Chapter 6 Part 1 - Market Failure & Government Intervention

Question 1

What does the price mechanism do?

Answer 1

• Signaling function (what to produce and how much to produce)
• Rationing function (for whom to produce)
• Incentive function (how to produce)

Question 2

What are the assumptions of the price mechanism?

Answer 2

• Free market (no govt intervention)
• Decision making is based on self-interest
• Perfect market conditions (perfect info, factors of production are perfectly mobile)
• Production and consumption does not generate externalities

Question 3

What is productive efficiency?

Answer 3

Productive efficiency is when economic agents produce the maximum amount of goods with all the scarce resources they have, such that producing more of the same good would require them to sacrifice production of another good.

Question 4

Define allocative efficiency

Answer 4

Efficient allocation of resources in a market implies that adequate available resources are used in the production of goods and services to bring about maximum total economic surplus (i.e. sum of consumer and producer surplus). In doing so, social welfare is maximised.

Question 5

What are the assumptions in allocating resources efficiently in the market?

Answer 5

• Decision-making is based on self-interest
• No externalities
• No consumer or producer can influence the market (market dominance)
• Perfect info
• Factors of production are perfectly mobile
  If any one of the assumptions does not stand, price mechanism would fail to achieve efficient resource allocation, aka market failure.

Question 6

Define marginal private cost (MPC)

Answer 6

MPC is the change in total private cost as a result of undertaking an additional unit of an economic activity. MPC curve is upward-sloping.

Question 7

Define marginal private benefit (MPB)

Answer 7

MPB is the change in total private benefit as a result of undertaking an additional unit of an economic activity. MPB curve is downward-sloping.

Question 8

Who are third parties?

Answer 8

Third parties are bystanders who are affected by decisions that are made by consumers or producers of goods.

Question 9

Define marginal social cost (MSC)

Answer 9

MSC is the change in total social cost (MPC + MEC) as a result of undertaking an additional unit of an economic activity.

Question 10

Define marginal external cost (MEC)

Answer 10

MEC is the change in total external cost as a result of undertaking an additional unit of an economic activity. MEC exist when there are negative externalities.

Question 11

Define marginal social benefit (MSB)

Answer 11

MSB is the change in total external benefit (MPB + MEB) as a result of undertaking an additional unit of an economic activity.

Question 12

Define marginal external benefit (MEB)

Answer 12

MEB is the change in total external benefit as a result of undertaking an additional unit of an economic activity. MEB exist when there are positive externalities.

Question 13

How to find net social benefit (NSB) / net private benefit (NPB)?

Answer 13

Total benefit - total cost

Question 14

Define market failure

Answer 14

Market failure occurs when the workings of the free-market result in an inefficient allocation of resources from the perspective of society.

Question 15

Define public goods

Answer 15

Public goods have the characteristics of non-rivalry in consumption, non-excludability in consumption and non-rejectability in consumption. They are non-maketable.

Question 16

What are private goods.

Answer 16

Private goods have the characteristics of rivalry in consumption and excludability in consumption, hence making them marketable.

Question 17

How do public goods cause market failure?

Answer 17

• Public goods cause market failure through being non-rivalry and non-excludability in consumption.
• Non-rivalry -> same unit of good can be collectively consumed -> MPC = 0 -> no effective supply
• Non-excludability -> costly to exclude anyone from consuming the good -> no incentive for people to pay - concealed demand or no effective demand
• No private firms would want to produce public goods
• Non-provision of public goods result in market failure

Question 18

How can the govt intervene in market for public goods?

Answer 18

With no effective demand and supply, market-based policy and moral suasion can’t be applied because there are no market participants. Instead, command and control policy has to be used (direct provision).
- Produced by govt and provided free to public; funded by taxes (e.g. National Defence)
- Produced by private firms and provided free to public; funded by taxes (e.g. traffic lights)

Question 19

What are the advantages and disadvantages of direct provision?

Answer 19

Advantages:
- Govt can ensure output maximise NSB

Disadvantages:
- Opp cost if need to cut down expenditure in other areas
- If govt is self-producing goods, they may not produce it at lowest possible cost as they are not motivated by profits

Question 20

Define externality

Answer 20

An externality is a cost or benefit arising from an economic activity that falls on a third party and is not taken into account by those who directly participate in the economic activity.

Question 21

What is a negative externality?

Answer 21

A negative externality gives rise to external cost which arises when individual actions inflict costs upon a third party without the latter being compensated.

Question 22

What are the 6 steps to explain how externalities lead to market failure?

Answer 22

1. Explain cost and benefit of consumption / production
2. Explain consumers / producers choose output to maximise NPB (MPB = MPC)
3. Explain how third parties are affected
4. Explain divergence between MPC & MSC or MPB & MSB
5. Explain how socially optimal output is obtained to maximise NSB (MSB = MSC)
6. Explain market has failed (over/under production/consumption)

Question 23

List down the market-based policies in reducing market failure due to negative externality in production

Answer 23

• Taxing the product
• Taxing the emission (carbon tax)
• Incentivising environmentally friendly methods of production

Question 24

List down the command and control policies in reducing market failure due to negative externality in production

Answer 24

• Quota on product
• Banning the product
• Permits: Quota on emission
• Tradeable permits (cap and trade)
• Nationalisation

Question 25

List down the moral suasion policies in reducing market failure due to negative externality in production

Answer 25

• Educating producers
• Encouraging producers to switch to less pollutive methods of production

Question 26

List down the tools used to reduce market failure due to positive externality in production

Answer 26

• Market-based policy: Supply-side subsidy
• Command and control: Supplementing production
• Moral suasion: Providing positive publicity

Question 27

List down the market-based policies in reducing market failure due to negative externality in consumption

Answer 27

• Taxing consumers
• Taxing producers
• Incentivising consumption of substitutes
• Incentivising consumers to switch to less pollutive alternatives

Question 28

List down the command and control policies in reducing market failure due to negative externality in consumption

Answer 28

• Quota on consumption
• Banning consumption

Question 29

List down the moral suasion policies in reducing market failure due to negative externality in consumption

Answer 29

• Educating consumers
• Changing consumer’s preferences

Question 30

List down the tools used to reduce market failure due to positive externality in consumption

Answer 30

• Market-based policies: Demand-side subsidy, supply-side subsidy, free provision, raising supply of goods that have positive externality
• Command and control: Compulsory consumption
• Moral suasion: Educating consumers

Question 31

What are the advantages and disadvantages of taxing the product in reducing market failure due to negative externality in production?

Answer 31

Advantages:
- Indirect tax forces firms to internalise external cost
- Govt can raise revenue which can be used to reduce harm to third parties
- Tax is flexible (it can be adjusted to size of MEC)
- Market participants still have liberty to pursue self-interests so long as they account for the full costs of their actions

Disadvantages:
- Value of external cost is mostly arbitrary and difficult to estimate; varies among different third parties, leading to over-tax or under-tax
- Taxes raise cost of production, supply falls, prices rise, affecting cost of living
- Admin or implementation costs may outweigh benefits from fall in DWL
- Fall in production levels would affect GDP and employment levels

Question 32

What are the advantages and disadvantages of taxing emission / pollution in reducing market failure due to negative externality in production?

Answer 32

Taxing emission raises cost of production.
Advantages and disadvantages largely the same as taxing the product.
Additional advantage: Incentivise firms to cut back on pollution, encouraging more eco-friendly alternatives, unlike indirect taxes

Question 33

What are the advantages and disadvantages of incentivising the use of environmentally friendly methods of production in reducing market failure due to negative externality in production?

Answer 33

Leads to higher cost of production, raising MPC, even with incentives like subsidies.
Can be used with indirect tax to eliminate DWL

Advantages:
- Long-term measure, help achieve sustainable growth
- Raises socially optimal output, hence less impact on growth and employment

Disadvantages:
- Firms may not be keen to switch to eco-friendly methods as it may be more costly; may not be willing to sacrifice profit-margins
- Opp cost if govt has to cut down expenditure in other areas

Question 34

What are the advantages and disadvantages of quotas on production in reducing market failure due to negative externality in production?

Answer 34

Advantages:
- Socially optimal output (Qs) can be achieved with quota (and there is definite reduction in pollution level)
- Easy to understand, implement and relatively easy to monitor. Heavy penalties must be imposed for quota to be effective

Disadvantages:
- No incentive for firms to find more eco-friendly methods; instead they may find cheaper methods which may pollute more in order to raise profits
- Govt need to be able to identify socially optimal output but its difficult to measure external cost
- Higher prices with quota causes other related industries to contract, causing economic growth employment levels to fall
- Prices rise, affecting cost of living
- Black market; reduce effectiveness of quota

Question 35

What are the advantages and disadvantages of banning the production in reducing market failure due to negative externality in production?

Answer 35

Considered when MEC is very high such that Qs = 0. When good is banned, DWL = 0.

Advantages:
- If MEC is sufficiently large, bans produce desirable outcomes for society

Disadvantages:
- Admin cost may outweigh social benefits from bans
- Black market, reduce effectiveness

Question 36

What are the advantages and disadvantages of permits (quota on emission) in reducing market failure due to negative externality in production?

Answer 36

Advantages:
- If firms seek more eco-friendly methods in order to produce more, MEC falls, Qs rises
- Qs can be attained and reduction in pollution is certain
- Firms are incentivised to find more eco-friendly methods, so that they can produce more
- If firms switch to more eco-friendly methods, NSB rise

Disadvantages:
- Govt need to determine Qs; tricky because MEC difficult to estimate
- Firms may not have incentive to find eco-friendly methods if permits are enough for them; occurs when govt issues too many permits due to over-estimation of Qs
- Restricting output cause supply to fall, prices rise, other related industries contract, affecting economic growth and employment levels
- Supply falls, prices rise, affecting cost of living
- Producers would want to max out given permit to pollute instead of pollution less than allowed

Question 37

What are the advantages and disadvantages of tradeable pollution permits (carbon trading) in reducing market failure due to negative externality in production?

Answer 37

Advantages:
- Govt can progressively reduce permits issued
- More cost-effective than regulation since price permit is determined by market forces
- Encourages eco-friendly methods as it incentivise firms to reduce emissions since it can sell excess permits
- Firms who do not want to pay higher price for permits (due to high demand for permit during economic growth) would result to pollution abatement (reduce pollution)

Disadvantages;
- Difficult to find Qs; If there are too many permits, price may be too low to incentivise firms to switch to eco-friendly methods; firms may choose to buy more due to low price
- Restriction to pollute lead to higher cost of production, supply falls, price rises, affect consumer expenditure (cost of living) and economic growth and employment levels
- Admin cost may outweigh benefits; better not to implement if cost exceed benefits

Question 38

What is the use of nationalisation in reducing market failure due to negative externality in production?

Answer 38

Nationalisation is the act of a govt taking control of an industry into the ownership of the state.
The typical aim of nationalised / state-owned industry is to maximise social welfare, not profits (especially when other measures fail to achieve socially optimal outcomes).

Advantage:
- It allows govt to monitor the level of external costs in process of production and being welfare-oriented, output will always maximise net social benefit, at Qs (MSC = MSB).

Disadvantages:
- Opp cost if govt has to cut down expenditure in other areas if it has insufficient funds
- Nationalised industries may be inefficient - bureaucratic and slow in decision-making as they face less competition
- Nationalised industries may not seek to improve cost efficiency as they not profit motivated

Question 39

What is the use of educating producers in reducing market failure due to negative externality in production?

Answer 39

Education campaigns can be put in place to sway producers’ decisions, by highlighting plight of 3rd parties, making them internalise part of the external cost. Ideally, where producers internalise entire external cost, Qp = Qs.

Advantage:
- If firms internalise externality voluntarily, outcome would be more permanent compared to disincentives like taxes, leading to less govt intervention.

Disadvantages:
- Mindset change may take a long time esp since adjusting production process is likely to result in higher cost of production
- Difficult to escape profit maxmisation mindset when it is obligated to shareholders, esp when adjustment in production processes likely to raise cost, reducing profits
- Reduction in production will lead to producing output that does not maximise NPB. Producers may not want to internalise externality to avoid reducing NPB.

Question 40

What is the use of encouraging producers to switch to less pollutive alternatives in reducing market failure due to negative externality in production?

Answer 40

Govt can help provide info and ideas to publicise various ways for firms to reduce pollution / encouraged to switch eco-friendly suppliers / recognised by govt agencies for green efforts, generating positive publicity, thus gaining larger customer base. Reduction in pollution leads to fall in MSC, increasing Qs.

Advantage:
- Firms may choose to move away from profit maximisation mindset to more environmentally responsible behaviour, raising NSB

Disadvantages:
- Mindset change may take a long time esp since adjusting production process raises production costs
- Difficult to escape profit maxmisation mindset when it is obligated to shareholders, esp when adjustment in production processes likely to raise cost, reducing profits
- Alternative production method raises cost, which may not incentivise producers to switch. As such subsidy may be needed to encourage producers.

Question 41

What is the use of taxation / charges in reducing market failure due to negative externality in consumption?

Answer 41

Charges (e.g. ERP)
Taxes (indirect tax on producers) raise COP (production cost), supply falls, prices (and MPC) rise

Advantages:
- Forces consumers to internalise negative externalities
- Govt can raise revenue, which can be used to reduce harm on 3rd parties
- Flexibility in charges / taxes according to size of MEC
- Being a market-based approach, market participants still have the ability to pursue self-interests so long as they account for full costs of their actions

Disadvantages:
- External cost is very difficult to estimate as it varies among 3rd parties, making it difficult to determine right amount of tax / charge, which may lead to over-tax / under-tax
- If PED inelastic (e.g. due to lack of substitutes), consumers may not be responsive to measure
- Sunk cost fallacy, having paid very high price of goods (e.g. car), they utilise them more often to get money’s worth, lowering PED, making them less responsive to tax / charge hikes, which reduces effectiveness of measure
- Admin cost may be higher than benefit from welfare loss prevented

Question 42

What is the use of incentivising the consumption of substitutes in reducing market failure due to negative externality in consumption?

Answer 42

E.g. cars -> public transport reduce MPB of driving

Advantages:
- Improving availability / desirability of substitutes helps consumers reduce consumption of goods that are less desirable at their own free will, thus being more effective than forcing consumers to change consumption pattern

Disadvantages:
- Difficult to incentivise consumers to consume substitutes because degree of substitutability; MPB may not be reduced significantly
- If govt want to reduce car consumption due to congestion, raising cost of consumption is more effective than making public transport more attractive
- Reliability of public transport cause consumers to lack confidence in viability of alternative (MPB fall less significant)

Question 43

What is the use of incentivising consumers to switch to less pollutive alternatives in reducing market failure due to negative externality in consumption?

Answer 43

E.g. Petrol cars to Electric vehicles
As consumers switch to alternatives (with subsidies etc.), MEC fall, Qs rise, DWL fall

Advantages:
- Lowers pollution level (due to vehicle usage)
- Enhance Singapore’s reputation in international arena as it is in line with global efforts to reduce carbon footprint

Disadvantages:
- Price (of EV) much higher than traditional (cars), subsidies may not be very effective unless generous subsidies are given, which may lead to opp cost
- Usage of EV need to be supported with appropriate infrastructure (charging points)
- Use of EV only address pollution, tho congestion is a greater issue (total MEC does fall significantly)
- Consumers may not want to switch because of its very high cost

Question 44

What is the use of quota (quantity restriction) in reducing market failure due to negative externality in consumption?

Answer 44

E.g. COE / Vehicle Quota System
Number of permits issued must be equal to Qs to ensure max effectiveness

Advantages:
- With quota like COE, govt can control vehicle growth and population, reducing pollution and congestion
- Revenues obtained from COE premiums can be used to build more roads (ironically), reducing congestion further
- Change in demand for cars and hence COE, only affects COE prices and keeps quota unchanged

Disadvantages:
- Quota only indirectly reduce congestion as it targets ownership, not usage (root cause of pollution and congestion); instead moral suasion / taxation and charges can be used
- Difficult to associate car ownership to usage. People may own multiple cars yet their usage is the same as those who own a single car; Impossible to associate COE quantity to usage; Overconsumption if too many COEs issued / Underconsumption if too few are issued
- Sunk cost fallacy; consume beyond levels of maximising NPB, higher usage results in more pollution and congestion

Question 45

What is the use of banning the consumption of goods in reducing market failure due to negative externality in consumption?

Answer 45

Advantage:
- If MEC is large enough, bans produce desirable outcomes for society

Disadvantages:
- Admin costs may outweigh benefits
- Black market may reduce effectiveness

+ Partial-bans (bans under certain circumstances); e.g. PMDs / smoking

Question 46

What is the use of educating consumers in reducing market failure due to negative externality in consumption?

Answer 46

Campaigns help internalise externality, causing MPC to rise. Campaigns can focus on other aspects other than effects on 3rd parties (e.g. consumers more interested in personal wellbeing cos of self-interest). Ideally, consumers internalise entire external cost, cosumption will be at Qs.

Advantage:
- If consumers internalise externalities voluntarily, outcome is more permanent than disincentives; less govt intervention

Disadvantages:
- Mindset change may take a long time esp since adjusting consumption is likely to result in cutting back on personal comfort and convenience
- Loss in comfort and convenience make consumers not very willing externality in long run

Question 47

What is the use of changing consumers preference in reducing market failure due to negative externality in consumption?

Answer 47

Govt can provide info and ideas to publicise various ways consumers can reduce pollution.
E.g. Plastic bags; MPB fall will publicity against it
Assuming MPB falls by exact amt of MEC, consumption will now be at Qs.

Advantage:
- Outcome would be more permanent than disincentives; less govt intervention

Disadvantage:
- Change in taste and preference may take a long time esp since adjusting consumption likely to result in losing personal comfort and convenience

Question 48

What is the use of supply-side subsidies in reducing market failure due to positive externality in production?

Answer 48

Advantages:
- Rewards first parties (firms) for bringing benefits to 3rd parties
- Subsidies are flexible and can be varied according to MEB size
- Rise in production levels, improve GDP and employment level; more pronounced if subsidies are given to industries that largely contributes to economy
- Subsidy cause COP to fall, supply rises, prices and MPC fall. Fall in price depends on PED. If inelastic, prices would fall more as producers pass greater subsidies to consumers; Lowers living costs

Disadvantages:
- Opp cost
- Very difficult to estimate MEB size as it varies among 3rd parties, leading over-subsidy (worse resource allocation) or under-subsidy (improvement)

Question 49

What is the use of supplementing production of goods in reducing market failure due to positive externality in production?

Answer 49

Advantages:
- Supplementing production would mean more goods being produced, leading to greater employment and economic growth
- Greater supply, lowers prices, lower cost of living

Disadvantages:
- Opp cost; If funds insufficient and need to cut down, standard of living may fall
- Not being profit motivated, govt may not seek to improve efficiency

Question 50

What is the use of providing positive publicity in reducing market failure due to positive externality in production?

Answer 50

Govt encourage producers to raise output by praising and publicising firms that benefit 3rd parties. Producers internalise ext benefit on 3rd parties, raising MPB.

Advantage:
- If firms internalise externality voluntarily, outcome would be more permanent than providing incentives; less govt intervention needed

Disadvantages:
- Mindset change may take long time esp since adjusting production may result in higher COP
- Difficult for firms to escape profit maximisation mindset esp when obligated to shareholders, esp when adjusting production process likely to raise cost and reduce profits

Question 51

What is the use of subsidies (supply and demand-side) in reducing market failure due to positive externality in consumption?

Answer 51

Demand-side subsidy lowers MPC. Supply-side subsidy lowers COP, supply rises, prices fall, MPC fall.

Advantages:
- Rewards first parties (consumers) for bringing benefits to 3rd parties
- Subsidies are flexible and can be varied according to MEB size
- Rise in consumption and production levels, improve GDP and employment level; more pronounced if subsidies are given to industries that largely contributes to economy
- Subsidy cause COP to fall, supply rises, prices and MPC fall. Fall in price depends on PED. If inelastic, prices would fall more as producers pass greater subsidies to consumers; Lowers living costs

Disadvantages:
- Opp cost
- Very difficult to estimate MEB size as it varies among 3rd parties, leading over-subsidy (worse resource allocation) or under-subsidy (improvement)

Question 52

What is the use of free provision (100% subsidies) in reducing market failure due to positive externality in consumption?

Answer 52

When there are high positive externality, it is appropriate to fully subsidise. If free provision leads to over-consumption, govt can reduce free provision to partial subsidy.

Advantages;
- Rewards first parties for bringing benefits to 3rd parties; free provision internalise externality
- Free provision can be varied according MEB
- Rise in consumption improves GDP and employment levels

Disadvantages:
- Opp cost
- Value of ext benefit is difficult to estimate as it varies among 3rd parties; Over-consumption if MEB is over-estimated and market failure not fully addressed

Question 53

What is the use of raising / supplementing supply in reducing market failure due to positive externality in consumption?

Answer 53

Raising supply, prices fall and MPC falls

Advantages:
- Supplementing production could result in increased govt revenues
- Keeps prices of essential goods affordable; improving equity

Disadvantages:
- Govt provision may lead to inefficiency and poor standards of service due to lack of profit-maximisation incentive; lack of incentive to minimise cost
- Opp cost

Question 54

What is the use of compulsory consumption in reducing market failure due to positive externality in consumption?

Answer 54

E.g. Compulsory education and vaccines
If compulsory consumption level is set at Qs, this eliminates under-consumption and DWL.
At Qs, consumer is not maximising NPB, making them unwilling to consumer Qs unless coerced or incentivised. Compulsory consumption requires monitoring and heavy penalty for non-compliance. If penalties are low, consumers may choose to ignore regulation and risk getting caught.

Advantage:
- Rules and regulation are easy to understand and implement

Disadvantages:
- Admin cost may be greater than benefits, due to NPB not maximised, making consumers unwilling to consume Qs and needing monitoring; Better off not implementing if admin cost more than benefits

Question 55

What is the use of educating consumers in reducing market failure due to positive externality in consumption?

Answer 55

Campaigns can focus on personal benefits rather than to 3rd parties, to be more effective. Consumers internalise ext benefit, raising MPB and Qp rises.

Advantages:
- If consumers internalise the externality voluntarily, outcome is more permanent compared to incentives; less govt intervention needed

Disadvantages:
- Mindset change may take a long time esp since adjusting consumption based on benefits to 3rd parties
- Difficult for consumers to run away from self-interest to maximise satisfaction, esp when raising consumption likely to raise expenditure; In this case, subsidies can be provided.