1.3.2 Externalities Quiz: Pearson Edexcel Economics A, Unit 1

The 20 questions

1. What is the difference between private cost and social cost?

   • Private cost and social cost are always identical, since external costs cannot be measured in money terms.
   • Social cost equals private cost plus any external cost imposed on third parties by the activity.
   • Social cost equals private cost minus any external cost, since third parties always gain from production.
   • Private cost equals social cost plus the subsidy received by the producer from the government.

2. What is an external benefit?

   • A benefit that the government pays to producers in the form of a per-unit subsidy in the market.
   • A benefit enjoyed by third parties who are not directly involved in the consumption or production of a good.
   • A benefit that is received only by the buyer of a good and no one else in the economy.
   • A benefit paid to the consumer directly by the producer as part of the price of the product in the market.

3. A factory produces steel and pollutes a nearby river. Which term describes the cost to fishers who lose income?

   • An external benefit, since the fishers gain from the steel that the factory provides to the economy.
   • An opportunity cost, since the fishers give up the steel they would have bought from the factory.
   • An external cost, since the fishers bear a cost of the production that is not paid for by the factory.
   • A private cost, since the fishers are paying for steel that the factory produces in the market.

4. In a market with a negative externality of production, which quantity is socially optimal compared with the market quantity?

   • The socially optimal quantity is zero, since any production with an external cost is always socially undesirable.
   • The socially optimal quantity equals the market quantity, since private and social costs are equal in every market.
   • The socially optimal quantity is lower than the market quantity, since marginal social cost exceeds marginal private cost.
   • The socially optimal quantity is higher than the market quantity, since marginal social cost is below marginal private cost.

5. On a diagram of a negative externality of production, which area represents the welfare loss?

   • The triangle between the marginal social cost and marginal private cost curves, between the optimal and market quantities.
   • The triangle between the demand curve and the supply curve above the market equilibrium quantity in the diagram.
   • The area under the marginal social cost curve from zero up to the socially optimal quantity in the diagram.
   • The rectangle below the market price and above the marginal private cost curve up to the market quantity.

6. A positive externality of consumption exists. Which statement describes the market outcome compared with the social optimum?

   • The market provides no quantity at all, since positive externalities always prevent trade from taking place.
   • The market provides exactly the socially optimal quantity, since private benefit equals social benefit in every case.
   • The market over-provides the good, since marginal social benefit is below marginal private benefit at the market quantity.
   • The market under-provides the good, since marginal social benefit exceeds marginal private benefit at the market quantity.

7. On a diagram of a positive externality of consumption, which area represents the welfare gain from correcting the market?

   • The triangle between the supply curve and the demand curve below the market equilibrium quantity in the diagram.
   • The rectangle below the market price and above the marginal social benefit curve up to the market quantity.
   • The triangle between the marginal social benefit and marginal private benefit curves, between the market and optimal quantities.
   • The area under the marginal social benefit curve from zero up to the market quantity, which is the total benefit.

8. A government subsidises the production of solar panels to correct for a positive externality. What is the intended effect?

   • The price is set above equilibrium, so producers supply fewer panels than before the subsidy was introduced.
   • The supply curve shifts left, reducing the quantity produced below the market level.
   • The supply curve shifts right, increasing the quantity produced towards the socially optimal level.
   • The demand curve shifts left, so consumers buy fewer solar panels than the market would otherwise provide.

9. A government imposes a tax equal to the external cost per unit of a polluting good. What is the intended effect?

   • The demand curve shifts right, so consumers buy more of the good and pollution falls in the market.
   • The price is set below equilibrium, so producers supply more output and the external cost is reduced.
   • The supply curve shifts left, so the market quantity moves closer to the socially optimal level.
   • The supply curve shifts right, so the market quantity rises further above the socially optimal level.

10. Which of the following best describes why a market produces too much of a good with a negative externality?

    • The government sets output too high by subsidising every unit that is produced in the market.
    • Producers pay only private costs and ignore the external costs they impose on others, so they supply more than is socially optimal.
    • Producers pay all the external costs and so supply less than is socially optimal in the market.
    • Consumers pay all the external costs through higher prices, so they buy less than is socially optimal.

11. Why might the distinction between market equilibrium and social optimum matter in a market with an externality?

    • The market equilibrium and social optimum are always the same, since all costs and benefits are reflected in prices.
    • The social optimum uses only private costs, while the market equilibrium includes the external costs imposed by production.
    • Equilibrium uses private costs and benefits, while the social optimum includes all external costs and benefits, so the quantities differ.
    • The distinction matters only for taxes and subsidies, since external costs have no effect on resource allocation in markets.

12. A market for a good has a marginal private benefit curve of P = 20 - Q and a marginal social benefit curve of P = 26 - Q (a constant external benefit of 6). What is the effect of this external benefit on the socially optimal quantity compared with the market quantity?

    • The socially optimal quantity is lower than the market quantity, since the external benefit reduces the total value of the good.
    • The socially optimal quantity is higher than the market quantity, since the external benefit raises marginal social benefit everywhere.
    • The socially optimal quantity equals the market quantity, since a constant external benefit cancels out in the market.
    • The socially optimal quantity is zero, since external benefits always reduce the efficient output of any good.

13. A firm's marginal private cost is MC = 2 + Q and its external cost is 3 per unit. What is the marginal social cost?

    • MSC = 3 + 2Q, since the external cost is doubled when added to the marginal private cost in the market.
    • MSC = 5 + Q, since the external cost of 3 is added to the marginal private cost at each quantity.
    • MSC = 6 + Q, since the external cost is multiplied by two and then added to the marginal private cost.
    • MSC = 2 + Q, since external costs are not included in the marginal social cost in any market.

14. Which of the following illustrates a negative externality of consumption?

    • Loud music played late at night by a neighbour, which disturbs people living nearby who did not choose to hear it.
    • A household's purchase of energy-efficient appliances, which lowers the energy bills of its neighbours.
    • A student's education, which raises the productivity of workers who never attended the school.
    • A vaccination that protects a person from illness, which reduces the risk of disease spreading to others.

15. A government considers whether to subsidise education. Which externality argument is most relevant?

    • Education has no external effects, so the case for a subsidy depends only on its price elasticity of demand.
    • Educated people generate benefits for others, such as higher productivity and lower crime, which the private market does not reward.
    • Education creates pollution, so the government should tax education to correct the external cost it imposes.
    • Education is a negative externality of consumption, so consumption should be reduced by a subsidy in the market.

16. Which statement best explains why external costs can make a free market outcome socially inefficient?

    • Resources are used to produce only at the lowest possible private cost, which always maximises social welfare in markets.
    • External costs have no effect on resource allocation, since they are always paid by the government in the market.
    • External costs reduce the price of goods, so consumers buy too much of them and producers gain no surplus.
    • Resources are used to produce output whose social cost exceeds its social benefit, because the market ignores the third-party costs.

17. Which of these best evaluates the use of a tax to correct a negative externality?

    • It can improve efficiency if the tax equals the external cost, though the tax rate is hard to measure and may create other distortions.
    • It never works, since firms always pass the full tax on to the government and so output does not change.
    • It always fully corrects the externality, since the tax rate can be set exactly to the external cost without any error in practice.
    • It is irrelevant, since externalities are always corrected automatically by the price mechanism without any tax.

18. Explain why a market with a positive externality of production may under-provide the good.

    • Producers capture only private benefits from production, so they supply less than the amount that would maximise total social benefit.
    • Positive externalities have no effect on production decisions, since producers ignore all effects outside their own firm.
    • Producers capture all social benefits from production, so they supply more than the amount that would maximise total social benefit.
    • Positive externalities raise private costs, so producers supply less than the amount that maximises private profit.

19. A market has an external cost per unit that rises as output rises. What does this imply for the difference between market and socially optimal output?

    • The gap is unchanged, since external costs that rise with output have no effect on the socially optimal quantity.
    • The gap disappears at high output, since larger external costs always offset private costs exactly in the market.
    • The socially optimal output rises above market output, since higher external costs raise the social benefit of production.
    • The gap between market and socially optimal output widens as output rises, because the marginal external cost increases with quantity.

20. Which of these is the best definition of a social optimum in the presence of externalities?

    • The output at which external costs are equal to external benefits, so that the net external effect is zero.
    • The output at which the price is highest, so that producers receive the largest revenue from the market.
    • The output at which marginal social benefit equals marginal social cost, so that total social welfare is maximised.
    • The output at which marginal private benefit equals marginal private cost, so that firms maximise profit in the market.

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