Module M10 Quiz: Externalities and Market Failure
25 questions · Introductory · Mix of multiple choice, calculation, and short answer
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Question 1
Lesson L01 · Externalities
A negative externality occurs when:
Type: Multiple Choice
- A) A firm earns negative profit
- B) The production or consumption of a good imposes costs on third parties not reflected in the market price
- C) A good is produced at too low a cost
- D) Government fails to provide a public good
Show Answer
Answer: B) The production or consumption of a good imposes costs on third parties not reflected in the market price
Negative externalities impose uncompensated costs on third parties — classic market failure.
Question 2
Lesson L01 · Externalities
Coal mining imposes dust and noise costs on nearby residents estimated at $8/tonne. If the market price of coal is $80/tonne and the private marginal cost is $60/tonne, what is the social marginal cost?
Type: Calculation
Show Answer
Answer: $68/tonne
MSC = MPC + external cost = $60 + $8 = $68/tonne
Question 3
Lesson L01 · Externalities
From Q2, the efficient price of coal (where P=MSC) would be \(68. The market produces at P=MC=\)60. Is the market overproducing or underproducing coal?
Type: Multiple Choice
- A) Underproducing
- B) Overproducing — market price is too low and output too high relative to the social optimum
- C) Producing the efficient quantity
- D) It depends on demand elasticity
Show Answer
Answer: B) Overproducing — market price is too low and output too high relative to the social optimum
Because the private market ignores the $8 external cost, it prices too low and produces more than the socially optimal quantity.
Question 4
Lesson L01 · Externalities
Give one example each of a positive and negative externality relevant to Australia.
Type: Short Answer
Show Answer
Answer: Negative: carbon emissions from coal-fired power (imposes climate costs on all). Positive: vaccination against influenza (reduces infection risk for non-vaccinated people).
Any valid Australian examples accepted — the key is third-party effects not captured in market prices.
Question 5
Lesson L01 · Externalities
Which market outcome does a negative production externality cause?
Type: Multiple Choice
- A) Too little output at too high a price
- B) Too much output at too low a price
- C) Efficient output but wrong distribution
- D) Zero output
Show Answer
Answer: B) Too much output at too low a price
MPC < MSC means producers ignore part of the cost → market price is too low → overproduction relative to the efficient level.
Question 6
Lesson L02 · Externalities
The Coase theorem states that private bargaining achieves efficiency if:
Type: Multiple Choice
- A) Government sets the right tax
- B) Property rights are clearly defined and transaction costs are low
- C) Both parties have equal bargaining power
- D) The good is a public good
Show Answer
Answer: B) Property rights are clearly defined and transaction costs are low
Coase's insight: if property rights are clear and transactions are costless, parties will bargain to the efficient outcome regardless of who holds the rights.
Question 7
Lesson L02 · Externalities
A factory pollutes a river damaging a fishery downstream. Pollution abatement costs $100k; damage to fishery is $150k. Under Coase what is the efficient outcome?
Type: Calculation
Show Answer
Answer: Abate pollution; net gain $50k
It's efficient to abate: social gain = $150k damage avoided - $100k abatement cost = $50k. Regardless of property rights, parties should bargain to this outcome if transaction costs are low.
Question 8
Lesson L02 · Externalities
Why does the Coase theorem often fail in practice for environmental problems like river pollution?
Type: Short Answer
Show Answer
Answer: Transaction costs are high — many affected parties (fishers, residents, recreational users) make negotiation costly. Free-riding on others' negotiations and difficulty measuring damages further impede private bargaining.
Large numbers of affected parties and high transaction costs prevent the costless bargaining the theorem requires.
Question 9
Lesson L02 · Externalities
Australia's water trading scheme in the Murray-Darling Basin is an example of:
Type: Multiple Choice
- A) A Pigouvian tax
- B) A Coasian approach — property rights in water are defined and tradeable, allowing efficient allocation through market exchange
- C) A price ceiling on water
- D) A public good provision
Show Answer
Answer: B) A Coasian approach — property rights in water are defined and tradeable, allowing efficient allocation through market exchange
Defining water entitlements as tradeable property rights allows market exchange to reallocate water to highest-value uses — the Coasian solution.
Question 10
Lesson L02 · Externalities
Which condition makes the Coase theorem most likely to work?
Type: Multiple Choice
- A) Large numbers of affected parties
- B) Low transaction costs and clearly defined property rights between a small number of parties
- C) Government-mandated compensation
- D) Identical valuations by both parties
Show Answer
Answer: B) Low transaction costs and clearly defined property rights between a small number of parties
The Coase theorem works best with few parties, clear rights, and low transaction costs — conditions rarely met in large-scale environmental problems.
Question 11
Lesson L03 · Externalities
A Pigouvian tax is set equal to:
Type: Multiple Choice
- A) The market price of the good
- B) The marginal external cost at the efficient quantity
- C) The total profit of the polluting firm
- D) The government's abatement cost
Show Answer
Answer: B) The marginal external cost at the efficient quantity
The optimal Pigouvian tax equals the marginal external cost at the socially efficient output — it forces producers to internalise the full social cost.
Question 12
Lesson L03 · Externalities
A factory's MPC=\(40 and external pollution cost=\)15/unit. An optimal Pigouvian tax is imposed. What price do consumers pay and what price do producers receive?
Type: Calculation
Show Answer
Answer: Consumers pay $55; producers receive $40 (before tax)
Tax=$15. Producers set MPC+tax=price: \(40+\)15=$55. Producers receive $55 but remit $15 tax, netting $40 = their MPC. Efficient outcome.
Question 13
Lesson L03 · Externalities
Why might tradeable permits be preferred over a Pigouvian tax when abatement costs are uncertain?
Type: Short Answer
Show Answer
Answer: With a tax we know the price of emissions but not the quantity. With permits we set the quantity directly — useful when we have a firm emission reduction target. If abatement costs vary across firms, permits also achieve the target cost-effectively through trading.
Permits give certainty over the quantity of pollution; taxes give certainty over the price.
Question 14
Lesson L03 · Externalities
A positive externality from education means the market:
Type: Multiple Choice
- A) Overproduces education
- B) Underproduces education — private demand is below social demand so the market equilibrium is below the efficient level
- C) Produces the efficient level
- D) Produces education only if subsidised
Show Answer
Answer: B) Underproduces education — private demand is below social demand so the market equilibrium is below the efficient level
The private demand for education reflects only private benefits. Social benefits (lower crime, productivity spillovers) mean MSB > MPB → market underproduces.
Question 15
Lesson L03 · Externalities
Which policy instrument gives polluters the most flexibility in HOW they reduce emissions?
Type: Multiple Choice
- A) Uniform emission standard
- B) Technology mandate (requires specific equipment)
- C) Pigouvian tax or tradeable permit (firms choose cheapest abatement method)
- D) Command-and-control regulation
Show Answer
Answer: C) Pigouvian tax or tradeable permit (firms choose cheapest abatement method)
Taxes and permits set a price on emissions but let firms choose the least-cost abatement method — maximising flexibility and cost-effectiveness.
Question 16
Lesson L04 · Externalities
Australia's carbon tax (2012-2014) was set at $23/tonne. Which government repealed it?
Type: Multiple Choice
- A) Rudd Labor
- B) Abbott Coalition
- C) Gillard Labor
- D) Morrison Coalition
Show Answer
Answer: B) Abbott Coalition
The Abbott Coalition government repealed the carbon price in July 2014, replacing it with the Direct Action policy.
Question 17
Lesson L04 · Externalities
Under the Safeguard Mechanism a firm emits 1.2 million tonnes CO2 against a 1 million tonne baseline. It must surrender credits for 200,000 tonnes at $30/credit. Calculate the compliance cost.
Type: Calculation
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Answer: $6 million
200,000 tonnes × $30/tonne = $6 million
Question 18
Lesson L04 · Externalities
Compare the economic efficiency of Australia's current Safeguard Mechanism with the 2012-14 carbon tax.
Type: Short Answer
Show Answer
Answer: Both put a price on carbon. The carbon tax was simpler and covered more emissions. The Safeguard Mechanism covers only large emitters (>100k tonnes) and uses baselines rather than an economy-wide price — potentially less cost-effective but more politically durable.
The carbon tax provided a uniform price signal; the Safeguard Mechanism is more targeted and complex.
Question 19
Lesson L04 · Externalities
Why is fuel excise NOT a pure Pigouvian tax on carbon emissions?
Type: Multiple Choice
- A) It is set too high
- B) It was designed primarily for road funding and revenue not to price the carbon externality from fuel combustion — and it applies uniformly rather than proportionally to emissions
- C) It only applies to diesel
- D) It applies to all goods
Show Answer
Answer: B) It was designed primarily for road funding and revenue not to price the carbon externality from fuel combustion — and it applies uniformly rather than proportionally to emissions
Australia's fuel excise predates carbon pricing and was designed as a user charge. It happens to reduce fuel use but is not calibrated to the marginal external cost of CO2.
Question 20
Lesson L04 · Externalities
What does 'carbon leakage' mean in the context of Australian climate policy?
Type: Multiple Choice
- A) Carbon being physically captured and stored underground
- B) Emissions-intensive industries relocating to countries without carbon pricing, potentially increasing global emissions
- C) The carbon price declining over time
- D) Government revenue from carbon permits being spent inefficiently
Show Answer
Answer: B) Emissions-intensive industries relocating to countries without carbon pricing, potentially increasing global emissions
Carbon leakage occurs when domestic carbon pricing makes Australian industry uncompetitive, causing production to shift offshore to lower-regulation countries.
Question 21
Lesson L05 · Externalities
A network externality means:
Type: Multiple Choice
- A) Networks are more expensive to build
- B) The value of a product or service increases as more people use it
- C) Externalities only affect computer networks
- D) Network goods are non-rival
Show Answer
Answer: B) The value of a product or service increases as more people use it
Network externalities (or network effects): each additional user increases the value of the network for all existing users (e.g. phone, social media, payment systems).
Question 22
Lesson L05 · Externalities
If Afterpay has 5 million Australian users and each additional user adds $2 of value to all existing users, calculate total network value added when the 5,000,001st user joins.
Type: Calculation
Show Answer
Answer: $10 million
Value added = $2 × 5,000,000 existing users = $10 million. This illustrates how network value grows super-linearly.
Question 23
Lesson L05 · Externalities
Why do markets with strong network effects tend toward 'winner-take-all' outcomes?
Type: Short Answer
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Answer: Users prefer the platform with the most users (highest network value). This creates a positive feedback loop: more users → more value → more users → dominant platform. Smaller rivals offer less value, making it hard to overcome the incumbent's lead.
Positive feedback loops from network effects concentrate users on one platform.
Question 24
Lesson L05 · Externalities
EFTPOS in Australia has high merchant adoption (near-universal). A rival payment system faces:
Type: Multiple Choice
- A) No barriers to entry
- B) A chicken-and-egg problem — merchants won't adopt without consumers and consumers won't use without merchants; the incumbent's large installed base is a major barrier
- C) Only cost barriers
- D) A legal monopoly
Show Answer
Answer: B) A chicken-and-egg problem — merchants won't adopt without consumers and consumers won't use without merchants; the incumbent's large installed base is a major barrier
Two-sided network effects create the chicken-and-egg problem: both sides need to be on the platform simultaneously, making it very hard for a new entrant to reach critical mass.
Question 25
Lesson L05 · Externalities
From a competition policy perspective network externalities are concerning because:
Type: Multiple Choice
- A) They always lead to lower prices
- B) They can entrench dominant platforms even if superior alternatives exist reducing consumer choice and innovation
- C) They increase economic efficiency
- D) The ACCC has no jurisdiction over digital markets
Show Answer
Answer: B) They can entrench dominant platforms even if superior alternatives exist reducing consumer choice and innovation
Network effects can create durable market power that resists competitive pressure even from better products — a major concern for digital markets regulation.