Market Failure: Externalities, Marginal Private/Social Costs and Benefits, Merit Goods, Demerit Goods, Public Goods, Information Failure

1. In a market with no externalities, social welfare is maximised where

A MPB = MPC
B MSB = MSC
C MPB > MPC
D MSC > MSB

2. A negative production externality exists when

A MPC is greater than MSC
B MSC is greater than MPC
C MPB is greater than MSB
D MSB is greater than MPB

3. A positive consumption externality exists when

A MPB is greater than MSB
B MSB is greater than MPB
C MPC is greater than MSC
D MSC is greater than MPC

4. In a free market with a negative production externality, output is usually

A below the socially efficient level
B above the socially efficient level
C exactly equal to the socially efficient level
D zero because firms cannot produce

5. In a free market with a positive consumption externality, output is usually

A above the socially efficient level
B below the socially efficient level
C exactly equal to the socially efficient level
D infinite because benefits are positive

6. If MPC = $20 and MSC = $32 at a particular output, the marginal external cost is

A $12
B $20
C $32
D $52

7. If MPB = $15 and MSB = $24 at a particular output, the marginal external benefit is

A $9
B $15
C $24
D $39

8. A chemical factory pollutes a river. Which relationship is most likely?

A MSC > MPC
B MPC > MSC
C MSB > MPB
D MPB > MSB

9. A vaccination reduces disease spread to people other than the vaccinated person. Which relationship is most likely?

A MSC > MPC
B MPB > MSB
C MSB > MPB
D MPC > MSC

10. Smoking creates health costs for passive smokers. This is mainly

A a positive production externality
B a negative consumption externality
C a public good problem
D a positive consumption externality

Written and Compiled By Sir Hunain Zia (AYLOTI), World Record Holder With 154 Total A Grades, 11 World Records and 7 Distinctions, Educate A Change.

11. If a market has a negative consumption externality, the free market demand curve is based on

A MSB rather than MPB
B MPB rather than MSB
C MSC rather than MPC
D government revenue rather than benefit

12. For a negative consumption externality, which statement is correct?

A MPB > MSB
B MSB > MPB
C MPC > MSC
D MSC < MPC

13. For a positive production externality, which statement is correct?

A MSC < MPC
B MSC > MPC
C MSB < MPB
D MPB > MSB

14. A beekeeper’s bees pollinate nearby fruit farms without payment. This is

A a negative production externality
B a positive production externality
C asymmetric information
D non-excludability only

15. A firm trains workers who later move to other firms, raising wider productivity. This may create

A external benefits of production
B external costs of consumption
C rivalry in consumption
D moral hazard only

16. The deadweight welfare loss from a negative production externality is caused by

A underproduction because private cost exceeds social cost
B overproduction because social cost exceeds private cost
C overconsumption because private benefit exceeds social benefit
D underconsumption because social benefit exceeds private benefit

17. The deadweight welfare loss from a positive consumption externality is caused by

A overproduction
B underconsumption
C productive efficiency
D excess taxation only

18. Which policy best corrects a negative production externality?

A subsidy equal to marginal external cost
B indirect tax equal to marginal external cost
C maximum price above equilibrium
D free provision

19. Which policy best corrects a positive consumption externality?

A tax on consumption
B subsidy or direct provision
C minimum price above equilibrium
D complete ban

20. A Pigouvian tax aims to

A make MPC equal MSC
B make MPB lower than MSB
C make all firms produce at zero cost
D make public goods rival

21. A subsidy for a good with external benefits aims to

A increase consumption towards the social optimum
B reduce consumption below the market level
C increase negative externalities
D reduce MSB below MPB

22. A merit good is usually

A underconsumed because individuals underestimate private or external benefits
B overconsumed because social costs are ignored
C non-rival and non-excludable
D always demanded more when income falls

23. A demerit good is usually

A underconsumed because benefits are underestimated
B overconsumed because costs are underestimated or ignored
C non-rival in consumption
D supplied only by government

24. Education is often considered a merit good because

A it creates private and external benefits and may be underconsumed
B it creates only external costs
C it is impossible to exclude non-payers
D one person’s education prevents all others from consuming it

25. Cigarettes are often considered demerit goods because

A consumers may underestimate health risks and external costs are created
B consumers always have perfect information
C they are non-rival and non-excludable
D they are always free goods

Written and Compiled By Sir Hunain Zia (AYLOTI), World Record Holder With 154 Total A Grades, 11 World Records and 7 Distinctions, Educate A Change.

26. A public good is

A rival and excludable
B non-rival and non-excludable
C rival but non-excludable
D non-rival but excludable only

27. Non-rivalry means

A non-payers cannot be excluded
B one person’s consumption does not reduce availability to others
C the good has no opportunity cost
D the government must produce it

28. Non-excludability means

A one person’s consumption reduces another’s consumption
B it is difficult or impossible to prevent non-payers from benefiting
C the good has negative income elasticity
D the good is always inferior

29. The free-rider problem is most associated with

A private goods
B public goods
C demerit goods only
D luxury goods

30. National defence is usually a public good because

A it is rival and excludable
B it is non-rival and non-excludable
C it has negative marginal utility
D it is always provided by private firms

31. A lighthouse signal is often used as an example of a public good because

A ships can easily be charged per use
B one ship using the signal does not reduce its availability to others and non-users are hard to exclude
C it is a free good with no opportunity cost
D it is demanded only by government

32. A toll road is not a pure public good because

A it is excludable
B it creates no benefit
C it has no opportunity cost
D it is always non-rival at all levels of traffic

33. A congested public road is no longer fully non-rival because

A one extra vehicle may reduce road space available to others
B non-payers can always be excluded
C it becomes a free good
D it becomes an inferior good

34. Which good is most likely to be a common resource?

A national defence
B fish stocks in international waters
C a private car
D a cinema ticket

35. A common resource is usually

A rival and non-excludable
B non-rival and non-excludable
C non-rival and excludable
D rival and excludable

36. The tragedy of the commons occurs because

A private users ignore the social cost of overusing a shared rival resource
B public goods are always overproduced by private firms
C merit goods are always banned
D all consumers have perfect information

37. Overfishing in international waters is most likely caused by

A non-rivalry and perfect excludability
B rivalry and difficulty excluding users
C high consumer surplus only
D a positive externality of consumption

38. Information failure occurs when

A all buyers and sellers have perfect knowledge
B economic agents make decisions based on incomplete or inaccurate information
C prices always equal marginal costs
D government never intervenes

39. Asymmetric information occurs when

A one party has more or better information than another
B all parties have identical information
C all information is free and perfect
D consumers know more than producers in every market

40. A second-hand car seller knows a car is defective but the buyer does not. This is

A asymmetric information
B positive externality
C public good provision
D productive efficiency

Written and Compiled By Sir Hunain Zia (AYLOTI), World Record Holder With 154 Total A Grades, 11 World Records and 7 Distinctions, Educate A Change.

41. Adverse selection is most likely when

A low-risk and high-risk consumers are equally likely to buy insurance at any price
B hidden information before a transaction causes higher-risk participants to be more likely to enter the market
C people take more risks after being insured
D firms produce where price equals marginal cost

42. Moral hazard is most likely when

A a person takes more risk because another party bears some cost of that risk
B buyers and sellers have identical information
C a product is non-rival
D a firm has no fixed costs

43. A fully insured driver drives less carefully than before. This is

A adverse selection
B moral hazard
C positive consumption externality
D productive efficiency

44. Health insurance attracting mainly people who already expect high medical costs is

A moral hazard
B adverse selection
C non-rivalry
D positive production externality

45. A dentist recommends unnecessary treatment because patients cannot judge whether it is needed. This is mainly

A asymmetric information
B non-excludability
C positive production externality
D allocative efficiency

46. Which government response is most suitable for information failure about harmful products?

A compulsory labelling and public information campaigns
B subsidy to increase consumption
C maximum price below equilibrium
D removal of all regulation

47. Which policy is most suitable where consumers underestimate the benefits of education?

A tax on school attendance
B subsidies, free provision or information campaigns
C ban on private schools
D higher price for education

48. Which policy is most suitable where consumers underestimate the costs of alcohol consumption?

A subsidy on alcohol
B health warnings, taxation and regulation
C free provision
D lower minimum legal drinking age

49. Which chain is most accurate for a negative production externality?

A production creates external cost → MPC below MSC → free market output too high → deadweight welfare loss
B production creates external benefit → MPC above MSC → free market output too low → tax needed
C consumption creates external cost → MPB below MSB → output too low → subsidy needed
D public good → rivalry → price mechanism works perfectly

50. Which chain is most accurate for a positive consumption externality?

A external benefit from consumption → MSB above MPB → free market demand too low → subsidy/direct provision may increase welfare
B external cost from production → MSC below MPC → free market output too low → subsidy improves welfare
C asymmetric information → perfect knowledge → no market failure
D demerit good → underconsumption → subsidy corrects external cost

Written and Compiled By Sir Hunain Zia (AYLOTI), World Record Holder With 154 Total A Grades, 11 World Records and 7 Distinctions, Educate A Change.

1. Answer: B

A wrong: MPB = MPC is only socially efficient if there are no externalities, but the wider welfare condition is MSB = MSC.
B correct: social welfare is maximised where marginal social benefit equals marginal social cost.
C wrong: MPB > MPC means private benefit exceeds private cost, so output may need to rise privately, not necessarily socially optimal.
D wrong: MSC > MSB means the last unit costs society more than it benefits society.

2. Answer: B

A wrong: this would mean external benefits of production or lower social cost than private cost.
B correct: negative production externality means external costs exist, so MSC = MPC + external cost, making MSC greater than MPC.
C wrong: MPB > MSB is negative consumption externality.
D wrong: MSB > MPB is positive consumption externality.

3. Answer: B

A wrong: MPB > MSB means consumers get private benefit greater than social benefit, suggesting negative consumption externality.
B correct: positive consumption externality means external benefits exist, so MSB is greater than MPB.
C wrong: this is linked to positive production externality.
D wrong: this is negative production externality.

4. Answer: B

A wrong: negative production externality causes too much output, not too little.
B correct: firms ignore external costs, so free market output is above the socially efficient level.
C wrong: market output and social optimum differ.
D wrong: firms can still produce; the issue is overproduction.

5. Answer: B

A wrong: positive consumption externality causes too little consumption.
B correct: consumers ignore external benefits, so demand based on MPB is below socially desirable demand.
C wrong: market output is not socially efficient.
D wrong: positive benefits do not mean infinite output because marginal costs still exist.

6. Answer: A

A correct: marginal external cost = MSC – MPC = $32 – $20 = $12.
B wrong: $20 is MPC.
C wrong: $32 is MSC.
D wrong: $52 adds MSC and MPC.

7. Answer: A

A correct: marginal external benefit = MSB – MPB = $24 – $15 = $9.
B wrong: $15 is MPB.
C wrong: $24 is MSB.
D wrong: $39 adds MSB and MPB.

8. Answer: A

A correct: river pollution creates external costs, so MSC exceeds MPC.
B wrong: private cost is lower than social cost when external costs exist.
C wrong: this is about benefits, not production cost.
D wrong: this suggests negative consumption externality.

9. Answer: C

A wrong: vaccination is mainly consumption with external benefits, not production cost.
B wrong: MPB > MSB would mean external costs.
C correct: vaccination benefits others by reducing disease spread, so MSB exceeds MPB.
D wrong: this is not a production cost issue.

10. Answer: B

A wrong: smoking is consumption, not production.
B correct: passive smoking creates external costs from consumption.
C wrong: cigarettes are private goods, not public goods.
D wrong: smoking creates external costs, not external benefits.

Written and Compiled By Sir Hunain Zia (AYLOTI), World Record Holder With 154 Total A Grades, 11 World Records and 7 Distinctions, Educate A Change.

11. Answer: B

A wrong: the free market demand curve reflects private benefit, not social benefit.
B correct: demand is based on marginal private benefit because consumers consider their own benefit.
C wrong: MSC and MPC relate to costs, not demand.
D wrong: government revenue is not the basis of the demand curve.

12. Answer: A

A correct: negative consumption externality means private benefit exceeds social benefit because society suffers external costs.
B wrong: MSB > MPB is positive consumption externality.
C wrong: this is about production costs.
D wrong: same problem; it would imply positive production externality.

13. Answer: A

A correct: positive production externality means production creates external benefits, so social cost is lower than private cost.
B wrong: MSC > MPC is negative production externality.
C wrong: this relates to consumption benefits.
D wrong: this is negative consumption externality.

14. Answer: B

A wrong: nearby fruit farms benefit from production activity.
B correct: the beekeeper’s production creates external benefits for fruit farms.
C wrong: asymmetric information means unequal information.
D wrong: non-excludability alone is a public good feature.

15. Answer: A

A correct: worker training by one firm may benefit other firms later, creating external production benefits.
B wrong: this is not a harmful consumption effect.
C wrong: rivalry is about one person’s use reducing availability.
D wrong: moral hazard is risk-taking when another party bears the cost.

16. Answer: B

A wrong: negative production externality creates overproduction, not underproduction.
B correct: firms ignore external costs, so social cost exceeds private cost and output is too high.
C wrong: this is negative consumption externality.
D wrong: this is positive consumption externality.

17. Answer: B

A wrong: positive consumption externality causes too little consumption, not overproduction.
B correct: external benefits are ignored, so the market underconsumes the good.
C wrong: productive efficiency does not create DWL here.
D wrong: taxation is not the cause.

18. Answer: B

A wrong: a subsidy would increase output, worsening overproduction.
B correct: a tax equal to marginal external cost internalises the externality by raising MPC towards MSC.
C wrong: a maximum price above equilibrium is ineffective.
D wrong: free provision increases output/consumption.

19. Answer: B

A wrong: a tax would reduce consumption further.
B correct: subsidy or direct provision encourages consumption towards the social optimum.
C wrong: minimum price reduces consumption.
D wrong: a ban prevents consumption.

20. Answer: A

A correct: a Pigouvian tax makes private decision-makers face the social cost by shifting MPC towards MSC.
B wrong: it does not lower MPB below MSB.
C wrong: firms do not produce at zero cost.
D wrong: public goods remain non-rival/non-excludable by nature.

21. Answer: A

A correct: subsidy lowers effective price/cost and increases consumption towards the socially efficient level.
B wrong: subsidy does not reduce consumption.
C wrong: subsidy for external benefits aims to correct underconsumption, not increase harm.
D wrong: it does not reduce social benefit.

22. Answer: A

A correct: merit goods are underconsumed because people underestimate benefits or ignore external benefits.
B wrong: this describes demerit goods/negative externalities.
C wrong: public goods are non-rival and non-excludable.
D wrong: negative income elasticity identifies inferior goods.

23. Answer: B

A wrong: underconsumption is linked to merit goods.
B correct: demerit goods are overconsumed because private or external costs are underestimated.
C wrong: demerit goods can be rival private goods.
D wrong: they may be supplied by private firms.

24. Answer: A

A correct: education benefits the individual and society through productivity, citizenship and lower crime, but may be underconsumed.
B wrong: education creates external benefits, not only costs.
C wrong: exclusion is possible through fees/admission.
D wrong: one person’s education does not prevent all others from receiving education.

25. Answer: A

A correct: cigarette consumers may underestimate health risks and impose costs on others through passive smoking/healthcare burdens.
B wrong: consumers may have imperfect information.
C wrong: cigarettes are rival and excludable private goods.
D wrong: cigarettes use scarce resources and have opportunity cost.

Written and Compiled By Sir Hunain Zia (AYLOTI), World Record Holder With 154 Total A Grades, 11 World Records and 7 Distinctions, Educate A Change.

26. Answer: B

A wrong: rival and excludable goods are private goods.
B correct: pure public goods are non-rival and non-excludable.
C wrong: rival but non-excludable goods are common resources.
D wrong: non-rival but excludable goods are club goods/quasi-public goods.

27. Answer: B

A wrong: that defines non-excludability.
B correct: non-rivalry means one person consuming the good does not reduce availability for others.
C wrong: public goods still have opportunity cost.
D wrong: government does not have to produce every non-rival good.

28. Answer: B

A wrong: this describes rivalry.
B correct: non-excludability means non-payers cannot easily be prevented from benefiting.
C wrong: negative income elasticity is about inferior goods.
D wrong: public goods are not necessarily inferior.

29. Answer: B

A wrong: private goods are excludable, so free-riding is easier to prevent.
B correct: public goods suffer from free-riding because non-payers cannot be excluded.
C wrong: demerit goods are about overconsumption and external costs.
D wrong: luxury goods are identified by high income elasticity.

30. Answer: B

A wrong: defence is not rival for citizens and exclusion is difficult.
B correct: one person being protected does not reduce protection for others, and non-payers cannot easily be excluded.
C wrong: marginal utility is not necessarily negative.
D wrong: national defence is usually provided by government, but the reason is its public-good nature.

31. Answer: B

A wrong: charging each ship directly is difficult.
B correct: one ship using the lighthouse signal does not reduce it for others, and excluding ships is difficult.
C wrong: it is not a free good because resources are needed to build/operate it.
D wrong: ships and society demand/benefit from it, not only government.

32. Answer: A

A correct: users can be excluded by charging a toll, so it is not a pure public good.
B wrong: toll roads create transport benefits.
C wrong: they have opportunity cost.
D wrong: congestion can make roads rival at high usage.

33. Answer: A

A correct: congestion means one extra vehicle reduces road space and speed for others.
B wrong: public roads are often difficult to exclude from, but the issue here is rivalry.
C wrong: it still uses scarce resources.
D wrong: inferior-good status is unrelated.

34. Answer: B

A wrong: national defence is a public good.
B correct: fish stocks in international waters are rival but difficult to exclude users from.
C wrong: private cars are private goods.
D wrong: cinema tickets are excludable.

35. Answer: A

A correct: common resources are rival but non-excludable.
B wrong: non-rival and non-excludable describes public goods.
C wrong: non-rival and excludable describes club goods.
D wrong: rival and excludable describes private goods.

36. Answer: A

A correct: users overuse shared rival resources because they do not bear the full social cost of depletion.
B wrong: public goods are more likely underprovided privately.
C wrong: merit goods are not always banned.
D wrong: perfect information does not define tragedy of commons.

37. Answer: B

A wrong: fish stocks are rival, not non-rival.
B correct: fish are depleted by use, and it is difficult to exclude fishers in international waters.
C wrong: consumer surplus alone is not the cause.
D wrong: overfishing creates external costs, not positive consumption benefits.

38. Answer: B

A wrong: perfect knowledge means no information failure.
B correct: information failure occurs when decisions are based on incomplete, inaccurate or misunderstood information.
C wrong: P = MC indicates allocative efficiency.
D wrong: information failure can occur with or without government intervention.

39. Answer: A

A correct: asymmetric information means one side of a transaction knows more than the other.
B wrong: identical information means symmetric information.
C wrong: information is not perfect.
D wrong: either producers or consumers may know more depending on the market.

40. Answer: A

A correct: the seller has better information about quality than the buyer.
B wrong: positive externality benefits third parties.
C wrong: public good provision is about non-rivalry/non-excludability.
D wrong: productive efficiency means minimum-cost production.

Written and Compiled By Sir Hunain Zia (AYLOTI), World Record Holder With 154 Total A Grades, 11 World Records and 7 Distinctions, Educate A Change.

41. Answer: B

A wrong: adverse selection is specifically about hidden information attracting high-risk participants.
B correct: adverse selection occurs before the transaction when hidden information causes worse-risk buyers/sellers to dominate.
C wrong: that is moral hazard after the transaction.
D wrong: P = MC is allocative efficiency.

42. Answer: A

A correct: moral hazard occurs after protection/insurance when someone takes more risks because another party bears the cost.
B wrong: identical information removes asymmetric information.
C wrong: non-rivalry is a public-good feature.
D wrong: fixed costs are unrelated.

43. Answer: B

A wrong: adverse selection occurs before insurance is agreed.
B correct: after being insured, the driver takes more risk because the insurer bears some cost.
C wrong: this is not an external benefit.
D wrong: productive efficiency is minimum-cost production.

44. Answer: B

A wrong: moral hazard is riskier behaviour after insurance.
B correct: adverse selection occurs when high-risk people are more likely to buy insurance due to hidden information.
C wrong: non-rivalry is unrelated.
D wrong: this is not a production externality.

45. Answer: A

A correct: the dentist has more expert information than patients and may exploit it.
B wrong: non-excludability is a public-good feature.
C wrong: this is not an external production benefit.
D wrong: this is inefficient, not allocatively efficient.

46. Answer: A

A correct: labelling and information campaigns reduce information failure by improving consumer knowledge.
B wrong: subsidy increases consumption of harmful products.
C wrong: maximum price may increase consumption by lowering price.
D wrong: removing regulation worsens information failure.

47. Answer: B

A wrong: tax makes education more expensive and worsens underconsumption.
B correct: subsidies, free provision and information campaigns increase access and awareness of benefits.
C wrong: banning private schools may reduce provision/choice.
D wrong: higher prices reduce consumption.

48. Answer: B

A wrong: subsidy would increase alcohol consumption.
B correct: warnings, taxation and regulation reduce consumption and correct underestimated costs.
C wrong: free provision increases consumption.
D wrong: lower legal drinking age increases access.

49. Answer: A

A correct: external production cost means MPC excludes some social cost, free-market output is too high, and deadweight loss results.
B wrong: production external benefit needs subsidy, not tax.
C wrong: negative consumption externality has MPB above MSB, not below.
D wrong: public goods are non-rival, and price mechanism fails due to free-riding.

50. Answer: A

A correct: external consumption benefit means MSB exceeds MPB, so market demand and output are too low; subsidy/direct provision can increase welfare.
B wrong: external production cost makes MSC above MPC and causes overproduction.
C wrong: asymmetric information means imperfect knowledge, not perfect knowledge.
D wrong: demerit goods are overconsumed and often need tax/regulation, not subsidy.

Written and Compiled By Sir Hunain Zia (AYLOTI), World Record Holder With 154 Total A Grades, 11 World Records and 7 Distinctions, Educate A Change.