XAT 2015 — VARC Question 26
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.)
Read the following statement carefully:
Statement 1:
In India factories dump their waste in the nearby water bodies.
Statement 2:
Government is thinking of granting tax benefits to factories which adopt
eco – friendly practices.
Which of the following options best captures the relationships between Statement 1 and Statement 2?
Answer & solution
- A
Statement 1 is an example of market failure and Statement 2 corroborates Statement 1.
- B
Statement 1 is an example of ‘adverse selection problem’ and Statement 2 is an example of ‘moral hazard problem’.
Statement 1 is example of market failure while Statement 2 suggests one way of reducing the problem.
- D
Statement 1 is an example of public good and Statement 2 is an example of private good.
- E
In Statement 1 the principal is ‘factory’ and in Statement 2 the principal is ‘government’.
Market failures can be viewed as scenarios where individuals' pursuit of pure self-interest leads to results that are not efficient – that can be improved upon from the societal point of view.
The scenario stated in statement 1 is a type of market failure where consumers and producers may fail to take into account the effects of their actions on third-parties who suffer as a result of the actions of consumers and producers attempting to pursue their own self interests.
Hence, eliminate options 2, 4 and 5.
Statement 2 suggests a method of reducing the problem stated in statement 1.
“Corroborates” meaning 'confirms or gives support to' in option A does not qualify the purpose of statement 2 and its relationship with statement 1. So, eliminate option 1.
Statement 2 gives the mitigation of the problem expressed in statement 1.
Option 3 correctly captures the relationship between the two statements.
Hence, the correct answer is option 3.