Tut 22 Answers

HWA CHONG INSTITUTION Year Two H2 Economics 2014 Tutorial #22: Microeconomics II – Market Failure & Government Intervention

TUTORIAL #22: MARKET FAILURE & GOVERNMENT INTERVENTION Section A: Complete BEE questions in Chapter #22 lecture notes Section B: Essay Practice Question 1: TYS 2005 Q4 (a) Explain why pollution and congestion caused by cars are likely to cause market failure. [10] (b) Discuss whether the Singapore government currently adopts appropriate policies to overcome this market failure. [15] Examiner's report TYS: N2005 Q4 This was one of the most popular questions. It produced some very good answers, particularly for part (a), with the best answers also giving excellent evaluative discussion of Singapore’s approach to dealing with this problem. A common response, and one that could have been improved, was to set the diagrams within the context of the production of cars rather than the use of cars. An improvement would have been achieved if the horizontal axis on the diagram had taken account of this distinction i.e. through use of quantity of miles driven or the number of cars owned rather than number of cars produced. Pollution was thus presented as the result of the manufacture of cars rather than the use of cars, although all policies later presented in the Singapore case referred to pollution (and congestion) caused by the use of cars. (a) In general terms this part of the question was well answered and Level 3 marks were frequently gained. Diagrams were normally correctly drawn and, although the majority of candidates carefully explained their diagrams, a surprisingly large number offered no explanation at all with a resultant loss of analysis marks. Key issues relating to deadweight welfare loss and overproduction were frequently correctly identified. A small number of candidates gave incorrect diagrams in the sense that they showed pollution and congestion affecting the benefit curves rather than the cost curves. These types of answer were also normally very poorly explained and the diagrams usually badly drawn. A minority did not apply their answers to the question set and gave obviously rehearsed answers to the problems of dealing with externalities in general or with application to totally different sources of externalities e.g. external benefits from education! (b) This part produced a much wider range of answers and as such worked as a very effective discriminator. The answers were normally set within the Singapore context and thus there was some good application. Mark differences were dependent to a large extent on the candidate’s ability to set the answer within this Singapore context and on the degree to which these alternative policies were analysed rather than simply described. This analysis frequently included reference to relevant diagrams that illustrated to use of a taxation instrument such as COE or ERP. Good answers also recognised potential benefits and problems associated the use of specific policies thereby allowing additional marks for evaluation. For example, the very best answers considered the use of COE to reduce car ownership and the use of ERP to reduce car usage alongside the benefits of both approaches in reducing congestion and pollution. There were some insightful responses to an obviously very topical issue. Mid-range answers tended to describe policies and offer limited evaluation. Weak answers simply listed

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HWA CHONG INSTITUTION Year Two H2 Economics 2014 Tutorial #22: Microeconomics II – Market Failure & Government Intervention

policies or considered only one policy and then in a rather abstract manner.

(a) Explain why pollution and congestion caused by cars are likely to cause market failure. [10] 1st Simple Schematic Plan (Cost-Benefit Approach – Use this for car trips only (Special Case to gel better with the ERP Intervention)) INTRODUCTION – Use KIA Key word: Market Failure. Issue: Identify driving will result in negative externality – pollution and congestion. Approach: This essay aims to…. BODY – Use SEED Define negative externality. Define and give examples of PMC, PMB and EMC of driving. Explain how market fails and leads to over-usage of road/driving with the help of a diagram. CONCLUSION INTRODUCTION Key words Issue Approach

Market failure occurs when free markets, operating without any government intervention, fail to deliver an efficient allocation of resources to produce goods and services. Due to the negative external cost incurred by pollution and congestion, markets do not capture the full cost associated with car-driving and thus cause market failure. This essay aims to explain why pollution and congestion caused by cars are likely to cause market failure.

BODY Negative Externality (Consumption of cars - driving) In a free market, drivers only weigh the private or individual costs and benefits of driving a car and do not take into account the negative externality they create to other road users. The Private Marginal Cost (PMC) of driving measures the additional cost to the driver from the additional journey/trip made. In this case, it is the cost, such as petrol and toll fee. The Private Marginal Benefit (PMB) of driving measures the additional value that the driver places on the additional journey/trip made. The benefit is the value placed by drivers for the convenience and comfort of commuting from place to place by car. However, when the roads get too congested it creates negative externality or External Marginal Cost (EMC) to third parties. Third-parties are those who are not directly involved either as consumers or producers. In this instance, the air pollution as a result of the emission of harmful substances from car exhaust pipes damage health. Besides, other road users such as office-workers and even ambulances which are caught in traffic jams would result in delay and this is costly to society in terms of loss of productivity and lives. The price mechanism fails to bring about a socially efficient allocation of resources in this case. This is because the cost to other parties created is unpriced by the price mechanism and therefore is not

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HWA CHONG INSTITUTION Year Two H2 Economics 2014 Tutorial #22: Microeconomics II – Market Failure & Government Intervention

included in the private costs of consumers. Hence we can say that there is a divergence between the Social Marginal Cost (SMC) and the PMC, and as a result SMC lies above that of PMC. I.e. SMC = PMC + EMC. What consumers pay is not the same (i.e. divergence) as what society has to pay. Figure 1: External Cost from Car Journeys/Trips Cost/Benefit

SMC

B

SMC = PMC + negative externality at QE (EMC = distance AB)

PMC C A PMB=SMB (assuming EMB = 0) QS

Qm

Quantity

In the diagram above, the market equilibrium quantity of car journeys/trips occurs at Qm when drivers account only for their private benefit and cost i.e. PMB=PMC. However, due to the presence of negative externalities (EMC which is measured by distance AB) of congestion and inconvenience to other road users, the social cost of car usage is higher than the private cost. Hence, the social equilibrium occurs when society takes into account of the negative externalities when SMB=SMC at QS (assuming no positive externalities present, PMB=SMB) There is an overconsumption of cars on the road by Qm-QS. The overconsumption created an increase in social cost of BCQ SQm, while the social benefit is only ACQSQm resulting in a deadweight welfare loss of ABC. CONCLUSION Hence, pollution and congestion caused by cars are negative externality which is a form of market failure. 2nd Simple Schematic Plan (Market Based Approach – FYI) INTRODUCTION – Use KIA Key word: Market Failure. Issue: Identify driving will result in negative externality – pollution and congestion. Approach: This essay aims to…. BODY – Use SEED Define negative externality. Define and give examples of PMC, PMB and EMC of driving. Explain how market fails and leads to over-usage of road/driving with the help of a diagram. CONCLUSION INTRODUCTION Key words

Market failure occurs when free markets, operating without any government 

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HWA CHONG INSTITUTION Year Two H2 Economics 2014 Tutorial #22: Microeconomics II – Market Failure & Government Intervention

Issue Approach

intervention, fail to deliver an efficient allocation of resources to produce goods and services. Due to the negative external cost incurred by pollution and congestion, markets do not capture the full cost associated with car-driving and thus cause market failure. This essay aims to explain why pollution and congestion caused by cars are likely to cause market failure.

NO EXTERNALITIES 



The Private Marginal Cost (PMC) measures the cost to producers from an additional unit of car produced such as the cost of raw materials like steel and wages of workers. The costs measured include all opportunity costs and hence PMC represents the opportunity costs of using society’s scarce resources to produce cars, on the assumption that there are no externalities. The Private Marginal Benefit (PMB) measures the benefit or value to consumers from an additional unit of car purchased. The benefit includes the convenience and comfort of driving instead of taking public transport PMB represents the benefit to society of using the limited resources to produce cars, on the assumption that there are no externalities. If there are no externalities, the free market price is able to allocate resources efficiently by equating PMC=PMB. At this output level, society welfare or net total benefit of using the limited resources to produce cars is maximised.

EXTERNALITIES  However the use of cars or driving generates external costs to third parties who are not part of the production or consumption process.  The usage of cars generates at least 2 form of negative CONSUMPTION externality viz. pollution and road congestion. It is a consumption externality because it is generated from the use rather than production of cars.  The usage of cars generates pollutants such as carbon monoxide are emitted and breathed in by passers-by who will have a higher risk of developing pollution-related diseases. If they do fall sick, the car drivers do not bear their medical expenses. Furthermore, each additional car driver adds on to the congestion on the road, increasing the commuting times for other road users which may result in loss of productivity such as workers reporting late for work, business meetings cancelled leading to loss of contracts, or even loss of lives as ambulances cannot ferry the injured to hospital on time.  These third party costs due to congestion and pollution generated from driving are not borne by the car drivers but by society at large. 

Third parties are not compensated by car drivers for the external costs they imposed on others. Hence, the negative consumption externality from driving cars are unpriced or not internalised by the price mechanism. As such, the free market has “under-priced” the usage of cars which will lead to an inefficient allocation of resources and hence market failure.



For each additional car, the social marginal cost (SMC) includes the private marginal cost (PMC) of the car plus the external marginal cost (EMC). Hence the actual cost borne by the society is represented by the SMC, which takes into account the full opportunity cost to society of an extra unit of car. SMC = PMC + EMC. 

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HWA CHONG INSTITUTION Year Two H2 Economics 2014 Tutorial #22: Microeconomics II – Market Failure & Government Intervention

Social Marginal Cost (SMC) = Private Marginal Cost (PMC) + External Marginal Cost (EMC) Figure 1: External Cost from the Usage of Cars SMC = PMC + EMC

Price C

PMC EMC at Qm

Ps

B

Pm

A PMB=SMB (since EMB=0) QS



Qm

Quantity

As seen in Figure 1, the presence of a Negative consumption externality causes a divergence between private and social costs of using cars. The SMC lies above the PMC. From society’s viewpoint, the SMC includes both the PMC and EMC (i.e. SMC =PMC + EMC)



Assume that driving cars yields no positive externality, EMB=0. Thus, PMB=SMB.



Assuming perfect competition, market equilibrium quantity of usage of cars which can be measured in terms of no of car trips or quantity of miles driven is Qm, where PMB = PMC.



However, this output does not represent the socially optimal level of consumption because it does not take into account the negative externality or third party costs imposed on society.



The socially efficient level of consumption or use of cars should be at QS where SMB=SMC, where the full costs and benefits and costs to society are included.



Qs is less than the market equilibrium level of consumption, Qm. where PMB = PMC. Thus there is overconsumption or use of cars by Qm – QS

  

Area QmQSBC is the total social cost incurred for the overconsumption Qm – QS. Area QmQSBA is the total social benefit gained for the overconsumption Qm – QS. Since total social costs incurred exceeds the total social benefits gained for overconsumption Q m – QS, Area ABC represents the deadweight welfare loss due to overconsumption of QS – Qm.

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HWA CHONG INSTITUTION Year Two H2 Economics 2014 Tutorial #22: Microeconomics II – Market Failure & Government Intervention

CONCLUSION Hence, pollution and congestion caused by cars are negative externality which is a form of market failure. (b) Discuss whether the Singapore government currently adopts appropriate policies to overcome this market failure. [15] Simple Schematic Plan INTRODUCTION BODY Policies that overcome congestion ERP: Control car usage 

COE: Control ownership

Policies that overcome pollution

Others: Public transport for alternatives

Rules and regulations

Explain how the policies work and their possible limitations

Reach a synthesis comparing the policies CONCLUSION INTRODUCTION Currently the government has adopted various policies to reduce congestion and pollution by reducing car usage, ownership and provision of an efficient public transport system. The ultimate goal of implementing these policies is to effectively reduce the number of cars driving on the road per hour, to the socially optimal level. BODY 1 – to reduce congestion predominantly Main Solution 1 (Electronic Road Pricing - ERP): Figure 2: ERP to internalise EMC from car trips Cost/Benefit SMC = PMC + EMC PMC + tax

C

PMC Ps Pm

B

A

PS - t

ERP = EMC at QD s



QS

PMB=SMB (since EMB=0) Qm

Quantity

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HWA CHONG INSTITUTION Year Two H2 Economics 2014 Tutorial #22: Microeconomics II – Market Failure & Government Intervention

Referring to Figure 2, the government make car users to pay a fee (a congestion tax on each unit of output), the amount of the tax corresponding to the external marginal cost (i.e. third-party costs) at Q S. This shifts the PMC upwards so that the new private marginal cost, PMC 1 now coincides with SMC since PMC1 = PMC + tax. The imposition of the tax equals to the EMC resulting in a number of car journeys that corresponds to the socially efficient level of output, QS where SMB=SMC. The tax is seen as payment for the congestion or third-party costs designed to get drivers to "internalize the externality" by considering the external costs of driving and serves as incentives to reduce the usage of cars. For Singapore, the road congestion tax imposed is known as the Electronic Road Pricing (ERP) where gantries are placed on roads to deduct fees on motorists using the highways leading to the Central Business District. If ERP correctly priced in the negative externality, road users should be able to use roads which are congestion free. In practice, ERP rates are adjusted to take into account different road traffic conditions at different spots and at different times of the day. Rates are highest during peak periods on busy roads where road congestion is most likely to occur. The system allows different areas to have different rates depending on the level and time of congestion. Hence the method is more equitable because it deters those who do not need to enter the CBD during the hike of the peak period from entering. Hence, those who enter during the hike of the peak will pay the highest ERP charges as they will be the ones who are both willing and able to pay those charges. In this way, this method spreads out the volume of traffic across different hours of the day thus avoiding heavy concentration of traffic at peak or rush hours. Limitations (GOVERNMENT FAILURE) LACK OF INFORMATION: Is it easy to obtain information of the actual cost of reducing congestion along Orchard during peak hours to work out the ERP rate? The government may not possess all the information needed to be able to estimate the ‘correct’ amount of tax to impose. An overvalued ERP may reduce the optimal use of the road, while an undervalued ERP may not reduce traffic congestion by much. Thus the lack of information may lead to government failure. Also, how does the government establish what citizens want it to do? Electoral system is not an ideal way to discover this. Proponents of government failure argue that the free market mechanism is the best way of finding out consumer preferences. LOOPHOLES: ERP on some roads may simply have the effect of diverting traffic, and hence congestion, to roads where there are no ERPs. As a consequent more ERP gantries have to be set up where traffic has increased thus creating a problem of “chasing after the jam”. Main Solution 2 (Certificate of Entitlement - COE): In theory, this is a quota system to restrict car ownership used in Singapore. Officially called the VQS (vehicle quota system), it requires a car buyer to purchase a Certificate of Entitlement (COE) for the purchase of new vehicles. The supply of COE is strictly regulated/rationed by the government while the price of COE is subject to bidding, hence it is determined by market forces. Prices of COEs sometimes soared, whilst at other times it might plummet according to demand and supply of COE in the market over time. Thus, to effectively control car ownership, the government will be reducing the number of COE for bidding over time so as to increase the price of COEs in order to deter car ownership. 

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HWA CHONG INSTITUTION Year Two H2 Economics 2014 Tutorial #22: Microeconomics II – Market Failure & Government Intervention

Note: COE is not a form of marketable permits.

Limitations (GOVERNMENT FAILURE)  LACK OF INFORMATION: Government may estimate the number of COEs wrongly. There were times that the price dropped to $1 when many cars were scrapped and the number of COEs in the open market increased tremendously.  BLUNT INSTRUMENT: it affects those who are not within the targeted group. Those who usually drive during off-peak which do not contribute to the congestion also end up paying high COEs.  NEGATIVE IMPLICATION: However, reducing COEs may have unintended consequences as it might leads to more intensive use of cars on the road. It makes car ownership more expensive thus creating the incentive for car owners to maximise the benefit from car ownership by using their cars more often. In other words curbing ownership has paradoxically cause more usage and road congestion. Furthermore, the high prices of COE can be a cause of rising living cost in Singapore since expenditure on transport is a main component in the Consumer Price Index. Evaluation/Synthesis (Comparing ERP and COE): A few years back, our government tried to steer away from car ownership deterrence towards car usage as the objective should be to "punish" those who use their cars during peak periods or congested roads and not those who own cars. However, this has changed as the cost of car usage is deemed relatively much smaller compared to buying a car. I.e. Once a car is bought, it seems right to maximize the use to spread the fixed cost over more journeys and thus drivers are not deterred by ERP payment. So the government is curbing car ownership again. Be it deterring car ownership or discouraging driving during peak hours, perhaps a better solution is to provide an excellent and affordable public transport. Refer to ‘Solution 3’. Solution 3 (provide good substitutes to driving) The use of substitutes such as public transport is widely encouraged to divert the private motorist away from using their cars. In Singapore, the affordable, extensive and efficient transport network such as existing and new MRT lines and buses would encourage some private motorists to give up driving cars. Limitation: Public transport is not so effective for many Singaporeans who are getting richer and more status-conscious. Cars are positional goods which people aspire to possess once they become successful. Thus, no matter how efficient public transport maybe, it cannot completely replaced/substitute for car ownership. This is an issue the government needs to carefully manage in an affluent country like Singapore. Suggestion: Thus government has enacted certain regulations to ensure that public commuters do not get hindered by traffic congestion. This would include the use of bus only lanes during peak hour, restricting cars from using these dedicated lanes. By having these lanes, the issue of third party cost may be reduced when private motorist do not impede the public transport commuters from getting to work. However, bus only lanes are good if it is well policed. Some private motorists may breach the rule by entering the lanes. In addition, the cost of having dedicated lanes may be prohibitively high in land scarce Singapore.

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HWA CHONG INSTITUTION Year Two H2 Economics 2014 Tutorial #22: Microeconomics II – Market Failure & Government Intervention

BODY 2 – to reduce air pollution Mandatory installation of catalytic converter in cars; car scrapping and annual inspection: ensuring car exhaust emission from all vehicles in use meet the limits set by Ministry of Environment; banning of leaded petrol to reduce sulphur content diesel fuel; introducing tax incentives to narrow the price gap between electric/hybrid vehicles and conventional ones. Conclusion/Synthesis (FINAL JUDGMENT) At present, the issue of traffic congestion is adequately managed by a combination of restrictions on car ownership and usage, matched with an efficient public transportation while pollution is kept under control by various regulations. However, in the long run, with Singapore’s population increasing and not matched by an increase in land space, it would be almost impossible to increase the number of private vehicles. Thus the only viable solution in the future would be to get most of Singapore households to rely on public transport. Towards this end the government has already stepped up construction of MRT lines to link up various parts of the island so to provide a comprehensive rail network to offer a good alternative to private car ownership. Question 2: IJC 2012 (a) Explain whether expressways and traffic lights are examples of public goods. [10] Learning Objectives: 1) Applying the characteristics of rivalry and excludability to a good to arrive at a proper categorization. 2) Learning how to handle an ambiguous context, e.g. expressways are rival during peak-hours and non-rival during non-peak hours, excludable with a toll booth and non-excludeable without a toll booth. The matrix table below can be used to guide discussion.

Part (a) Public goods are those goods or services that are non-rival and non-excludable in consumption.  A good is non-rival in consumption if one person’s consumption of the good does not reduce the quantity available to another person. Because of this, once a public good is provided, the marginal cost of providing the good to an additional user is zero. With zero marginal cost, the basic principle 

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HWA CHONG INSTITUTION Year Two H2 Economics 2014 Tutorial #22: Microeconomics II – Market Failure & Government Intervention

of optimal resource allocation calls for provision of public goods and services at zero price or no charge. However, if the price is zero, no firm would want to supply the good. This results in a missing market. 

A.

A good is non-excludable in consumption if it is difficult to exclude non-payers from enjoying the good. This gives rise to a free rider problem. Since non-payers can also enjoy the good, no one would be willing to pay for it. As a result, demand is concealed and difficult to estimate. With no price and marginal cost, this leads to zero production resulting in complete market failure. EXPRESSWAYS

Rivalry  A motorist’s use of the expressway will not reduce the quantity available to other motorists during off-peak hours. However, rivalry occurs when there is overcrowding during peak hours. 

There is additional cost involved in allowing one additional motorist to be on the expressway during peak hours, such as the time loss due to traffic congestion. This means that there is a price that consumers would be willing to pay, hence producers will be willing to produce since it is possible for them to charge a price. Debatable

Excludability  Expressways can be treated in the same way as a public good. However, in reality, it is possible to exclude non-paying motorists from using the expressway. ERP charges can be collected for the use of expressway, i.e. non-excludability in consumption. This can be done either manually via toll booths where cars are barred from entering the expressway if they do not pay a fee or using the ERP gantry system. 

B.

There are administrative costs involved in collecting money for use of expressways e.g. labour costs or the high initial cost of building ERP gantry. Hence, government may choose not to build the gantry at some areas and as a result there is non-excludability in consumption. TRAFFIC LIGHTS

Rivalry  The use of the traffic light by pedestrian does not reduce the “quantity” available to another pedestrian. This will mean that the cost of providing service of traffic light to an additional pedestrian is zero. Since optimal resource allocation is attained where P = MC. Since the marginal cost of providing additional unit of traffic light is zero, it will efficient when the price of it is set at zero. Profit-maximizing producers are not willing to produce traffic light since they are unable to charge a price for the use of it. Excludability  Once the traffic light is provided for a consumer, others who do not pay for the use gets to use the traffic light as well. There is no way to obtain payment from each consumer who is using the traffic lights. Hence, it is difficult to exclude non-payers from enjoying the service provided by traffic lights. This gives rise to the problem of free riders, and no one is willing to pay for the use of the service. As no one is willing to reveal his demand for public goods, this means that there is concealed demand. In this case, no profit maximizing producers will want to produce traffic lights.

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HWA CHONG INSTITUTION Year Two H2 Economics 2014 Tutorial #22: Microeconomics II – Market Failure & Government Intervention

Conclusion  Traffic light is an example of public good as it satisfies the two characteristics of non-rivalry and non-excludability. Expressways can be considered as a public good although the characteristic of non-rivalry may not hold true all the time. 

For a good to be classified as a pure public good, it must satisfy the two characteristics of nonrivalry and non-excludability. Therefore, it can be concluded that traffic light is an example of public good, whereas expressway is not a pure public good.

Mark Scheme Level L3

Descriptors Well-developed explanation on the key characteristics of “public good” in terms on degree of rivalry, degree of non-excludability and extent of market failure. There is a clear stand on whether traffic light and expressways are examples of a public good.

Marks 7-10

L2

Under-developed explanation on concept of “public good”. Unable to make clear links between the characteristics of a public good and nature of the two goods.

5-6

L1

Descriptive answer with little economic analysis.

1-4

Question 3: Adapted from RJC 2011 and IJC 2012 (a) Distinguish between public and merit goods. [10] (b) Assess the economic case for free university education in Singapore. [15] Schematic for Q3(a) Intro  

Define public goods Define merit goods

 

Body Distinguish based on rivalry, excludability and provision Use examples Conclusion

Tutor's notes: Emphasize on the command word "distinguish" which affects the structuring of the essay. It requires the two concepts of merit good and public good to be contrasted (no need for similarities!) throughout the answers. The contrast of concepts can be done by using the at least three key criteria identified. It should be understood that real-life examples should be cited to achieve Level 3 marks. The matrix below can be used for brainstorming/planning to "scaffold" the writing process. Introduction: 

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HWA CHONG INSTITUTION Year Two H2 Economics 2014 Tutorial #22: Microeconomics II – Market Failure & Government Intervention

(Adopt KIA structure in Intro)  Provide definitions of Merit good and Public good  State approach of "distinguishing" the concepts using criteria: rivalry, excludability and provision Body: Distinguishing Criteria Rivalrous in consumption - Definition: The consumption of the good by one person diminishes the amount available for another person to consume.

Excludable in consumption - Definition: Means that it is technically possible or feasible to exclude anyone who has not paid for the good/svc from consuming it once it is produced. Provision

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Merit goods

Public goods

Yes Explain the concept of rivalry using an example of one person’s consumption of healthcare service such as flu vaccination when one person consumes vaccination, there will be one less available for the others Yes Explain the concept of excludability using an example of consumption of flu vaccination the direct benefits from the consumption of the flu vaccination is confined to those who pay for the vaccine Provision by private sector Due to the rivalrous and excludable characteristics of the merit good, it can be provided by the private sector. Due to the characteristic of excludability  those who wish to enjoy the good must pay for them  Firms are therefore able to charge a price for the good since there is an expression of demand  Rational profit maximizing firms will hence be incentivized

No Explain the concept of non-rivalry using an example of street lighting The consumption of street lighting by one person does not diminish the quantity or quality available for the next person.

No Explain the concept of non-excludability using an example of street lighting No single person has to pay to enjoy the light provided by street lighting. i.e. it is technically impossible / prohibitively expensive to exclude anyone who walks on the street from benefiting from it even though he /she doesn’t pay for it directly. Provision by government Non-provision by private sector, can only be provided by the government (financed by taxation) Non-rivalry  cost of supplying the good to an additional consumer is zero i.e. MC=0  to achieve AE, P = MC = 0  not possible for private sector to supply the good if P = 0 since private firms are assumed to be profitmotivated  Since there will be zero allocation of resources to the provision of the public good, there is a misallocation of resources and AE is not achieved, leading to market failure, calling for the government intervention.

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HWA CHONG INSTITUTION Year Two H2 Economics 2014 Tutorial #22: Microeconomics II – Market Failure & Government Intervention

to supply the good for a profit *Note: However, while the free market tends to produce merit goods, it tends to be underproduced and underconsumed due to problems of imperfect information and the existence of positive externalities. So, the provision of merit goods tends to create that of a partial market failure problem.

Non-excludability  free-rider problem  no expression of demand/concealed demand  firms are unable to charge a market price for the good without information with regards to demand for the good.  unprofitable for private firms to supply the good  free market thus allocated zero resources to the provision of this good, leading to complete market failure.  government intervention required Due to the characteristics of non-rivalry and non-excludability, no resources will be allocated to the production of public goods when left to the private sector. The problem of a complete market failure calls for the government to intervene to provide for such goods that yield high positive externalities.

(b) Assess the economic case for free university education in Singapore. [15] Option 1: For weaker classes that have lesser tutorial time, please see resources at DropBox-> C2 H2 Econs -> Lectures, Notes, Slides and Tutorials -> Market Failure -> Tutorial Sharing -> Sharing for Essay Qn 3 by David Chong -> Option 1 resources Option 2: For stronger classes that have more tutorial time to conduct a debate, please see resources at DropBox-> C2 H2 Econs -> Lectures, Notes, Slides and Tutorials -> Market Failure -> Tutorial Sharing -> Sharing for Essay Qn 3 by David Chong -> Option 2 resources Schemmatic for Q3(b) INTRODUCTION BODY Thesis I: Merit Good Argument Thesis II: Income Inequality Anti-thesis I: EMB hard to determine; EMB Anti-thesis II: Equity issue from free higher varied across university courses and other education and other counter-arguments counter-arguments SYNTHESIS CONCLUSION Introduction  Market failure occurs when markets operating without government intervention, fail to deliver an efficient or optimal allocation of resources.

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HWA CHONG INSTITUTION Year Two H2 Economics 2014 Tutorial #22: Microeconomics II – Market Failure & Government Intervention

 

Therefore, social welfare may not be maximised – leading to a loss of allocative and productive efficiency (i.e. welfare losses for society). The economic case for free university education can be examined mainly based on the relevant sources of market failure in university education, namely merit good and equity arguments.

Thesis I: Economic Case for Free University Education - Merit Good  The market for university education in Singapore can be an example of a merit good.  It has positive externalities and is deemed intrinsically desirable by the government.  Coupled with imperfect information, the good tends to be under-consumed when left to an individual.  E.g. Many young people can be myopic when making university and degree course decisions. Or they may be averse to taking on debts even though it might be in their long-term financial interest to do so.  Thus, to correct market failure, government intervention is required to achieve a more efficient allocation of resources so as to ensure that society’s welfare is maximised.  The Private Marginal Benefit (PMB) to the students receiving university education refers to additional benefits from consuming an additional unit of higher education, like improvement in knowledge and ability to secure a higher paying career.  The Private Marginal Cost (PMC) measures the additional cost to universities from an additional unit of education produced, such as the wages of professors, utility bill.  The External Marginal Benefit (EMB) refers to benefits accrued to third parties who are not directly involved in the consumption or production of the university education.  For example, there is compelling evidence that human capital increases productivity and thereby increases an economy’s trend rate of growth and international competitiveness.  Education is found to yield additional indirect benefits to economic growth for example by stimulating capital investments and technological development and adoption across many different industries in Singapore, like biomedical and finance sectors.  However, the third parties in the society do not compensate students for the external benefits they reaped. Hence in this case of a positive consumption externality, the students are not concerned about the external benefits to third parties but their own private benefits as the external benefits are "unpriced" by the price mechanism and not included in the private benefits.  As such, we can say that the free market has “over-priced” the consumption of university education which will lead to an inefficient allocation of resources and hence market failure.  For each additional unit of education, the social marginal benefit (SMB) includes the private marginal benefit (PMB) plus the external marginal benefit (EMB). Hence, the actual benefit reaped by the society is represented by the SMB, which takes into account the full benefits to society of an extra unit of education.

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Figure 1: External benefit from consumption of university education Price PMC=SMC (since EMC=0) B

EMB at Qm

PS

Pm

A SMB = PMB + EMB PMB Qm



  

 

QS

Quantity

As seen in Figure 1, the presence of an external benefit causes a divergence between private and social benefits, with SMB above PMB as SMB = PMB + EMB. Assume that consumption of education in this case yields no negative externality, EMC=0. Thus, PMC=SMC. (Assuming perfect competition, market equilibrium quantity of education is Q m, where PMB = PMC, as consumers and producers of vaccines only consider their own benefits and costs.) However the socially efficient quantity of education should be at QS where SMB=SMC, where the full costs and benefits and costs to society are considered. Q m is less than the market equilibrium quantity, QS. where PMB = PMC. Thus there is underconsumption of education by the quantity Q S – Qm. The merit good argument hence forms the main economic case for free university education when the positive externailties generated is sufficiently high. Theoretically, the government might provide a subsidy to producers corresponding to the external marginal benefit i.e. subsidy = EMC at QS (distance BD) on each unit of education. This shifts the PMC downwards so that the new PMC, which equals PMC – subsidy, coincides with the PMB at QS. Figure 2: Subsidy to internalise EMB from university education Price PMC=SMC (since EMC=0) B

PMC – subsidy

PS A Subsidy = EMB at QS

Pm D

SMB = PMB + EMB

PMB

PS – s 

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HWA CHONG INSTITUTION Year Two H2 Economics 2014 Tutorial #22: Microeconomics II – Market Failure & Government Intervention

   

Qm Qs Quantity Hence, the new market equilibrium quantity where PMB = PMC – subsidy, now coincides with the socially efficient quantity QS, where SMB = SMC. If the subsidy accurately reflects the external marginal benefit, students are now in effect being compensated for the external benefit they bring to third parties as the price they are paying is now lower at PS – s, compared to Pm before the subsidy. The externality has then been internalised. Besides positive externality, information failure may also occur as students cannot possibly know the specific private benefit to them of getting good grades at university. They will be well aware of the sacrifice required to study, but will not know the benefits to them in terms of a future job, salary, status and skills. Therefore, government subsidy may also be used to address the underconsumption of university education due to information failure.

Anti-thesis / Evaluation :  Subsidies used to internalise a positive externality is a market-based approach.  This approach gives private individuals the freedom of choice in making rational decisions with regard to the best level of consumption that would maximise society’s welfare.  The government’s role is not to replace the market but to help markets price in the externality so that private individuals can take into account the full social benefits of consuming university education.  However, in practice, it is difficult to determine the amount of subsidy accurately in order to attain the socially optimum level of education, as it is difficult to accurately measure the extent of EMB due to tangible and intangible benefits.  To argue that the EMB is sufficiently large to warrant a large subsidy such that P=0 is highly debatable. (Especially, when compared to primary and secondary levels of education, the EMB of tertiary education may be significantly lower, with PMB significantly higher.)  Therefore, if the main benefit of a degree is a higher salary to the student, it seems justifiable that the recipient of this benefit should pay for the personal benefit he/she receives. Thus associated to the subsidy is equity consideration (which is discussed below).  In addition, the levels of EMB also vary at different types of university education – the EMB may be higher for certain specialization, such as medicine and law, as opposed to Archeology. (This is again a highly "normative" issue, but given the context of Singapore, it is likely to be the case.)  If this is indeed the case, varied subsidy amount catering to different types of higher education may need to be imposed (according to the varied extent of EMB generated).  Last but not least, in the analysis, we assumed that PMC=SMC, hence the potential negative externalities of higher education have been mainly ignored in the debate.  An alternative to heavy subsidies by the government, would be direct provision of university education to supplement the underproduction by the private sector. In Singapore’s case, however, the government does not provide university education at no cost to the consumer, but rather contributes to the costs of setting up the public universities (campus construction etc).  Thus, on balance, based on the merit goods argument, the ground for free university education across the board seems shaky. A more calibrated approach of "customized" subsidy according to EMB by university courses may be required. Thesis II: Economic Case for Free University Education – Income Inequality 

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 





There is also a common argument that university education should be free to ensure "equality of opportunity". Markets can generate what is perceived to be an ‘unacceptable’ distribution of income and too high a level of "social exclusion" where citizens of lower incomes are denied access to essential goods and opportunities considered ‘normal’ by a society, like university education. E.g. Public universities in Germany charge no or only marginal tuition fees, i.e. tuition fees are mostly or completely covered by public funds. Should Singapore be like Germany? In Singapore, the transition to a knowledge-based economy leads to more opportunities being created in sectors requiring highly skilled labour, like in biomedical sector, while the lower-skilled production is increasingly phased out. Those who are highly educated and possess the relevant skills experience a faster increase in income as the demand for such workers will increase while those who are low-skilled would have difficulty getting employment with the fall in demand for such workers. Thus, a re-distribution to the lower-income in the form of university subsidies can be used to reduce income inequality in Singapore (which has been deteriorating in recent years). If students from lower income group have to pay for university education, this may dissuade them from pursuing it. In theory, students could take out loans or work part-time, but this may be sufficient to discourage students from studying and instead may enter the job market earlier.

Anti-thesis / Evaluation:  Is it equitable for students to make a financial contribution to their degree education?  They stand to gain financially from a degree – education is an investment and it is rational for students to "borrow" at this stage of their life-cycle to finance such investment. It is rational to forgo current earnings in return for higher future earnings  Furthermore, access to higher education to people from less privileged backgrounds can be protected. Tuition fees can be "means-tested" to offset the danger that fees will hit lower income students hardest.  Funding tuition from general taxation is an expensive and poorly targeted way of intervening in the market, because graduates, who are predominantly found towards the top of the income distribution, benefit at the expense of everyone else e.g. why should non-graduates pay for the degrees of graduates?  The basis of promoting students to a higher level of education is solely on the basis of achievement, merit and hard work, upheld by the principle of meritocracy. Meritocracy recognises and rewards everyone who works hard and excels and it is the best means to maximize the different capacities of a small country like Singapore. Thus, to provide free university education may erode the incentive to work hard and excel which may be detrimental to the enhancement of human capital of Singapore. Furthermore, the argument that education should be provided free is much stronger for the case of primary and secondary education than for higher education to achieve meritocracy aim as it benefits more in the society. Other Evaluations – Intervention Cost & Government Failure  Intervention cost of the government in the provision of education has to be carefully considered. The Singapore government spends approximately S$9.7 billion in its education budget. To

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

increase such a hefty sum invested into education, there are high opportunity costs on government funds. There may also be government failure as well in terms of bureaucracy, inefficiency and lack of public support for free university education.

Conclusion  The economic case for free higher education in Singapore is based on merit good argument and income inequality considerations.  For merit good argument, even if positive externalities exist, it is unclear whether the extent is sufficient to justify a high subsidization, given high intervention cost and potential for government failure.  On the other hand, negative repercussions of free higher education on income inequality in the long term can be significant.  For Singapore, as the intervention cost of heavy subsidy is high, less extreme forms and multipronged approach in intervention in the market for higher education is required.  For instance, "mean-tested" subsidy, coupled with other bursary schemes to help the students from less-privileged background can be used to tackle the equity issue. Question 4: TYS 2008 Q3 (a) Explain why imperfect information and immobility of factors of production may lead to market failure. [10] (b) Evaluate the policies currently used by the Singapore government to correct these causes of market failure. [15] Examiner’s Report: This was a popular question but it proved difficult for many candidates to access the higher mark range because there was a widespread inability to link the two concepts to market failure adequately. Thus the term ‘market failure’ all too often triggered a prepared response on market failure in general rather than one that was well directed to the question set. That said, it must not be overlooked that a significant minority were exceedingly well prepared for this question. These candidates were able to explain why both imperfect information and immobility of factors of production leads to market failure in part (a) and to evaluate the policies employed in Singapore in part (b). (a) Many candidates wrote at length either on the issues that result in negative/positive externalities causing market failure or on issues linking monopoly to market failure. There was limited attempt to link these responses either to imperfect knowledge or to immobility of factors. Where a link was made, many candidates considered only imperfect knowledge. This was really surprising because often the same candidates, when answering questions on the macroeconomics part of the examination paper, used the concept of immobility of factors due to lack of education or skills in explaining why there is a need for supply-side policy. The best answers used a number of approaches. Some argued that a lack of information about external costs and benefits will cause market failure. This approach was accepted, provided an explicit link to imperfect information was made. Others explained that individuals may not also be able to value private

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benefits and gave current examples relating to the market for healthcare within Singapore. These excellent answers also referred to the difficulties in achieving productive efficiency if labour, land and capital were not perfectly mobile. Often these candidates referred to both occupational and geographical mobility. These candidates explained why labour may not have the skills to switch jobs when there was a structural change in the economy and this may lead to market failure in the sense of absence of productive efficiency. The problems of governments being unable to value the cost of externalities were also alluded to in terms of imperfect information. Weak candidates often confused ‘imperfect knowledge’ with imperfect markets, and assumed that consumers did not have knowledge of prices or of products produced by monopolists.

(a) Explain why imperfect information and immobility of factors of production may lead to market failure. [10] Simple Schematic Plan INTRODUCTION BODY How imperfect information leads to market How immobility of factors of production leads failure to market failure (1) Due to ignorance of (2) Due to ignorance of Labour immobility Capital Immobility the actual benefits benefits/costs to - occupational to oneself others (EMB/EMC) - geographical - If perceived benefits are less Only use ‘SEED’ for 1 than the actual perspective under benefits, it will time constraint. lead to underconsumption Note: In fact, if - If perceived ‘SEED’ is already benefits are been used for (1), this more than the part will be brief as actual benefits, it there is still will lead to over- immobility of FOP to consumption be covered. Only use ‘SEED’ for 1 perspective under time constraint. CONCLUSION SUGGESTED ANSWERS INTRODUCTION Key words Market failure occurs when free markets, operating without any government intervention, fail to deliver an efficient allocation of resources to produce goods and services. Issue & This essay aims to explain why imperfect information and immobility of factors of Approach production may lead to market failure.

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BODY (A) HOW IMPERFECT INFORMATION MIGHT LEAD TO MARKET FAILURE In an efficient market, both buyers and sellers have good knowledge of the product in order to make rational decisions that equate marginal benefits to marginal costs. When imperfect information exists, buyers and sellers are prevented from achieving the efficient outcome. The inefficient allocation of resources leads to welfare loss. The case of health care is a classic case whereby consumers (i.e. patients) may have very poor knowledge about their health conditions and rely on the doctors to give them the information. E.g. patients suffering from the early stages of a serious disease may not consult their doctor until the symptoms become acute, by which it may be too late. This is the problem of ignorance. Misallocation  Such imperfect information will result in misallocation of resources in providing the service or drugs for the patients.  In the case of ignorance, consumers might end up under-consuming medical/health-care services e.g. health-screening for major illnesses like cancer etc. They fail to go for regular check-up as their perceived benefits are lower than the actual benefits.  Yet, there could be cases where consumers buy products that leave them worse off. For example, smokers fail to realize the harm smoking brings about such as lung cancer to themselves and also people around them. Their perceived benefits are much higher than actual benefits as they only take into account of the enjoyment or satisfaction they gain from smoking and are unaware of the harm it does to their health. Also, if they are more aware of the harm they have done to passive smokers such as their family members, they might cut back on smoking. Such ignorance will lead to over-consumption and thus over-production. Example of colorectal cancer screening Ignorance of benefits to oneself 

Consumers may underestimate their true private marginal benefits from colorectal cancer screening due to imperfect information. For example, if consumers knew that colorectal cancer is now the most common cancer in Singapore affecting both males and females, they would realise that the benefit of such screenings is that it has a good chance of detecting the cancer early. Furthermore, the early stage of colorectal cancer is often localised to the bowel and hence early diagnosis can often lead to a complete cure. Figure 1: Imperfect information on actual PMB of cancer screening Price PMC = SMC (assume EMC = 0) C

B

PMB actual = DD (perfect info)



A

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HWA CHONG INSTITUTION Year Two H2 Economics 2014 Tutorial #22: Microeconomics II – Market Failure & Government Intervention

PMB perceived = DD (imperfect info) Qm      

QS

Quantity

Assume that there are no positive or negative externalities. As seen in Figure 9 above, with imperfect information, consumer demand for colorectal cancer screenings is lower at PMB perceived as they underestimate the actual benefit of such screenings. As such, the market equilibrium quantity would be at Qm where PMB perceived = PMC. However, the true private marginal benefit should be at PMB actual. Hence, the socially efficient quantity should be higher at QS where PMB actual = PMC. Hence the ignorance of the full benefits of colorectal cancer screenings causes an underconsumption QS – Qm of such screenings.

 

Area QSQmCB is the actual total private benefit gained for the underconsumption QS – Qm. Area QSQmAB is the total private cost incurred for the underconsumption QS – Qm.



Since the actual total private benefits gained exceeds the total private costs incurred for underconsumption QS – Qm, area ABC represents the deadweight welfare loss due to underconsumption of QS – Qm.

(B) HOW IMMOBILITY OF FACTORS OF PRODUCTION MIGHT LEAD TO MARKET FAILURE Immobility of factors of production contributes to market failure as resources cannot respond to Market incentives to produce goods and services demanded by consumers or disincentives to stop or cut production. The greater the immobility of factors, the more difficult it is for markets to achieve socially efficient allocation of resources. The 2 most common context of factor mobility: (a) labour immobility (includes occupational immobility and geographical immobility) (b) Capital immobility. Explain how occupational immobility of labour leads to market failure (STRUCTURAL UNEMPLOYMENT)  Very often as an economy progress, there will be a shift of focus in the types of industries in the economy.  For instance, a developed economy may create more employment opportunities in the service sector whereas the manufacturing industries are facing a decline in their business due to a loss in the comparative advantage.  Despite greater opportunities in the service industries, workers are not able to switch jobs immediately to work in the service sector due to occupational immobility. They lack the skills to work in this sector.  Thus, even though there may be abundant supply of workers in the economy, they will not be able to fill the job vacancies that are created in the service sector. These workers become structurally unemployed.  For example, a large number of unemployed factory operators with primary school education in Singapore may not be able to work in growing industries like pharmaceutical 

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industries. This implies that there is a mismatch of skills between the unemployed and those required in expanding sunrise industries in Singapore. Explain how geographical immobility of labour leads to market failure  Workers are not able to travel to another location to work even though there are job vacancies. Geographical immobility exists in large countries (e.g.UK, USA, China and India) when there are barriers to prevent people moving from one region to another in search of jobs.  These barriers include family and social ties, costs involved in moving home, regional variations in house prices and differences in the general cost of living between regions.  Thus market failure occurs because resources are not being reallocated from areas with few jobs opportunities & unemployed labour even though there is high demand for labour & plenty of job vacancies in another region/country or industry. Explain how geographical immobility of capital leads to market failure  Certain capital goods are difficult to transfer from one use to another. E.g. A train once built is only useful as a train. It cannot be changed into a car or a plane. For other capital goods, it is difficult to transfer it from a geographical location to another. For example, a petrochemical plant built in China cannot be easily uprooted and transferred to the US.  In research and development there is a need to make capital more mobile in order to channel more funds to bring about the discovery of cutting edge technology or new cures for deadly flu virus CONCLUSION (b) Evaluate policies currently used by the Singapore government to correct these causes of market failure. [15] Examiner’s Report: (b) Answers to this part of the question tended to fall into two broad types of response: those that addressed the question and those that wrote in length about policies to resolve any and all forms of market failure in general terms. Many candidates wrote at length about policies designed to reduce monopoly power without any reference whatsoever to either imperfect information or immobility of factors. There were some very good answers but these were in a relatively small minority. These candidates examined a range of policies to overcome the problems caused by imperfect information – in the context of Singapore these included health warnings on cigarette packets, better product labeling to encourage healthy eating, compulsory education and the requirements for medical practitioners to clearly display prices so that patients are given full knowledge of the likely cost of their treatment. Where lack of information about externalities was used to explain market failure, appropriate policies to correct for this failure in the Singapore context were given. A common example of evaluative judgement was the problems of government failure when setting taxes or subsidies to overcome market failure due to externalities. In terms of a lack of factor mobility, candidates often referred to government policy in terms of training and skill enhancement and in research and development needs to make capital more 

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mobile. Good evaluative comment explained that the Singapore government had done much to improve transport facilities and that geographical mobility was less of an issue in Singapore than in many larger countries. Simple Schematic Plan INTRODUCTION BODY Policies that correct imperfect information Policies that correct immobility of factors of production (1) Correct ignorance of (2) Correct ignorance of Correct labour immobility Correct capital benefits to oneself benefits to others through supply-side Immobility through through education (EMB) through policies such as supply-side policies subsidy and training /education & such as tax incentives correction of better infrastructure and financial help ignorance of costs to others (EMC) through taxation Explain how these policies work and possible limitations. CONCLUSION SUGGESTED ANSWERS INTRODUCTION The Singapore government is current using various policies especially supply-side policies to correct these two causes of market failure. This essay will aim to explain how they work and possible limitations. Solutions to correct imperfect information For ignorance of own benefits and positive externalities (benefits to third party), the Singapore government uses public education to encourage the consumption of healthcare products or services. The Health Promotion Board in Singapore often organizes health education program in schools and runs national campaign nationwide to inform the public about the benefits of healthcare. Residents will be more aware of the full social benefits of health to themselves as well as to society at large. With such awareness talks and campaigns, the more accurate assessment of PMB and thus moving PMB perceived nearer to or even reach the PMBactual. Referring to Figure 1, with perfect knowledge, consumers will be able to know the actual PMB of colorectal cancer screening and hence consume at the socially optimal level Qs where PMBactual = PMC, eliminating the welfare loss area ABC. Limitations: Education is a long drawn process that involves changing mindsets. It is not merely the dissemination of information by the state. Its effectiveness depends on whether the information is treated as credible or merely state propaganda. For instance, the ill effects of smoking is sometimes derided as scare tactics used by the without proven scientific basis. Private tobacco companies have attempted also to provide evidence to debunk the link between smoking and cancer. 

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HWA CHONG INSTITUTION Year Two H2 Economics 2014 Tutorial #22: Microeconomics II – Market Failure & Government Intervention

It is often difficult to change the mindsets of people in adopting a healthier lifestyle or to go for immunization to prevent certain diseases. Individuals tend to make decisions based on private benefits and costs, ignoring the external benefits of consuming healthcare services sufficiently. Solution to correct immobility of factors of production SUPPLY-SIDE POLICIES to overcome occupational immobility of labour (macro policy)  The Singapore government encourages the workers to attend courses to upgrade their skills to meet the changing demand of the economy. They provide retraining programmes to help workers obtain the requisite skills for the new economy. For example, in Singapore, the Workforce Development Agency (WDA) developed a Continuing Education and Training (CET) infrastructure, based on an established network of Industry Skills and Development Councils, to help it chart the future of manpower development in each economic sector. EDB, in conjunction with the WDA, also helps in the retraining of PMETs (Professionals, Managers, Executives and Technicians).  In 2008 the government introduces the Skills Program for Upgrading and Resilience (SPUR) where a subsidy is provided to workers who attend higher courses to upgrade their educational knowledge and skills.  This reduces market failure caused by occupational immobility as the policy allows the workforce in Singapore to acquire new skills to find a job in the sunrise industries such as the service sector. Limitations: Success of training subsidies would depend on whether the age gap, attitude gap, aptitude gap & expectation gap with regards to training & job openings can be bridged. Policies to overcome geographical immobility of labour The Singapore government has also spent a lot of resources to improve the transport network system such as the extension of the MRT lines to more parts of the country and the building of more expressways to improve the accessibility and connectivity between parts of the island. This is to reduce geographical immobility so that workers are able to travel to different parts of the country to work. Evaluation: In small countries like Singapore, geographical mobility is less of an issue than in many larger countries especially after the government had done much to improve transport facilities. Policies to overcome geographical immobility of capital For capital immobility, governments can perhaps target certain sectors and encourage firms to purchase capital goods (that they view as important) by giving them preferential incentives (e.g., tax cuts, financial help). CONCLUSION Hence, the Singapore government has implemented appropriate policies to correct market failures arising from imperfect information and immobility of factors of production. Even though these policies may not completely correct the market failures, government intervention in the form of subsidies & education to correct underconsumption and taxes & campaigns to correct overconsumption/production as well as the constant improvement to a world class transportation network in Singapore will definitely reduce the extent of market failure due to imperfect information & 

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HWA CHONG INSTITUTION Year Two H2 Economics 2014 Tutorial #22: Microeconomics II – Market Failure & Government Intervention

factor immobility respectively. Resources are hence allocated more efficiently and the equilibrium level of output will be moved closer to the socially efficient level. Question 5: TYS 2011 Q1 Consumers and producers are generally assumed by economists to be motivated by self-interest. (a) Explain how, according to economists, the pursuit of self-interest can help to address the problem of limited resources and unlimited wants. [10] (b) Assess whether the price mechanism will always allocate scarce resources in the most efficient manner for all goods and services in a market economy. [15] Part (a) Examiner’s Report Although there were some excellent answers to both parts of this question, the vast majority of candidates gave a good response to part (b) with more superficial responses to part (a). (a) Most candidates showed an understanding of scarcity and the need to make choices. In consequence, the concept of opportunity cost was usually well illustrated. A minority of candidates referred to the maximisation of consumer surplus, CS (or private benefits from consumption) and producer surplus, PS (or profit maximisation). In these top responses, a good use was made of supply and demand diagrams on which CS and PS were clearly illustrated. Only a few candidates, however, linked scarcity to self-interest. The majority confined their answers to a simple supply and demand diagram with arbitrary prices above/below the equilibrium price and some explanation of how the surplus/shortage was removed.

Paraphrase the questions + requirements of the questions: This question asks how consumers and producers, when pursuing their self-interests, enable limited resources to be allocated despite their unlimited wants. Therefore, we need to understand what the respective self-interests of the consumers and producers are, how they go about pursuing them, and how their self-interests overlap. Dissect Question Using the 3’Cs’ C – Command word Explain: Use SEE approach C – Concept (s)

Limited resources and unlimited wants – Scarcity, which is in other words the ‘Central Problem of Economics’.

C – Context

Behaviour of consumers and producers in pursuing their respective selfinterests

A simple schematic Plan: INTRODUCTION BODY Pursuit of self-interest by: Consumers Producers - The self-interest of consumers revolves - The self-interest of producers revolves around around maximizing the consumer surplus maximizing the producer surplus they derive from 

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HWA CHONG INSTITUTION Year Two H2 Economics 2014 Tutorial #22: Microeconomics II – Market Failure & Government Intervention

-

-

from the consumption of goods and services, given their limited disposable income. Because their disposable income is limited, consumers are constrained by their ability and willingness to pay for goods and services. Consumers thus have to make choices since it is impossible for them to consume everything. Opportunity costs are thus incurred, because the spending of disposable income on one type of good or service means that another type of good or service has to be forgone.

the sale of goods and services, given limited resources and cost constraints. Because resources acquired and owned by producers are limited, producers have to make choices since it is impossible for producers to produce everything. Opportunity costs are also incurred because the usage of resources to produce one type of good or service means that the production of another type of good or service has to be forgone. Therefore, producers need to decide What to Produce, How to Produce and For Whom to Produce, given the consumers’ ability and willingness to pay.

CONCLUSION SUGGESTED ANSWERS INTRODUCTION Key Words

Consumers have unlimited wants, which refer to the desire for ever higher levels of consumption of goods and services, be it tangible items (e.g. food, clothes, and houses) or services which are intangible activities (e.g. banking, medical services). However, this is impossible in reality, as consumers and producers are constrained by limited resources, also known as scarcity.

Issue & Approach

No matter how much resources are available they are scarce in the sense that they are not sufficient to meet all wants. Individuals and societies must then make choices among the alternative uses so as to maximise the use of resources to achieve most wants. The problem with scarcity can be overcome (not solved, since scarcity is a permanent problem) when consumers and producers, each pursuing their own self-interests, interact to determine what to produce, how to produce and for whom to produce, given the limited resources.

BODY Behaviour of Consumers Features Consumers are constrained by their limited disposable income.

Elaboration Consumers are paid wages for providing their labour services to producers. The wages they take home after taxation by the government form their disposable income. No matter how high or low the disposable income, each consumer’s disposable income is limited. Since consumers have to pay a price, which takes up a portion of their disposable income, to producers in order to purchase goods and services, it is impossible for consumers to consume everything to satisfy their unlimited wants.

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HWA CHONG INSTITUTION Year Two H2 Economics 2014 Tutorial #22: Microeconomics II – Market Failure & Government Intervention

Therefore, consumers have to make choices regarding what goods and services to consume.

Given this limited disposable income, each consumer has to decide what goods and services to consume. It is therefore inevitable that their second best choice of goods and services to consume has to be forgone. This is also known as opportunity cost. Therefore, after weighing their first and second best choices, consumers consume according to their ability and willingness to pay. These are the two criteria for effective demand. Ability to pay has to be backed by sufficient purchasing power, which is derived from limited disposable income. Willingness to pay depends on the consumers’ tastes, preferences and degree of necessity for the good or service.

As a result, some goods and services are in high demand because consumers have the highest ability and willingness to pay for these goods and services. Consumers tend to be able and willing to pay a high price for these goods and services. The converse is also true. In doing so, Consumers place a value on each unit of good or service that they are able and willing consumers to pay, according to their perceived satisfaction from consuming that unit of good or hope to pursue service. Based on this, the effective demand curve can be constructed. their selfinterest, which Therefore, consumers enjoy consumer surplus when they end up paying a market price is to maximize that is lower than what they are able and willing to pay. Consumers thus earn ‘bonus’ their consumer satisfaction from not having to pay for every bit of perceived satisfaction from surplus at the consumption. Price ($) prevailing market price.

P* Demand Q*

Quantity of toys

From the diagram above, the given market price for each unit of toy is P*. Consumers will consume a total of Q* units. Consumers will not consume beyond Q* units, because they would lose consumer surplus since the market price P* would be higher than the price consumers are able and willing to pay. For units below Q*, consumers gain consumer surplus because P* is lower than the price consumers are able and willing to pay. Therefore, consuming at Q* maximizes consumer surplus, which is approximately represented by the shaded triangle under the demand curve and above the equilibrium price. Behaviour of Producers Features Producers

Elaboration are There is a finite number of resources that producers can acquire and hence make use 

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HWA CHONG INSTITUTION Year Two H2 Economics 2014 Tutorial #22: Microeconomics II – Market Failure & Government Intervention

constrained by of to produce goods and services at any point in time. Examples of resources include limited land, labour, capital and raw materials. resources available for production. Therefore, producers have to make choices regarding what goods and services to produce, and in what quantities.

Since not all wants can be satisfied, producers and consumers have to choose which wants to satisfy i.e. combination of goods and services to produce and how much wants to satisfy i.e. quantities to produce of goods and services. As mentioned earlier, some goods and services are in high demand because consumers have the highest ability and willingness to pay for these goods and services. Consumers tend to be able and willing to pay a high price for these goods and services. The converse is also true. Therefore, producers are inclined to channel more resources to produce goods and services that are in higher demand, and fewer resources to produce goods and services in lower demand.

The diagram above shows that initially, consumers have to pay a price of $75,000 for each car. At this unit price, the total quantity of cars demanded is 20,000. Car makers respond to this by channeling resources towards the production of 20,000 cars. When consumers have a stronger preference and/or a greater willingness and ability to purchase cars, demand for cars increase from DD to DD1. At the same price $75,000, there is a shortage of 10,000 cars at point B. This shortage puts upward pressure on car prices. Producers respond to this by channeling more resources towards the production of 4,000 more cars (A to C), since producers now stand to receive a price of higher than $75,000 for each car. Yet as the price increases, some consumers may realise that they are unwilling or unable to pay the higher price, hence total quantity of cars demanded falls by 6,000 (B to C). The market thus reaches a new equilibrium where quantity demanded equals quantity supplied at a higher price $100,000. In doing so, producers hope to pursue their self-interest, which is to maximize their

Therefore, the pursuit of self-interest encourages the use of resources in line with consumers’ preferences. The producers’ aim to maximise profits, which is approximated by producer surplus, will give them incentive to produce those goods that can fetch higher prices. Producer surplus is the excess of what a producer is willing and able to put up for sale 

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HWA CHONG INSTITUTION Year Two H2 Economics 2014 Tutorial #22: Microeconomics II – Market Failure & Government Intervention

producer surplus.

for a good or service over the actual price he receives. The higher the demand, the higher the price per unit and hence the larger the producer surplus enjoyed. Producer surplus is approximately represented by the area under the equilibrium price and above the supply curve. From the previous diagram, we see that by responding to the higher demand for cars, the producer surplus increases, which is beneficial to producers. Hence, there will be minimum wastage of resources in terms of producing goods that are not wanted, ensuring that more wants can be satisfied with the limited amount of resources. In addition, to reduce costs of production and hence further increase profits, producers may strive to make more efficient use of the limited resources needed to produce goods and services.

CONCLUSION Through all this self-seeking, a system develops that needs no planning and functions as if an invisible hand was guiding the economy and the problem of limited resources and unlimited wants could be alleviated. However, despite the fact that pursuit of self-interest enables the economy to produce more goods and services efficiently, it does not completely remove the problem of limited resources and unlimited wants. This is because as long as available resources are finite and human wants or desire to consume goods and services are infinite, scarcity would always remain a problem. From the above discussion, we can clearly see that the pursuit of self-interest can address the problem of scarcity by alleviating it but it does not help to solve the problem of scarcity. (b) Assess whether the price mechanism will always allocate scarce resources in the most efficient manner for all goods and services in a market economy. [15] Examiner’s Report Most candidates were well prepared for a question on market failures and gave appropriate diagrams supported by sound analysis. However, in the majority of cases, the efficient allocation of resources was not considered beyond vague assertions, meaning only a few grasped the importance of comparing market failures to the efficient solution provided by the free market paradigm.

Paraphrase the questions + requirements of the questions: This question requires you to recapitulate the meaning of allocating scarce resources in the “most efficient manner”. Is this possible in reality? What are the factors that may hinder resources from being allocated in the most efficient manner? A practical question you might want to ask yourself while attempting this question:  If the price mechanism were so perfect in allocating resources, then why is there more often than not a need for government intervention? It shows that the price mechanism is not entirely perfect… Dissect Question Using the 3’Cs’ C – Command word Assess: Thesis/anti-thesis expected; evaluation expected; conclusion with reasoned judgment expected. C – Concept (s) Efficient allocation of resources 

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C – Context

Free workings of the price mechanism in a market economy

A simple schematic Plan: INTRODUCTION BODY Thesis: Price mechanism is able to allocate scarce resources for all goods and services in a market economy. Anti-thesis: Price mechanism will lead to an inefficient allocation of scarce resources in a market economy due to the following reasons (give two possible reasons) CONCLUSION INTRODUCTION Address the issue:  Price mechanism refers to the free market forces of demand and supply from which the market equilibrium price and output of goods and services are determined.  To allocate scarce resources in the most efficient manner for all goods and services is to make the best or optimal use of resources to satisfy consumer wants and needs.  Whether the price mechanism will always allocate scarce resources in the most efficient manner for all goods and services in a market economy depends on the existence of sources of market failure and government intervention. BODY Thesis: Price mechanism is able to allocate scarce resources for all goods and services in a market economy.  Prices as the signaling and rationing functions to allocate resources:  Prices are used as signaling mechanism to indicate to producers what and how much to produce to satisfy consumer wants.  On the other hand, the profit-motive acts as the incentive mechanism to drive producers to supply according to the tastes and preferences of consumers. Hence the tastes and preferences of consumers dictate 'what' and 'how much' to produce for each type of goods and services. The higher the demand for a good as tastes and preferences changed towards that good, the higher the market equilibrium price will be, cp.  Resources will then be diverted to the production of goods (rise in quantity supplied and equilibrium quantity, ceteris paribus) which fetch higher market prices as desired by the consumers. (What to produce)  Producers would only supply the right or desired quantities of the goods. Any shortfall in supply would be indicated by rising prices and more resources would be diverted to producing them. Conversely, over-supply would be indicated by falling prices and resources would be diverted away from their production. (How much to produce)  Prices are also used as a rationing mechanism. The price mechanism works to distribute goods and services only to those with both willingness and ability to pay for them. In this sense, price mechanism is said to be efficient in allocating the scarce resources used to produce goods and services that are most highly valued by consumers as indicated by the high demand and high equilibrium price. (From whom to produce)

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However, this is only true if consumers who value the goods most highly have the ability to purchase them. Those who lack the purchasing power will not have access to the goods. Hence, there may be an inequitable allocation of resources. Anti-thesis: Price mechanism will not ALWAYS allocate scarce resources in the MOST efficient manner for all goods and services in a market economy/ Price mechanism will lead to an inefficient allocation of scarce resources in a market economy… … with the existence of any of the following: (i) Public Goods (ii) Externalities (iii) Imperfect Information (iv) Market Dominance Discuss at least 2 sources of market failure above and explain how each leads to inefficient allocation of resources, using diagrams. Evaluation: With government intervention, price mechanism may allocate resources more efficiently. CONCLUSION Stand: Price mechanism will always allocate scarce resources in the most efficient manner when the economy is operating under conditions of perfect competition and no presence of externalities. If any of these conditions is not met, in a free market, price mechanism would result in an inefficient allocation of resources ('market fails') and there would be a need for the government to step in to correct this market failure and achieve a better allocation of scarce resources. Question 6: TYS 2001 Discuss whether the price system is the best mechanism for the allocation of economic resources. [25] A simple schematic plan: INTRODUCTION BODY Thesis: Price mechanism may achieve efficiency in resource allocation Anti-thesis: Price mechanism is unable to achieve efficient allocation of resources Synthesis: Possible roles of government intervention in resource allocation CONCLUSION Introduction Theoretically, the price mechanism can be the best apparatus in the allocation of scarce economic resources according to the preferences of the consumers. This outcome is achieved when the price's signaling and incentive functions lead producers to produce only goods and services that are most 

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desired by consumers in the correct or right quantities, using the most efficient methods of production. However, in reality, the mechanism does not always achieve economic efficiency. The essay will discuss how the price mechanism may not achieve economic efficiency in resource allocation. Thesis: Explain how price mechanism may achieve efficiency in resource allocation Demand and supply analysis can illustrate how economic efficiency may be achieved via price mechanism in the free market and highlight the conditions necessary for this outcome:  Price act as a signal between consumers and producers to allocate scarce resources  Goods and services are produced according to consumers’ willingness and ability to buy, thus it reflected consumers’ preferences.  These preferences are transmitted to producers; who used the most efficient way (least cost) to produce these goods and services.  Price mechanism also ensures productive efficiency as it assumes the producers will use the least-cost production techniques, avoiding wastage of resources. (productive efficiency (min LRAC) can be achieved in a PC market.) Price mechanism is described as an "invisible hand", its automatic, thus no need for costly coordination, bureaucracy etc.  Price mechanism can achieve allocative and productive efficiency - produce the right quantity at the least cost.  This can be illustrated by considering situations where prices is above the equilibrium – surpluses occurring which drives down prices, which according to the law of demand, increases quantity demanded and with that of the law of supply, decreases the incentive to produce and hence a fall in quantity supplied, returning the market back into equilibrium where demand equals supply, an automatic adjustment which caters to the desires and ability of both consumers and producers. Under perfect competition (i.e. with no market dominance) and where there is no externalities: DD = PMB = SMB and SS = PMC = SMC  Allocation of resources is socially efficient (socially desired) in a market economy when the Social Marginal Benefit (SMB) = Social Marginal Cost (SMC)  This means that the additional benefit of producing/consuming one more unit of good is equal to the additional cost incurred in producing/consuming one more unit of the good. Social welfare is thus maximised. Illustrating this diagrammatically: Figure 1: Socially Efficient level of Good X using marginalist principle Price A SS = PMC = SMC SMBQ1 SMCQ2

B

SMBQs = SMCQs P1 SMBQ2 SMCQ1 

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HWA CHONG INSTITUTION Year Two H2 Economics 2014 Tutorial #22: Microeconomics II – Market Failure & Government Intervention

DD = PMB = SMB C Q1  

QS

Q2

Quantity

At QS, SMB=SMC. Hence the quantity of good X produced is socially efficient and social welfare is maximised. I.e. An allocative efficient amount of resources are used to produce the socially desirable quantity of Good X. Why is social welfare maximised at QS? Let’s see what happens if quantity is less or more than QS. Our analysis below is based on the marginalist principle, also known as ‘thinking at the margin’.



At Q1, SMBQ1 > SMCQ1. Thus society values an additional unit of Good X more than the additional cost that will be incurred in its production. And this is the situation faced for any quantity of Good X that is less than QS. Hence, social welfare is not maximized and there is room for improvement in social welfare if the quantity of Good X is increased until QS. So at Q1, there is underproduction/consumption of the good.



At Q2, SMBQ2 < SMCQ2. Thus society values an additional unit of Good X less than the additional cost that will be incurred in its production. And this is the situation faced for any quantity of Good X that is greater than QS. Hence, social welfare is not maximized and there is room for improvement in social welfare if the quantity of Good X is decreased until QS. So at Q1, there is overproduction/consumption of the good.

Thus, social welfare will be maximised when output is at the socially optimal level Q S where SMB = SMC. At QS, there will be no more under-production/consumption or over-production/consumption. In this case, the social welfare generated is the area ABC, the sum of the consumer and producer surplus. Anti-thesis: Explain why price mechanism is unable to achieve efficient allocation of resources In a complex, uncertain environment, agents have imperfect knowledge; they are not able to predict the consequences of their actions. Without knowing all the information, it is unrealistic to expect price mechanism to achieve efficiency in resource allocation. Highlight any three conditions that might not be present for price mechanism to achieve efficiency:  Externalities  Public Goods  Imperfect markets  Inequity  Explain how the above factors lead to the failure of price mechanism to achieve efficient allocation of resources Synthesis: Discuss the possible roles of government intervention in resource allocation Will government intervention be justified when price mechanism fails to achieve efficiency?

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Will government intervention necessarily lead to a more efficient outcome?  What about possible government failures? Conclusion

L3 15 – 21 L2 10 – 14 L1 1–9

Knowledge, Application, Understanding and Analysis For a comprehensive and detailed analysis of the role of price mechanism in achieving efficient resource allocation. The answer illustrates an ability to recognise the underlying assumptions and conditions for efficiency to be achieved. The answer includes a sound conclusion based on economic analysis. For an undeveloped explanation that explains the concepts of efficiency and/or inefficiency. OR an answer that explains the role of price mechanism in terms of resource allocation without reference to efficiency. For an answer that shows some knowledge of concepts of efficiency, and/ or price mechanism without explanation. Answer contains several conceptual errors. Evaluation

E2 3–4

For an evaluative assessment based on economic analysis or empirical evidence.

E1 1–2

For an evaluative not supported by analysis.

Section D: Case Study Practice NOTE WHILE ATTEMPTING A CASE STUDY:  Take note of the headings of the extracts as they may drop some hints to the coverage.  As you read through the passages, HIGHLIGHT key points including statistics as you most likely need to quote some of them in the answers and link the passages to economics concepts.  You have to scrutinize (Note the year(s), units, axes and etc) the charts, figures and tables (if any).  Read through all the questions before start attempting.  You have to make some form of reference to ALL THE TABLES / CHARTS / FIGURES / EXTRACTS in the data. In other words, if you did not use info from a particular table/chart/figure/extract in the case study at all, it will mean you have left out some important information and that will lead to losing of some marks. (Refer to Case Study Skills package)

Question 1 – 2011 HCI H1 Economics Prelims The Market for Olive Oil Extract 1: The expanding olive oil market As the world begins to explore alternative uses of vegetable oils, especially those that held promises to be redeveloped as “Biodiesel”, olive oil has been spared from this oil hungry world. In an unexpected spin-off from the Eurozone contagion hitting the Mediterranean countries in 2011, Greek producers being uncertain of the future of the debt-laden state, are now hoarding stocks of olive oil rather than selling them on the open market. It is reported in The Grocer magazine in 2011 that there

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would be further increases in the price of the olive oil that is widely used in UK for frying and as a salad dressing since Greece is the world's third-largest olive oil producer, after Spain and Italy. Yet, we are seeing a continuous increase in production by the three main producer countries, Spain, Greece and Italy. The main reason is due to an increase of the field productivity which resulted from better crop and harvest practices, the use of irrigation and the disappearance of marginal fields. This is with the exception for the effects of El Nino which peaked in the middle of the decade. El Nino causes extreme weather (such as floods and droughts) in many regions of the world. Developing countries dependent upon agriculture and fishing are the most affected. Olive oil is considered a healthier and important ingredient in the traditional Mediterranean diet. The recent acceptance of olive oil by its new Asian markets is due to nutrition and health properties. Scientific studies of biological properties for olive oil have increased consumers awareness and interest in this product. Olive oil contains a wide variety of valuable antioxidants that are not found in other oils. Antioxidant compound in olives is believed to play a significant role in the many health benefits attributed to olive oil. Studies also suggest that olive oil has a protective effect against certain malignant tumors in the breast, prostate and digestive tract. The studies also suggest that a higher proportion of monounsaturated fats in the diet are linked to a reduction in the risk of coronary heart disease. Source: Adapted from www.independent.co.uk, 17 July 2011 Figure 1: World Price of Olive Oil

Source: International Monetary Fund Extract 2: Environmental effects of olive production in the EU

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Soil erosion is cited in numerous publications as one of the principal environmental problems associated with olive farming in Mediterranean regions. Soil erosion has various environmental impacts, notably the loss of productive capacity, leading to the need for increased external inputs and ultimately to desertification. Down-stream effects of run-off like excessive use of fertilizers and herbicides being washed into water courses and groundwater are also felt by the communities as their water sources become contaminated. Olive farms in the EU range from the very small (500ha) and from the traditional, low-intensity grove to the intensive, highly mechanized plantation. Overall, three broad types of plantations were identified: 

Low-input traditional plantations and scattered trees, often with ancient trees and typically planted on terraces, which are managed with few or no chemical inputs, but with a high labour input.



Intensified traditional plantations which to some extent follow traditional patterns but are under more intensive management making systematic use of artificial fertilizers and pesticides and with more intensive weed control and soil management. There is a tendency to intensify further by means of irrigation, increased tree density and mechanical harvesting.



Intensive modern plantations of smaller tree varieties planted at high densities and managed under an intensive and highly mechanized system, usually with irrigation.

As a result of their particular plantation characteristics and farming practices, the low input traditional plantations have the least negative effects on the environment. These plantations are also the least viable in economic terms and hence most vulnerable to abandonment. The intensified traditional and modern intensive systems are inherently having the greatest negative environmental impacts. Source: Adapted from Olive Oil Production in EU, 2008 Extract 3: Proposal for good agricultural and environmental practice in olive farming The EU constitutional rights allow the Member States to take various environmental measures in relation to agriculture, when they consider these to be appropriate. These measures may include specifying environmental requirements. Member States can decide on the appropriate financial penalties for not obeying the legal environmental requirements of EU. At the same time, it is important to establish the type of environmental conditions which are considered as appropriate. Member states can give support payments for its environmental friendly production. For example, farmers in an area with highly erodible crop land were required to draw up and implement a soil-conservation plan in order to be eligible for crop support payments. These plans could include options such as conservation tillage, contouring and the construction of terraces. However, it would be difficult to value the gains objectively. A plantation in a rural area might have less benefits reaped compared to one where there are communities. Problems also arise when there is a need to determine whether the correct plan has been used. For example, in Spain, soil erosion is widely cited as the principal environmental problem associated with olive plantations. Yet in Italy, it is

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the intensive exploitation of the land through the continuous tillage or spraying of residual herbicides to control weeds that had caused an impoverishment of the soil. Source: Adapted from The Environmental Impact of Irrigation in the EU, 2009 Questions (a)

(i) (ii)

(b)

Explain the likely impact of the Euro-zone contagion on revenue from the export of olive oil to Asian markets. With the aid of diagrams, explain how market failure could arise from (i) consumption of olive oil; (ii) production of olive oil. Evaluate the measures proposed by the EU member states to control environmental degradation due to olive farming.

(c )

(d)

(a)

Describe the trend in the world price of olive oil between 2001 and 2010. Account for the above trend.

[2] [4] [4] [6] [6] [8]

[Total: 30marks] (i) Describe the trend in the world price of olive oil between 2001 and 2010.

[2]

Trend upwards or increasing from 2001 to 2005 Trend downwards or decreasing thereafter Marker Comment:  Some students see the years wrongly to 2011.  Stating of details that is unnecessary (ii) Account for the trend in the world price of olive oil between 2001 and 2010. Case reference / evidence based on Extract 1: (a) Price trended upwards…. Fall in supply or supply curve shift leftwards. El Nino effect caused supply disruptions (e.g. crop failure) severe enough to outweigh productivity gains, thus prices trended upwards from 2001 onwards peaking in 2005. Thereafter prices fell. (b) Price trended downwards Increase in supply > increase in demand In the aftermath of El Nino effect, the increase in “field productivity” caused supply to increase faster than increase in demand for olive oil valued for its health benefits, thus causing prices to trend downwards. Markers Comment:  Students are not able to look at net effects.  Students combined the factors wrongly.  Awfully drawn diagrams.

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[4]

HWA CHONG INSTITUTION Year Two H2 Economics 2014 Tutorial #22: Microeconomics II – Market Failure & Government Intervention

(b)

Explain the likely impact of the Euro-zone contagion on revenue from the export of olive oil to Asian markets.

[4]

Export revenue for Olive Oil is likely to FALL. Explain using economic analysis: (1) Px rise (figure 1 and extract 1), demand is most likely price elastic in Asian Markets. Why? It is a “new” market. Therefore demand unlikely to be price inelastic as Asians have not yet acquired the same kind of dependence on Olive Oil as the Mediterranean region. Unlike in the Mediterranean, it is NOT an important ingredient” in Asian diet or cooking [Extract 1]. It is mainly use for health reasons e.g. anti-oxidant properties. (2) Volume of Olive Oil exported likely to fall. In the data, this is due to speculative hoarding by sellers. Given that prices are trending upwards, instead of selling exporters stand to gain by hoarding it as it value will appreciate over time. Thus the withdrawal of supply from the export market due to speculative reasons cause export volume or quantity to fall. Conclusion: Ceteris paribus, given that prices rose and export volumes fell, the revenue from export of olive oil is certain to fall. FYI The context is Asian market cf Mediterranean market Olive oil is not a staple diet (i.e. not a necessary ingredient for Asian style cooking food and taste buds) in Asian Market. In fact, it has been newly Introduced to Asian Markets valued for its health benefits. Can also accept: Demand might be price inelastic given that olive oil has RARE medicinal qualities valued by the consumers - Evidence from data: " contains a wide variety of antioxidants NOT found in other oils". Markers Comment:  Students do not understand what the question wants  Students are unable to bring in the concept of elasticity.  Students are not able to conclude on the impact on the export revenue. (c )

With the aid of diagrams, explain how market failure could arise from (i) consumption of olive oil; Figure 1: External benefit in consumption in Olive Oil Market Price PMC=SMC (since EMC=0) PS

EMB at Qm

Pm

B Quantity of Olive oil

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[6]

HWA CHONG INSTITUTION Year Two H2 Economics 2014 Tutorial #22: Microeconomics II – Market Failure & Government Intervention

SMB = PMB + EMB PMB Qm

QS

Quantity

Explain with reference to diagram: o Positive externality o PMC = cost of production of the producers of olive oil o PMB = satisfaction or utility derived from consumption of olive oil use in cooking and valued for its health benefits o EMB = spillover health-related benefits to third parties e.g. Consumption of olive oil produces healthy individuals who are more productive – benefit employers; economy; save healthcare costs for the state. Market failure => Inefficient allocation leading to DWL due to under-consumption because of divergence between private and social benefits. Can also accept: Imperfect information – Imperfect info seems to be the more obvious answer here than positive externalities. If imperfect info, diagram needed? Markers Comment:  Students are not able to draw the diagram correctly.  Axes are not well labeled.  Diagram is not well explained  Examples are not well illustrated. (ii) production of olive oil. Figure 2: External cost in production in Olive Oil Market SMC = PMC + EMC

Price C

PMC EMC at Qm

Ps

B

Pm PMB=SMB (since EMB=0) QS

Qm

Quantity

Explain with reference to diagram: o Negative externalities o PMC = cost of production borne by producers of olive oil o PMB = satisfaction or utility derived from consumption of olive oil use in cooking and 

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[6]

HWA CHONG INSTITUTION Year Two H2 Economics 2014 Tutorial #22: Microeconomics II – Market Failure & Government Intervention

o

o

valued for its health benefits EMC = environmental issues mentioned in the data:  Soil erosion leading to desertification  Water pollution from use of fertilisers/pesticides, contaminating drinking water. Market failure => Inefficient allocation leading to DWL due to over-production because of divergence between private and social costs

Markers Comment:  Confusion between consumption and production of olive oil.  Awfully diagrams  Examples are not well illustrated. (d)

Evaluate the measures proposed by the EU member states to control environmental degradation due to olive farming. Policies used :  Legal regulation (“the appropriate financial penalties for not obeying the legal environmental requirements”)  Subsidy (“a receipt of support payments for its environmental friendly production”) 1) Explanation of Subsidies: - Diagram to explain how subsidies work Figure 3: Subsidies in Olive Oil Market SS1

Price P2+S

SS2

$S

P1 P2

DD1

Quantity Q1

Q2

A subsidy will help lower the cost of production for the environmentally friendly method. This will shifts the supply curve downwards. Thus more olives can be produced using the environmentally friendly method. – reducing EMC due to production of olive? – Gap between Qm and Qs narrows?

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Evaluation : o “it would be difficult to value the gains objectively”. Thus it will be difficult to have subsidy on a case by case basis. o The data suggest that the most harmful method of farming comes from highlymechanised plantation. However, if the farmers deem that the yield and gains from the mechanized method will be much more than the subsidy, they may still stick to the environmentally harmful method of farming olives. Possible change: EU may just subsidize the low-input traditional plantations to encourage farmers to use that method for farming instead of a case by case basis. 2) Legal regulation Explain that the penalties will act as a deterrence as it will increase the farmers’ cost if they are caught not meeting the requirements. – change the farmer’s behavior to use more environmentally friendly method of production – reducing EMC due to production of olive? – Gap between Qm and Qs narrows? Evaluation : Monitoring is going to be a problem as the area involved for monitoring is going to very big. It is the entire European Union though mainly in the Spain, Italy and Greece. Thus it may be totally ineffective. Possible change: Might just want to target the major firms only. 3) Alternative policies “Green Tax” Taxes for those farmers who uses excessive fertilizers and herbicides or over-exploited the land Explain how taxes will work. The government might force the firm to pay a fee (an indirect tax on each unit of output), the amount of the tax corresponding to the external marginal cost i.e. Tax=EMC. This shifts the PMC upwards so that the new PMC, PMC1, now coincides with SMC since PMC1 = PMC + EMC (=tax) The tax is designed to get firms to "internalize the externality" by considering the external costs of production. Figure 3: Tax to internalize negative production externality in olive oil market SMC = PMC + EMC

Price C

PMC + tax PMC

Ps Pm

B Tax = EMC at Qs 

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HWA CHONG INSTITUTION Year Two H2 Economics 2014 Tutorial #22: Microeconomics II – Market Failure & Government Intervention

PS - t

PMB=SMB (since EMB=0) QS

Qm

Quantity



The imposition of the tax results in an output that corresponds to the socially efficient level of output, QSE.



Also, if the tax is seen as payment for the use of the environment, there may be incentives to reduce soil erosion.



The imposition of the fee moves the equilibrium to the socially efficient level where SMC = SMB because when the firm attempts to maximize profit now and produce at where PMB=PMC1, the outcome will be QSE which will be the socially efficient outcome.

Evaluation: o Amt of green tax needs to be determine accurately o Demand might be price inelastic which would mean the tax would have to be very high, causing political dissatisfaction Conclusion: On the one hand the consumption of Olive oil generates PE e.g. health benefits whilst on the other the production of Olive Oil generates NE. viz environmental degradation. Thus, policies should not be aimed at discouraging consumption but encouraging the use of environmentally friendly techniques or green technology to produce olive oil. Regulations are at best a short term stop gap measure. Long term sustainable policies should provide incentive for olive producers to adopt “green techniques of farming” by making the technology available and relatively cheap. A concerted effort by member states is required. Also need to engage other olive oil producing economies as well to holistically target the problem. Level L3 5-6 L2 3-4

L1 1-2 E2 2 E1

Descriptors For a well-developed answer that is able to provide sound analysis and assessment of the various key policies relevant to the context. Ability to suggest some key alternative policies or refinements. For an answer that is on track and uses economic analysis. However,  Answer is not well developed  Generic or too theoretical ( little reference to the data)  Lop-sided  Major conceptual flaws Mostly irrelevant answer; descriptive with no economic analysis. For a judgment that is supported by economic analysis. For an unexplained judgment 

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HWA CHONG INSTITUTION Year Two H2 Economics 2014 Tutorial #22: Microeconomics II – Market Failure & Government Intervention

1 Markers Comment:  Students misunderstood that the penalty is a form of tax when it is the punishment for the not obeying the regulation  Students are not able to explain subsidy in a framework.  Students did not go further to talk about possible alternatives or possible improvements.

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HWA CHONG INSTITUTION Year Two H2 Economics 2014 Tutorial #22: Microeconomics II – Market Failure & Government Intervention

Question 2 – 2008 MJC H1 Economics Prelims The Price of Growth Extract 1: Tackling the pollution problem According to the World Bank, China has 16 of the world's 20 most polluted cities. Estimates suggest that 300,000 people a year die prematurely from respiratory diseases. The main reason is that around 70% of China's mushrooming energy needs are supplied by coal-fired power stations, compared with 50% in America. In 2002, the State Environmental Protection Administration (SEPA) found that the air quality in almost two-thirds of 300 cities it tested failed World Health Organisation standards – yet emissions from rocketing car ownership are only just becoming an issue. Hopes that China will “leapfrog” the West with super-green cars are naive, since dirty fuel messes up clean engines and the high cost of new cars keeps old ones on the road. Adding it all up, the World Bank concludes that pollution is costing China an annual 8-12% of its $1.4 trillion GDP in direct damage, such as the impact on crops of acid rain, medical bills, lost work from illness, money spent on disaster relief following floods and the implied costs of resource depletion. In 2001, the 10th Five-year Plan for Environmental Protection by SEPA set ambitious emissionreduction targets and boosted environmental spending to 700 billion yuan ($85 billion) for 2001-05 – equivalent to 1.3% of GDP, up from 0.8% in the early 1990s. A legal framework has been created. Beijing's good intentions, however, have so far had only limited impact, thanks to the vast, decentralised bureaucracy through which it is forced to govern such a huge country. Around the country, SEPA's branches, known as Environmental Protection Bureaus, are supposed to monitor pollution, enforce standards and collect fines. But they are more in thrall to local governments – whose priorities are to maintain growth and employment in their jurisdiction – than to head office in Beijing. It is no rarity, therefore, to find a bureau imposing a fine on a dirty local enterprise (thus fulfilling its duty), but then passing the money on to the local administration, which refunds it to the company via a tax break. SEPA's impotence is one reason why penalties, even when it can impose them, remain laughably light. Mr Sun says the maximum he can fine a polluting company in Shanghai is 100,000 yuan or about $12,000. But just as fundamental is that China lacks an understanding of the concept that the polluter should pay. Adapted from The Economist, 19 Aug 2004 Extract 2: Clean air spells competitive edge Some newly arrived business executives and their families are shocked by what they find in many Asian Cities: traffic-clogged streets, fume-belching vehicles and noxious smog limiting visibility and making the air unpleasant to breathe. However, a minority of cities, including Singapore that manages to maintain a pleasant, pollution-free environment at least most of the time are finding that being ‘clean and green’ can be significant part of

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HWA CHONG INSTITUTION Year Two H2 Economics 2014 Tutorial #22: Microeconomics II – Market Failure & Government Intervention

the overall comparative economic advantage that determines where the international flow of talent and investment goes. For example, the Financial Times reported earlier this month that Hong Kong’s worsening air pollution is prompting managers of some major hedge and asset funds to move to Singapore, reflecting a trend that could undermine the territory’s status as a regional financial hub while enhancing the competitive position of Singapore. Singapore has imposed tough vehicle fuel emission standards and regulations to limit industrial pollution. The government has also made it expensive to own private cars while offering alternative public transport, including pollution-free, electricpowered mass rapid transit rail system with extensive and convenient connections. Japan has long adopted a similar approach while the South Korean capital, Seoul, has recently launched a similar strategy.

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Adapted from The Straits Times, Aug 12, 2006

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HWA CHONG INSTITUTION Year Two H2 Economics 2014 Tutorial #22: Microeconomics II – Market Failure & Government Intervention

Questions (a)

(i)

With reference to Figure 1, describe the trend of global carbon dioxide emissions from fossil burning over the stated period.

[2]

(ii)

Suggest possible reasons for the trend observed.

[3]

(b)

To what extent does Table 1 support the view that higher growth results in greater pollution?

[3]

(c)

(i)

With the aid of a diagram, explain the market failure in China based on Extract 1.

[4]

(ii)

Assess the need for the Chinese government to change its current policy to bring about cleaner air.

[8]

With the help of the data given, discuss the possible impact of a reduction of carbon dioxide emissions upon an economy.

[10]

(d)

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[Total: 30marks]

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HWA CHONG INSTITUTION Year Two H2 Economics 2014 Tutorial #22: Microeconomics II – Market Failure & Government Intervention

(a)

(i)

With reference to Figure 1, describe the trend of global carbon dioxide emissions from fossil burning over the stated period.

[2]

Increasing throughout [1m]; increasing at an increasing rate after 1950 [1m]. (ii)

Suggest possible reasons for the trend observed. 

Increase in global economic growth after 1950s resulted in increased income levels, thus allowing people to consume more energy-consuming goods e.g. electrical appliances  rise in CO2 emission.



Rapid industrialization especially post of the 50s or increased levels of industrial production implies that factories may be using more energy to drive their production more harmful pollutants released into the air  rise in CO2 emissions.



Increase in global population may result in more electricity consumption  more fossil fuel burnt to generate electricity rise in CO2 emissions

[3]

Any other logical reasons (b) To what extent does Table 1 support the view that higher growth results in greater pollution?

[3]

Higher growth  Higher pollution. How true? Yes! (Positive correlation with reference to Table 1)



Exceptions:





 (c)

(i)

China & India (top 2 in terms of growth) - also top 2 in terms of CO2 emissions. On the other hand, Japan (bottom in terms of both growth and CO2 emissions) Comparing the 3 countries with low growth (same econ growth rate of 1.8% - varied correlation: o EU’s CO2 emission is lowest (0.2%). o USA's CO2 emission is relatively high (1.2%). Notable exception, UK's growth rate is higher than 1.8% but an emission is negative!

With the aid of a diagram, explain the market failure in China based on Extract 1. Recognize that pollution caused by factories is a form of negative externalities in production [1m] which are often ignored (define)

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[4]

HWA CHONG INSTITUTION Year Two H2 Economics 2014 Tutorial #22: Microeconomics II – Market Failure & Government Intervention

Support with e.gs / evidence [1m]: Evidence from Ext 1, para 2 - “impact on crops of acid rain, medical bills, lost work from illness, money spent on disaster relief following floods and the implied costs of resource depletion.”  divergence between social & private costs (SMC > PMC) Figure 1: External cost from factory production Price

SMC = PMC + EMC C EMC at Qm

Ps

PMC

B

Pm PMB=SMB (since EMB=0) QS

(ii)

Qm

Quantity



Assuming perfect competition, market equilibrium quantity of steel is Qm, where PMB = PMC, as consumers and producers only consider their own benefits and costs.



However the socially efficient quantity of production should be at QS where SMB=SMC, where the full costs and benefits and costs to society are considered. QS is less than the market equilibrium quantity, Qm. where PMB = PMC. Thus there is overproduction by factories by the quantity Qm – QS

 

Area QmQSBC is the total social cost incurred for the overproduction Qm – QS. Area QmQSBA is the total social benefit gained for the overproduction Qm – QS.



Since total social costs incurred exceeds the total social benefits gained for overproduction Qm – QS, area ABC represents the deadweight welfare loss due to overproduction of QS – Qm.

Assess the need for the Chinese government to change its current policy to bring about cleaner air. Intro: Highlight the reason why the Chinese government intervenes – Improve efficiency resulting from market failure. Identify policy that SEPA have been put in place: Legislation – rules and regulations put in place by government to ensure compliance.

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[8]

HWA CHONG INSTITUTION Year Two H2 Economics 2014 Tutorial #22: Microeconomics II – Market Failure & Government Intervention

Explain how legislation works to bring about cleaner air in China From Extract 1, “SEPA's branches, known as Environmental Protection Bureaus, are supposed to monitor pollution, enforce standards and collect fines”. China’s approach is to enforce standards in hope of reducing the pollution levels with the threat of penalties such as fines. The government draws up legislations, puts in place measures to ensure compliance; and take law breakers to task. The fear of being penalized / fined would reduce the pollution level by reducing energy usage to socially optimal. Evaluate the effectiveness of Legislation Extract 1 states that the penalties “remain laughably light”  amount of fine or penalty imposed is too low to have any effect, rendering the policy largely ineffective in reducing Qm to socially optimal. Presence of government failure in China as seen from the bureaucratic nature & difficulties & inability in enforcing such standards on a huge country e.g. priorities of local govt to maintain employment and growth which may conflict with SEPA’s objective in reducing pollution / imperfect information as seen from the lack of cooperation and no sharing of patchy data / government is reluctant to impose price rises due to fear of public unrest. Lack of government and people’s understanding of ‘polluter’s pay principle’, rendering such rules to be a flop due to weak enforcement e.g. “refund of fines to firms in the form of tax breaks”

Justify the need for China to change its current policy: Not necessary to change current policy – Legislation may still work. Improvements needed to enhance effectiveness: By increasing the penalties and ensure that it is strictly adhered to. However, to ensure that the restrictions are enforced, much monitoring needs to be done and this might pose to be a huge burden on the government. Given the large population size and land mass of China, this will lead to a substantial amount resources being utilized to solve the problem. There is a need to change the current policy as it is ineffective and refining the 

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HWA CHONG INSTITUTION Year Two H2 Economics 2014 Tutorial #22: Microeconomics II – Market Failure & Government Intervention

policy may not work: Suggest one other policy China can adopt to bring about cleaner air:  Briefly explain tax or any other relevant policies – like tradable permits / improving efficiency of public transport system.

Figure 2: Tax to internalise EMC from factory production Price SMC = PMC + EMC PMC + tax

C

PMC Ps Pm

B

PS - t

Tax = EMC at Qs D QS



 

A PMB=SMB (since EMB=0) Qm

Quantity

The government might impose an indirect tax on producers corresponding to the external marginal cost i.e. Tax=EMC at QS (distance BD) on each unit of steel. This shifts the PMC upwards so that the new PMC, which equals PMC + tax, coincides with the SMC at QS. Hence, the new market equilibrium quantity where PMB = PMC + tax, now coincides with the socially efficient quantity QS, where SMB = SMC. If the tax accurately reflects the external marginal cost, producers are now in effect paying for the use of the environment as the price they are receiving is now lower at PS – t, compared to Pm before the tax. The externality has then been internalised or priced in.

Synthesis (Reasoned judgment) Looking at the contribution China is making to world pollution (“China has 16 of the 

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HWA CHONG INSTITUTION Year Two H2 Economics 2014 Tutorial #22: Microeconomics II – Market Failure & Government Intervention

world's 20 most polluted cities”), the current policy adopted are probably insufficient and ineffective to a large extent. Just as suggested in Extract 1 of the hopes for “super-green cars”, there is a need for China to look into long term solutions for the country. For example, just as how some of the Asian economies have been responding, China could consider a more efficient public transport system in light of the growing income level. (Eg. In Extract 2). The process however would be a difficult one given the nature of China’s economy which is one of a huge population and vast rural-urban divide. (d)

With the help of the data given, discuss the possible impact of a reduction of carbon dioxide emissions upon an economy.

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[10]

HWA CHONG INSTITUTION Year Two H2 Economics 2014 Tutorial #22: Microeconomics II – Market Failure & Government Intervention

Introduction:  The macro-goals of any government would be to achieve both internal goals, i.e. sustained growth, low inflation, low unemployment, and external goals, i.e. healthy BOP.  Carbon dioxide emissions cause environmental degradation and will have adverse effect on the economy. To some extent, a reduction of carbon emissions will benefit the economy.  The reduction in CO2 emission will impact an economy differently in short term and long term. Short run impact on the economy: 1. Slowdown economic growth To reduce CO2 emissions  govt need to impose measures to reduce energy usage / reduce fossil-fuel burning  measures imposed on businesses may raise production cost (e.g. compulsory installment of pollution abatement equipment, pollution tax etc.)  fall in SRAS  slow down economic growth 2. Rise in unemployment Slowdown in growth  firms cut back on production  dd for labour falls  rise in unemployment 3. Rise in inflation Rise in firm’s cost of production  fall in SRAS  firms pass on the higher cost to consumers cost-push inflation (Illustrate with AD-AS diagram) 4. Worsen BOP Rise in cost of production due to measures undertaken to reduce CO2 emission domestic gds become less competitive in international market  export revenue falls (assuming PEDx > 1)  current account worsens Long run impact on the economy 1. Boosts economic growth & improve SOL  Pollution-free environment attracts foreign direct investment (FDI) and foreign talents to an economy. Evidence: Hong Kong vs Singapore in Ext 2. Hong Kong’s worsening pollution has discouraged foreigners to do business there.  Ext 1, para 2: “pollution is costing China an annual 8-12% of its $1.4 trillion GDP in direct damage”. Reduction in CO2 emission will increase NI. (Illustrate with AD-AS diagram with economic analysis) 

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HWA CHONG INSTITUTION Year Two H2 Economics 2014 Tutorial #22: Microeconomics II – Market Failure & Government Intervention



Improvement in SOL (non-material) with less health problems etc. as quality of air improves

2. Reduces unemployment  With an increase in FDI, the increase in productive activities would help create jobs for the people, therefore reducing unemployment  Particular sectors such as the tourism sector will stand to benefit more as clean air would attract more tourist, thus increase in employment in the tourism sector 4. Effect on BOP  Attraction of FDI to an economy with lower carbon dioxide emission  inflow of money under the capital account  thus BOP improves.  In the longer term, money will flow out under the current account when the FDI transfer earnings back to their own country, thus worsen BOP Synthesis/Conclusion – Distinction between two types of economy –Relatively Poor versus Rich developed countries. On balance, whether benefits outweigh costs of reducing CO2 emissions depend on country’s stage of economic development. In general, emerging/developing economies will probably incur a much higher trade-off in terms of slower economic growth. Their main concern/priority is improving SOL and alleviating poverty. A slower growth would make it harder to solve problems of high unemployment and low material SOL (at least material) and poverty. However for developed countries, the impact is more likely to be positive. They have already reached a stage of development where SOL is relatively high and hence better environmental quality would further enhance the quality of life.

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