. Monopolies will always lead to economic inefficiency. No, perfect price discriminating monopolies lead to 100% efficiency. Provide the most likely economic explanation for why we see the following phenomena (answers should be one, reasonable sized line for each!): Why might General Electric sell its own brand of washing machine while simultaneously allowing Sears to sell the identical machine under the "Kenmore" brand? So GE can price discriminate between high and low valued buyers. Why might forcing insurance companies to cover any individuals who apply for insurance at the same rate benefit society? To avoid incomplete markets due to information problems. Why do we have "lemon laws" for used car buyers? So that the information problem about the quality of the car can be avoided. Why might allowing a company to pollute an amount equal to the total emissions from all current pollution sources be better than allowing each source to not exceed its current level? Because the company can tradeoff reductions among its various sources (based on marginal costs) and thus achieve the same aggregate level of pollution as before but at a lower cost. Why might forcing a manufacturer who uses and pollutes water from a neighboring stream to intake their water from downstream of the outtake be a good policy? So that they take into account the fact that they pollute the water in their decisions on how much to pollute---that is, so that they recognize the negative externality they create by polluting water. Provide short answers to each of the following questions. Auto insurance companies often offer different levels of coverage by setting different deductibles. Levels that offer less insurance are cheaper to the consumer. What information problem do auto insurance companies confront relative to the care that drivers take to avoid accidents? They do not know how much care and skill the driver uses when driving. How might this deductible policy alleviate this problem? Because users with greater care/skill will self-select and buy the higher deductibles. Consider an industry with, say, ten competing firms. If the firms were to get together and act as a single firm, could they all be better off? Yes. Why (provide a simple proof)? Since the firms can always agree on doing what they were doing before, they can never be worse off. Moreover, by agreeing to raise prices they can act like a monopolist, which typically means they can earn more profit. Given the above result, why don't we see this happening more often? (Assume for your answer that it is not illegal to do so.) Because there is a social dilemma that occurs---if everyone else raises their prices and reduces their output, then I have an incentive to break the agreement and reap more profits...since we all have this incentive, the agreement can break down.