A Level Economics H3 Market Failure Quiz

Answer Key – A-Level Economics H3 Quiz: Market Failure

Total Marks: 50

Section A: Multiple Choice (Questions 1–5)

1. A – A common resource is overused because each user ignores the external cost imposed on others.
Explanation: The tragedy of the commons occurs when a rivalrous but non-excludable resource (e.g., a fishery) is over-exploited because individual users do not bear the full social cost of their actions. Option B describes the free-rider problem for public goods; C describes asymmetric information; D describes a club good.
[2 marks]

2. A – Transaction costs are zero and property rights are clearly defined.
Explanation: The Coase Theorem states that if property rights are clearly assigned and transaction costs are negligible, private bargaining can achieve an efficient outcome without government intervention, regardless of who initially holds the rights.
[2 marks]

3. B – High-risk individuals are more likely to purchase insurance than low-risk individuals.
Explanation: Adverse selection arises from hidden information before a transaction. In insurance, high-risk individuals are more likely to seek coverage, raising average premiums and potentially driving out low-risk buyers. Option A describes moral hazard (behaviour after the contract).
[2 marks]

4. A – Offering efficiency wages above the market-clearing wage.
Explanation: Moral hazard in the labour market involves workers shirking after being hired. Efficiency wages increase the cost of job loss, giving workers an incentive to work harder, thus reducing shirking. Co-payment (B) addresses moral hazard in insurance; (C) and (D) are not direct responses to shirking.
[2 marks]

5. A – Pure public good because it is non-excludable and non-rivalrous.
Explanation: A lighthouse is non-excludable (ships cannot be charged) and non-rivalrous (one ship's use does not reduce another's). Hence it is a classic pure public good.
[2 marks]

Section B: Short Answer (Questions 6–10)

6. Adverse selection occurs before a contract is signed, due to hidden information. In car insurance, high-risk drivers are more likely to buy comprehensive policies, raising average premiums and discouraging low-risk drivers.
Moral hazard occurs after a contract is signed, due to hidden action. For example, an insured driver may drive more recklessly because the insurance company bears the cost of accidents.
Marking: 2 marks for each concept with a clear example (1 mark for definition, 1 mark for example).
[4 marks]

7. Tragedy of the commons: The lake is a common resource (rivalrous, non-excludable). Each fisherman maximises his own catch, ignoring the negative externality (depletion of fish stock) imposed on others. Since no one owns the lake, no one has an incentive to conserve. The result is overfishing and eventual depletion.
Policy measure: Introduce a quota system (e.g., catch limits) or assign property rights (e.g., individual transferable quotas) to align private incentives with social efficiency.
Marking: 2 marks for explanation of the tragedy; 2 marks for a valid policy with brief justification.
[4 marks]

8. Club good: A good that is excludable but non-rivalrous up to a point of congestion.
Example: A subscription-based streaming service (e.g., Netflix) or a private golf club.
Explanation: It is excludable because only paying members can use it; it is non-rivalrous because one member's use does not reduce another's enjoyment (until congestion occurs).
Marking: 1 mark for definition, 1 mark for example, 1 mark for explanation.
[3 marks]

9. Adverse selection: Sellers know the quality of their cars; buyers do not. Buyers, fearing "lemons," are only willing to pay an average price. High-quality sellers withdraw from the market, leaving only low-quality cars. The market may collapse.
Market-based solution: Sellers can signal quality by offering warranties or third-party certification (e.g., AA inspection). This allows buyers to distinguish high-quality cars and restores trust.
Marking: 2 marks for explanation of adverse selection; 2 marks for a valid solution with reasoning.
[4 marks]

10. Coase Theorem: If the factory has the right to pollute, the farm can pay the factory to reduce pollution. If the farm has the right to clean water, the factory can pay the farm for the right to pollute. In either case, private bargaining leads to an efficient outcome.
Conditions: (1) Clearly defined property rights; (2) Low/zero transaction costs (e.g., few parties, easy negotiation).
Marking: 2 marks for explanation of bargaining; 2 marks for the two conditions.
[4 marks]

Section C: Data-Response and Essay (Questions 11–20)

11. Tradeable permits: The government sets a total allowable catch (cap) and issues permits equal to that cap. Fishermen can buy and sell permits. This creates a market for fishing rights, ensuring that the resource is used by those who value it most. The cap prevents overfishing, addressing the tragedy of the commons.
Marking: 2 marks for explaining the cap-and-trade mechanism; 2 marks for linking to efficiency and the tragedy of the commons.
[4 marks]

12. Economic problem: Moral hazard – patients take less care of their health because the cost of treatment is borne by the state.
Co-payment: Patients pay a small fee for each visit, making them bear part of the cost. This reduces frivolous use and encourages preventive care, aligning individual incentives with social efficiency.
Marking: 2 marks for identifying moral hazard; 2 marks for explaining co-payment and its effect.
[4 marks]

13. Efficiency wages: The firm pays above the market-clearing wage to increase the opportunity cost of shirking. If a worker is caught shirking and fired, they lose the wage premium. This reduces moral hazard in the labour market, where the firm cannot perfectly monitor effort.
Marking: 2 marks for explanation of efficiency wages; 2 marks for linking to moral hazard.
[4 marks]

14. Classification: The park is a common resource (rivalrous at peak times, non-excludable).
Market failure: If provided privately, the park would be under-provided because it is difficult to exclude non-payers. Even if provided, overuse at peak times would lead to congestion (tragedy of the commons).
Marking: 1 mark for classification; 2 marks for explanation of market failure.
[3 marks]

15. Principal-agent problem: The manager (agent) may pursue personal goals (e.g., empire-building, shirking) rather than maximising shareholder value (principal's interest). Information asymmetry – the manager knows more about their actions than shareholders – makes monitoring difficult.
Strategy: Link manager compensation to share price or profit (e.g., performance bonuses, stock options) to align incentives.
Marking: 2 marks for explanation of the problem; 2 marks for a valid strategy.
[4 marks]

16. Pigouvian tax: The tax should be set equal to the marginal external cost (MEC) at the socially optimal output. This internalises the externality, making the factory bear the full social cost of pollution.
Limitation: The government may not know the exact MEC, leading to an incorrect tax. Also, firms may relocate to avoid the tax, or the tax may be politically unpopular.
Marking: 2 marks for explaining the tax; 2 marks for a valid limitation.
[4 marks]

17. Tragedy of the commons: Each herder adds cattle to maximise personal profit, ignoring the negative externality of overgrazing. Since the land is common, no one has an incentive to conserve. The result is degradation of the land.
Policy evaluation: A quota system (e.g., limiting cattle per herder) can be effective but requires enforcement. Alternatively, privatisation (assigning property rights) gives herders an incentive to manage the land sustainably, but may be inequitable.
Marking: 2 marks for explanation of the tragedy; 2 marks for evaluation of one policy.
[4 marks]

18. Adverse selection: Sellers know the condition of their phones; buyers do not. Buyers only offer an average price, so sellers of high-quality phones leave the market. The market becomes dominated by low-quality phones.
Solution: Sellers can offer warranties (signalling) or use third-party certification (e.g., a certified refurbishment label) to credibly convey quality. This reduces information asymmetry and restores trade.
Marking: 2 marks for explanation; 2 marks for a valid solution.
[4 marks]

19. Economic problem: Moral hazard – the borrower takes on more risk than agreed because the bank bears the downside.
Monitoring: The bank can require regular financial reports or collateral to reduce risk-taking.
Co-payment: The borrower must contribute a share of the project's cost (e.g., 20% equity), so they bear some loss if the project fails, aligning incentives.
Marking: 2 marks for identifying moral hazard; 2 marks for explaining one strategy.
[4 marks]

20. Policy measures for a fishery:

Tradeable permits (ITQs):

• How it works: The government sets a total allowable catch and allocates permits. Fishermen can buy/sell permits.
• Strengths: Creates a market for fishing rights; efficient allocation; incentivises sustainable fishing.
• Weaknesses: Initial allocation may be inequitable; requires monitoring and enforcement; may be costly to administer.

Pigouvian tax (e.g., a tax per tonne of fish caught):

• How it works: Tax equals the marginal external cost of overfishing.
• Strengths: Internalises the externality; generates government revenue.
• Weaknesses: Requires accurate knowledge of MEC; may be evaded; may not prevent overfishing if set too low.

Regulation (e.g., catch quotas, closed seasons):

• How it works: Direct limits on fishing activity.
• Strengths: Clear and enforceable; protects the resource.
• Weaknesses: May be inefficient (uniform rules ignore cost differences); enforcement costs; may create black markets.

Marking descriptors:

• 6 marks: Excellent – evaluates two policies with clear strengths/weaknesses and a reasoned judgement.
• 4–5 marks: Good – explains two policies with some evaluation.
• 2–3 marks: Basic – describes policies with limited evaluation.
• 0–1 mark: Minimal – vague or irrelevant answer.

[6 marks]

END OF ANSWER KEY