3 Government intervention in the price system

Government intervention
3 in the price system
Supplement
Further activities
1 What could reduce
a a deadweight loss in an industry
b income inequality?

2 Explain which of the following government policies might increase efciency but reduce equity.
a reducing unemployment benet
b reducing the top rate of tax
c increasing the quality of state education
d improving state health care
e removing controls on the prices that electricity rms can charge.

3 Using a diagram in each case, explain the effect of:

a the introduction of a subsidy to rms producing cars on the market for cars in the country
b the introduction of a smoking ban in public places on the market for cigarettes.

Multiple-choice questions
1 When would the price mechanism fail to allocate resources efciently?
a Firms base their production decisions on private costs when social costs are higher.
b Firms base their production decisions on social costs when there are both private and external
costs.
c There is a lack of barriers to entry into and exit from the market.
d There is a high degree of competition in the market.

2 What is a source of market failure?

a an absence of externalities
b asymmetric information
c rms making a loss when demand falls
d rms making supernormal prots in the short run

3 When does a monopoly result in market failure?

a when the rm encounters hit and run competition
b when the rm experiences economies of scale
c when the rm produces where marginal cost is equal to average cost
d when the rm produces where marginal cost is less than price

Original material Cambridge University Press 2011 Chapter 3 Activities 1

 3 Government intervention in the price system

4 The diagram below shows an industry producing under conditions of constant average cost.

Costs/revenue
S

V X
R MC

AR

0
Y Z
MR
Output

Under perfect competition, the industry produces an output of Z. When it becomes a monopoly,
output changes to Y. Which area represents the deadweight loss which arises?

a RSUV
b STU
c UVX
d YUXZ

5 A government privatises an industry and sells it to a number of competing rms. In which circum-
stance would this move increase efciency?
a The rms which are set up engage in predatory pricing.
b The rms which are set up ignore externalities.
c The industry experiences diseconomies of scale at a relatively low level of output.
d The industry is a natural monopoly.

6 Which strategy that a rm might adopt would turn consumer surplus into producer surplus?
a aiming to achieve allocative efciency
b engaging in price discrimination
c implementing price cuts
d reducing prot margins

7 A state regulator of a privatised rm aims to improve productive efciency. To nd out whether its
efforts are succeeding, the regulator should check the relationship between the rms:
a average cost and marginal cost
b average cost and average revenue
c average revenue and marginal revenue
d marginal revenue and marginal cost.

8 Which invention would turn a public good into a private good?

a a more powerful light source that increases the strength of the light emitted by lighthouses
b ood defences that allow individual properties to be protected
c mobile phones that enable people to make and receive payments
d street lights that come on automatically when someone walks down the street

Original material Cambridge University Press 2011 Chapter 3 Activities 2

 3 Government intervention in the price system

9 What is a cause of labour market failure?

a an absence of age discrimination
b exible wage structures
c geographical immobility of labour
d investment in human capital

10 Which combination of government policies would make the distribution of income more uneven?

Progressive direct taxes Regressive indirect taxes State benets

a decrease decrease increase
b decrease increase decrease
c increase increase decrease
d increase decrease increase

Data response questions

Google is a giant in the search engine market and Microsoft is a giant in the operating systems
market (see the table below). In 2009 Google announced that it was planning to challenge Microsofts
dominance of the operating systems market by launching its own system. This is Chrome OS, which
Google claims starts quickly, does not need constant updates of software and will not be vulnerable to
viruses.
Also in 2009, Microsoft launched an updated version of its own operating systems, Windows 7. Users
had found a number of problems with its previous version, Windows Vista.
Some economists argue that both Google and Microsoft have too much power and that reducing their
power could increase productive efciency.

Market shares in 2009

Firms share of the market

Operating system (%) Search engine use (%)
Microsoft Windows 90 Google 81.2
Apple 8 Yahoo 9.2
Others 2 Bing (Microsoft) 5.3
Others 4.3

1 Explain two possible reasons why Google is seeking to challenge Microsofts dominance of the
operating systems market. [4]
2 Explain why having considerable market power in another industry makes it easier for a rm
to enter a new market. [5]
3 a From the extract, identify one reason why someone may want to buy the Chrome OS system. [1]
b Identify a reason not mentioned in the extract why someone may choose the Windows 7
system. [1]
4 Using the table, comment on whether Microsoft was a monopoly in 2009. [3]
5 Discuss whether reducing market power would increase productive efciency. [6]

Original material Cambridge University Press 2011 Chapter 3 Activities 3

 3 Government intervention in the price system

Essay question
The government in Namibia stated that electricity prices should cover costs and should also be
based on the principle of allocative efciency. Discuss whether this approach to pricing can be
supported in theory. [25]

(9704, May/June 2008, question 2)

Guidance for students

In your answer you need to bring out the meaning of allocative efciency. You should discuss whether
economic theory suggests rms always seek to cover their costs and give examples of cases where this is
not the case. You might also explore the meaning of costs in terms of the difference between social and
private costs.

Homework suggestions
Short answer questions

1 Identify three sources of market failure.

2 Why might a monopoly be dynamically inefcient?
3 Identify three advantages of using regulations to correct market failure.
4 Explain one advantage and one disadvantage of raising state unemployment benet.
5 Identify two reasons why some people are wealthy.
6 What is meant by government failure?
7 Identify two reasons to privatise a state-owned enterprise.
8 What are two reasons for imposing a tax?
9 Identify two benets of reducing the top-rate income tax.
10 What effect is the introduction of at taxes likely to have on income distribution?

Homework essay question

a Using a demand and supply diagram, explain how the imposition of an indirect tax can
give rise to a deadweight loss. [10]
b Discuss the extent to which a government subsidy to fruit farmers would encourage the
consumption of fruit. [15]

Original material Cambridge University Press 2011 Chapter 3 Activities 4