Market Failure: External Costs, External Benefits, Merit Goods, Demerit Goods, Public Goods

1. Market failure occurs when

A government spends more than it receives in tax revenue
B the price mechanism allocates resources inefficiently
C a firm makes losses in the short run
D demand equals supply in a market

2. Which situation is most likely to cause market failure?

A perfect information and no external effects
B private costs equal social costs
C external costs are ignored by producers or consumers
D firms respond to price changes

3. Social cost is equal to

A private cost only
B external cost only
C private cost + external cost
D private benefit – external benefit

4. Social benefit is equal to

A private benefit + external benefit
B private benefit – external benefit
C private cost + external cost
D external cost – private cost

5. An external cost is

A a cost paid directly by the producer
B a cost suffered by a third party not involved in the transaction
C a cost included in the market price
D a cost paid only by the government

6. An external benefit is

A a benefit received only by the consumer who buys the good
B a benefit received by a third party not involved in the transaction
C a benefit included fully in the market price
D a benefit received only by producers

7. Which is the best example of an external cost?

A a factory pays wages to workers
B a factory pays rent for land
C smoke from a factory damages nearby residents’ health
D a firm pays for raw materials

8. Which is the best example of an external benefit?

A a student gets higher income after education
B a vaccinated person reduces spread of disease to others
C a firm earns higher profit after advertising
D a consumer enjoys eating a meal

9. If external costs exist in production, the free market is likely to

A overproduce the good
B underproduce the good
C produce the socially optimum quantity
D produce no output at all

10. If external benefits exist in consumption, the free market is likely to

A overconsume the good
B underconsume the good
C produce exactly the socially efficient output
D charge a price of zero

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. A chemical firm pollutes a river. The firm does not pay for the damage. What is most likely?

A private cost is greater than social cost
B social cost is greater than private cost
C external benefit is greater than private benefit
D social benefit is equal to zero

12. If private cost is $8 and external cost is $5, what is social cost?

A $3
B $5
C $8
D $13

13. If private benefit is $12 and external benefit is $4, what is social benefit?

A $4
B $8
C $12
D $16

14. If social cost is $20 and private cost is $14, what is external cost?

A $6
B $14
C $20
D $34

15. If social benefit is $25 and private benefit is $18, what is external benefit?

A $7
B $18
C $25
D $43

16. Which statement is correct when there is a negative externality?

A social cost is greater than private cost
B private benefit is greater than social benefit
C external benefit is greater than external cost
D private cost is zero

17. Which statement is correct when there is a positive externality?

A social benefit is greater than private benefit
B social cost is less than private cost
C external cost must be zero
D private benefit must be zero

18. A government taxes cigarettes because smoking creates healthcare costs for society. What is the main reason?

A cigarettes are public goods
B cigarettes create external costs
C cigarettes create no private benefit
D cigarettes are free goods

19. A government subsidises education because it creates a more skilled and productive society. What is the main reason?

A education creates external benefits
B education creates only external costs
C education is a demerit good
D education has no private benefit

20. Which is most likely to be a merit good?

A cigarettes
B alcohol
C education
D gambling

21. Which is most likely to be a demerit good?

A vaccination
B healthcare
C education
D tobacco

22. A merit good is usually

A underconsumed because consumers undervalue its benefits
B overconsumed because consumers ignore its costs
C non-rival and non-excludable
D supplied only by private firms

23. A demerit good is usually

A underconsumed because consumers overestimate its harm
B overconsumed because consumers underestimate its harm
C non-rival and non-excludable
D always free of external costs

24. Which statement best explains why healthcare may be a merit good?

A consumers may not fully understand its long-term benefits
B it creates no benefit to society
C it is always non-excludable
D it is always produced at zero cost

25. Which statement best explains why alcohol may be a demerit good?

A consumers may ignore long-term health damage and external costs
B it creates only external benefits
C it is impossible to exclude non-payers
D it has no private benefit

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. Which good is most likely to be a public good?

A public park with entry tickets
B street lighting
C private healthcare
D cinema ticket

27. A pure public good is

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

28. Non-rival means

A one person’s consumption reduces the amount available for others
B one person’s consumption does not reduce the amount available for others
C people can be stopped from using the good
D only government can produce the good

29. Non-excludable means

A people cannot easily be prevented from using the good once provided
B one person’s use reduces availability for another
C the good has no benefit
D the good is always privately profitable

30. Which is the clearest example of non-rival consumption?

A one person eating a slice of pizza
B one person using street lighting while others can also benefit
C one person buying a train ticket for a reserved seat
D one person drinking bottled water

31. Which is the clearest example of non-excludability?

A a cinema refusing entry to people without tickets
B a shop refusing to sell to non-payers
C people benefiting from flood defence even if they did not pay directly
D a private tutor teaching only paying students

32. The free-rider problem occurs when people

A pay twice for the same good
B benefit from a good without paying for it
C cannot consume a good because it is rival
D demand less when price falls

33. Which market failure is most directly linked to public goods?

A free-rider problem
B inflation
C occupational immobility
D price elasticity of demand

34. Why might private firms be unwilling to provide national defence?

A it has no benefit to consumers
B non-payers cannot easily be excluded
C it is always a demerit good
D its marginal benefit is always zero

35. Which good is most likely to be rejected as a pure public good?

A lighthouse signal
B national defence
C street lighting
D restaurant meal

36. Which statement about public goods is correct?

A all goods provided by government are public goods
B public goods are non-rival and non-excludable
C public goods are always merit goods
D public goods always have zero opportunity cost

37. Which is not necessarily a public good even if provided by the state?

A national defence
B flood defence
C state education
D street lighting

38. Why is state education not a pure public good?

A it creates no external benefits
B it is rival because classroom places and teacher time are limited
C it has no private benefit
D it cannot be provided by government

39. Which policy is most likely to reduce consumption of a demerit good?

A subsidy
B indirect tax
C lowering the legal age to consume it
D advertising its benefits

40. Which policy is most likely to increase consumption of a merit good?

A indirect tax
B subsidy
C ban
D reducing information about its 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.

41. A government provides free vaccinations. Which market failure is it most likely trying to correct?

A external benefits and underconsumption
B external costs and overconsumption
C monopoly profits
D excess supply

42. A government bans dumping waste into rivers. Which market failure is it most likely trying to correct?

A positive externalities
B negative externalities
C shortage caused by high demand
D free-rider problem only

43. A government provides information campaigns about smoking. Which reason best explains this policy?

A to reduce information failure and overconsumption of a demerit good
B to increase demand for cigarettes
C to make smoking a public good
D to remove all opportunity cost

44. Which policy directly makes producers pay for external costs?

A subsidy on production
B indirect tax on production
C free provision of the product
D maximum price below equilibrium

45. Which policy directly encourages consumption of a good with external benefits?

A subsidy to consumers or producers
B indirect tax
C ban on consumption
D minimum price above equilibrium

46. Which is most likely to create a welfare loss in a free market?

A private cost equals social cost and private benefit equals social benefit
B external costs cause output above the socially optimum level
C consumers and producers have perfect information
D public goods are fully funded voluntarily by all users

47. Which statement about externalities is correct?

A externalities affect third parties outside the transaction
B externalities are always benefits
C externalities are always paid for in the market price
D externalities occur only in production, never consumption

48. Which is an example of a positive consumption externality?

A pollution from a factory
B traffic congestion caused by car use
C education increasing civic awareness and productivity
D a firm lowering production costs

49. Which is an example of a negative consumption externality?

A second-hand smoke harming non-smokers
B new machinery increasing output
C training workers improving firm productivity
D vaccination reducing illness for others

50. A good is underprovided by the free market because non-payers cannot be excluded and one person’s use does not reduce another’s benefit. What type of good is it?

A private good
B public good
C demerit good
D inferior good

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: this is a budget deficit, not market failure.
B correct: market failure occurs when the price mechanism causes inefficient resource allocation.
C wrong: a firm making losses does not automatically mean market failure.
D wrong: demand equalling supply is equilibrium, not market failure.

2. Answer: C

A wrong: perfect information and no external effects reduce market failure.
B wrong: if private cost equals social cost, external costs are absent.
C correct: ignored external costs mean the market price is too low and output may be too high.
D wrong: firms responding to price changes is normal price mechanism behaviour.

3. Answer: C

A wrong: private cost alone ignores third-party costs.
B wrong: external cost alone ignores the cost to the producer or consumer.
C correct: social cost = private cost + external cost.
D wrong: this mixes benefit concepts incorrectly.

4. Answer: A

A correct: social benefit = private benefit + external benefit.
B wrong: external benefit should be added, not subtracted.
C wrong: this is social cost, not social benefit.
D wrong: this mixes cost concepts incorrectly.

5. Answer: B

A wrong: this is a private cost.
B correct: an external cost is suffered by a third party outside the transaction.
C wrong: external costs are not fully included in the market price.
D wrong: external costs can be suffered by individuals, firms or society.

6. Answer: B

A wrong: this is a private benefit.
B correct: an external benefit is received by a third party outside the transaction.
C wrong: external benefits are not fully reflected in the market price.
D wrong: external benefits can be received by wider society, not only producers.

7. Answer: C

A wrong: wages are a private cost to the firm.
B wrong: rent is a private cost.
C correct: pollution harming nearby residents is a third-party cost.
D wrong: raw materials are a private cost.

8. Answer: B

A wrong: higher income for the student is a private benefit.
B correct: reduced disease spread benefits others, so it is an external benefit.
C wrong: higher profit is a private benefit to the firm.
D wrong: meal enjoyment is a private benefit.

9. Answer: A

A correct: if external costs are ignored, the good is too cheap and overproduced.
B wrong: underproduction is more likely with external benefits.
C wrong: socially optimum output requires external costs to be considered.
D wrong: output does not become zero automatically.

10. Answer: B

A wrong: external benefits usually cause underconsumption, not overconsumption.
B correct: consumers ignore benefits to others, so free-market consumption is too low.
C wrong: socially efficient output requires external benefits to be considered.
D wrong: external benefits do not mean price becomes zero.

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: private cost excludes unpaid pollution damage, so it is lower than social cost.
B correct: social cost includes private cost plus external pollution cost.
C wrong: river pollution is an external cost, not external benefit.
D wrong: social benefit is not zero just because pollution exists.

12. Answer: D

A wrong: $3 is not private cost plus external cost.
B wrong: $5 is only the external cost.
C wrong: $8 is only the private cost.
D correct: social cost = $8 + $5 = $13.

13. Answer: D

A wrong: $4 is only the external benefit.
B wrong: $8 is private benefit minus external benefit.
C wrong: $12 is only the private benefit.
D correct: social benefit = $12 + $4 = $16.

14. Answer: A

A correct: external cost = social cost – private cost = $20 – $14 = $6.
B wrong: $14 is private cost.
C wrong: $20 is social cost.
D wrong: $34 adds social and private cost.

15. Answer: A

A correct: external benefit = social benefit – private benefit = $25 – $18 = $7.
B wrong: $18 is private benefit.
C wrong: $25 is social benefit.
D wrong: $43 adds social and private benefit.

16. Answer: A

A correct: negative externality means external cost exists, so social cost is greater than private cost.
B wrong: that may apply to ignored harm in demerit goods but is not the general definition.
C wrong: negative externality means external cost, not benefit.
D wrong: private cost does not have to be zero.

17. Answer: A

A correct: positive externality means external benefit exists, so social benefit is greater than private benefit.
B wrong: positive externality concerns benefits, not necessarily costs.
C wrong: external costs may exist separately, but positive externality focuses on external benefits.
D wrong: private benefit can still exist.

18. Answer: B

A wrong: cigarettes are not public goods.
B correct: smoking can create external costs such as healthcare costs and second-hand smoke.
C wrong: smokers may receive private benefit.
D wrong: cigarettes are scarce economic goods, not free goods.

19. Answer: A

A correct: education benefits society through productivity, tax revenue and civic benefits.
B wrong: education does not create only external costs.
C wrong: education is usually a merit good.
D wrong: students receive private benefits too.

20. Answer: C

A wrong: cigarettes are usually demerit goods.
B wrong: alcohol is usually a demerit good.
C correct: education is a merit good because it is often underconsumed and creates external benefits.
D wrong: gambling is usually a demerit good.

21. Answer: D

A wrong: vaccination is usually a merit good.
B wrong: healthcare is usually a merit good.
C wrong: education is usually a merit good.
D correct: tobacco is a demerit good because consumers may underestimate harm and it creates external costs.

22. Answer: A

A correct: merit goods are often underconsumed because consumers undervalue private and external benefits.
B wrong: this describes demerit goods.
C wrong: non-rival and non-excludable describes public goods.
D wrong: merit goods can be supplied by government or private firms.

23. Answer: B

A wrong: consumers usually underestimate harm, not overestimate it.
B correct: demerit goods are overconsumed because consumers ignore or underestimate harm.
C wrong: this describes public goods.
D wrong: demerit goods often create external costs.

24. Answer: A

A correct: people may undervalue prevention and long-term health benefits, causing underconsumption.
B wrong: healthcare can benefit society.
C wrong: healthcare is usually excludable and partly rival.
D wrong: healthcare uses scarce resources.

25. Answer: A

A correct: consumers may ignore future health damage and harm to others, so alcohol may be overconsumed.
B wrong: alcohol does not create only external benefits.
C wrong: alcohol is excludable.
D wrong: consumers may receive private benefit.

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: entry tickets make the park excludable.
B correct: street lighting is usually non-rival and non-excludable.
C wrong: private healthcare is rival and excludable.
D wrong: cinema tickets are excludable and seats are rival.

27. Answer: B

A wrong: rival and excludable describes a private good.
B correct: pure public goods are non-rival and non-excludable.
C wrong: rival and non-excludable is a common resource.
D wrong: non-rival and excludable may be a club good.

28. Answer: B

A wrong: this describes rival consumption.
B correct: non-rival means one person’s use does not reduce availability for others.
C wrong: this describes excludability.
D wrong: public or private ownership is not the definition.

29. Answer: A

A correct: non-excludable means non-payers cannot easily be stopped from benefiting.
B wrong: this describes rivalry.
C wrong: non-excludable goods can have major benefits.
D wrong: private profitability is difficult because of free riders.

30. Answer: B

A wrong: eating pizza is rival because less remains for others.
B correct: many people can benefit from street lighting at the same time.
C wrong: a reserved train seat is rival.
D wrong: bottled water is rival.

31. Answer: C

A wrong: cinema entry is excludable.
B wrong: shops can exclude non-payers.
C correct: flood defences protect people even if they did not pay directly.
D wrong: private tutoring is excludable.

32. Answer: B

A wrong: paying twice is not free riding.
B correct: free riders receive benefits without paying.
C wrong: rivalry is a different issue.
D wrong: this is not related to price-demand movement.

33. Answer: A

A correct: public goods are linked to the free-rider problem because non-payers cannot be excluded.
B wrong: inflation is macroeconomic price-level rise.
C wrong: occupational immobility is a labour market issue.
D wrong: PED measures responsiveness of demand.

34. Answer: B

A wrong: national defence has clear benefit.
B correct: because defence is non-excludable, people can benefit without paying, reducing private incentive to provide it.
C wrong: national defence is not a demerit good.
D wrong: its marginal benefit is not always zero.

35. Answer: D

A wrong: lighthouse signals can be non-rival and non-excludable.
B wrong: national defence is a classic public good.
C wrong: street lighting is commonly a public good.
D correct: a restaurant meal is rival and excludable, so it is a private good.

36. Answer: B

A wrong: government-provided goods are not always public goods.
B correct: public goods are defined by non-rivalry and non-excludability.
C wrong: public goods and merit goods are different concepts.
D wrong: public goods still use scarce resources and have opportunity cost.

37. Answer: C

A wrong: national defence is usually a public good.
B wrong: flood defence is often a public good.
C correct: state education is provided by government but is rival and excludable in principle.
D wrong: street lighting is usually a public good.

38. Answer: B

A wrong: education can create external benefits.
B correct: classroom places, teachers and resources are limited, so education is rival.
C wrong: education has private benefits.
D wrong: it can clearly be provided by government.

39. Answer: B

A wrong: subsidy would reduce price and increase consumption.
B correct: indirect tax raises price and discourages consumption.
C wrong: lowering legal age may increase consumption.
D wrong: advertising benefits may increase consumption.

40. Answer: B

A wrong: indirect tax raises price and reduces consumption.
B correct: subsidy lowers price and encourages consumption of merit goods.
C wrong: a ban reduces consumption.
D wrong: less information may reduce consumption.

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: A

A correct: vaccinations create external benefits and are often underconsumed in the free market.
B wrong: this describes negative externalities and demerit goods.
C wrong: monopoly profit is not the main issue.
D wrong: excess supply is not the reason.

42. Answer: B

A wrong: river dumping creates external costs, not benefits.
B correct: dumping waste creates negative externalities for third parties.
C wrong: the issue is pollution, not high-demand shortage.
D wrong: free-rider problem is mainly linked to public goods.

43. Answer: A

A correct: information campaigns help consumers understand harm and reduce overconsumption of a demerit good.
B wrong: the aim is to reduce, not increase, cigarette demand.
C wrong: smoking cannot be made a public good by information campaigns.
D wrong: opportunity cost remains.

44. Answer: B

A wrong: subsidy lowers producer costs and may increase output.
B correct: indirect tax forces producers/consumers to internalise external costs through higher prices.
C wrong: free provision encourages consumption.
D wrong: maximum price does not make producers pay external costs.

45. Answer: A

A correct: subsidy lowers price/cost and encourages consumption or production of goods with external benefits.
B wrong: indirect tax discourages consumption.
C wrong: a ban prevents consumption.
D wrong: a minimum price raises price and discourages consumption.

46. Answer: B

A wrong: if private and social values are equal, market allocation is likely efficient.
B correct: external costs cause overproduction above the socially optimum level, creating welfare loss.
C wrong: perfect information reduces market failure.
D wrong: voluntary full funding would reduce public good underprovision.

47. Answer: A

A correct: externalities are costs or benefits affecting third parties.
B wrong: externalities can be costs or benefits.
C wrong: they are not fully reflected in market prices.
D wrong: they can occur in production or consumption.

48. Answer: C

A wrong: factory pollution is a negative production externality.
B wrong: traffic congestion is a negative consumption externality.
C correct: education consumed by individuals benefits society through awareness and productivity.
D wrong: lower production costs are a private supply-side issue.

49. Answer: A

A correct: smoking by consumers can harm non-smokers, a negative consumption externality.
B wrong: machinery affects production.
C wrong: worker training improving firm productivity is a private benefit unless third parties benefit.
D wrong: vaccination reducing illness is a positive consumption externality.

50. Answer: B

A wrong: private goods are rival and excludable.
B correct: non-excludable and non-rival goods are public goods and are often underprovided by free markets.
C wrong: demerit goods are overconsumed due to underestimated harm.
D wrong: inferior goods are income-related, not defined by non-rivalry/non-excludability.

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.