XAT 2015 — VARC Question 25
Analyse the passage given and provide an appropriate answer for the questions that follow.
For private goods, competitive markets ensure efficiency despite the decentralized nature of the information about individual’s tastes and firm technologies. Implicitly, market competition solved adverse selection problems and the fixed- price contracts associated with exogenous prices solve moral hazard problems. However, markets fail for pure public goods and public intervention is thus needed. In this case, the mechanisms used for those collective decisions must solve the incentive problem of acquiring the private information that agents have about their references for public goods. Voting mechanisms are particular incentive mechanisms without any monetary transfers for which the same question of strategic voting, i.e., not voting according to the true preferences, can be raised. For private goods, increasing returns to scale create a situation of natural monopoly far away from the world of competitive markets. When the monopoly has private information about its cost or demand, its regulation by a regulatory commission becomes a principal – agent problem.
(Note: Public goods are those in which individuals cannot be excluded from use and where use by one individual does not reduce availability to others, while an individual can be excluded in case of private goods.)
Which of the following cannot be concluded from the above paragraph?
Answer & solution
Public intervention is the panacea when market fails.
- B
Adverse selection problems as well as moral hazard problems may not arise in competitive markets.
- C
Strategic voting is nothing but a non – monetary incentive mechanism.
- D
Lack of access to private information regarding preferences of agent leads to incentive problem.
- E
Public regulations may address problems associated with natural monopoly.
Option 1 cannot be concluded from the passage. Although it has been stated that "However, markets fail … public intervention is thus needed", this is only under the specific condition of markets failing for “pure public goods”, not otherwise. So public intervention cannot be considered as the “panacea” or ultimate solution for market failure.
Option 2 can be concluded from "Implicitly, market competition ... problems." Eliminate option 2.
Option 3 can be concluded from "Voting mechanisms are ... raised." Eliminate option 3.
Option 4 can be concluded from “... the incentive problem of acquiring the private information … for public goods.”.
Option 5 can be concluded from "When the monopoly has ... problem.". The sentence says that when the natural monopoly is faced with problems, it is regulated by the regulatory commission and hence a solution can be expected.
Hence, the correct answer is option 1.