RI H1 Economics Lecture Notes 3 Market Failure and Government Intervention

RAFFLES INSTITUTION YEAR 5 H1 ECONOMICS 2018 MARKET FAILURE AND GOVERNMENT INTERVENTION 1 Introduction 2 Efficiency and Equity in Relation to Markets 2.1 How the free market leads to efficient allocation of resources 2.2 Market Failure 2.2.1 Externalities 2.2.1.1 Negative externalities 2.2.1.2 Positive externalities 2.2.2 Demerit & Merit Goods 2.2.3 Public Goods 3 Government Intervention 3.1 Rationale for government intervention 3.2 Taxes and Subsidies (Market-oriented Policies) 3.3 Government Legislation and Regulation 3.4 Direct Government Provision 3.5 Joint Provision 3.6 Education and Campaigns 4 Application to the Singapore Economy 4.1 Solving Traffic Congestion and Air Pollution 4.2 A Closer Look at Education in Singapore 4.3 Examining Healthcare in Singapore Appendix: A: Assessment of the Free Market Economy B: The EU Emissions Trading System References 1 Dornbusch, Begg & Fischer. Economics. 7th Edition. Chapter 15. 2 Sloman, J. Economics. 6th Edition, Hertfordshire: Prentice Hall. Chapter 10 & 11. 3 Gwartney, Stroup & Sobel. Economics: Private and Public Choice. 9th Edition. Dryden. Chapter 5 4 Lipsey, Courant, Purvis & Steiner. Economics. 10th Edition. HarperCollins. Chapter 20. 5 Economics in Public Policies, The Singapore Story, Tan Say Tin et al. Marshall Cavendish, Chapter 3, 6 & 7 Lecture Objectives At the end of this series of lectures, students should be able to: • explain what is meant by allocative efficiency • explain the meaning of market failure • explain the causes of market failure: oexplain externalities as a source of market failure oexplain the concepts of merit and demerit goods and why they result in market failure oexplain why public goods are not provided by the free market with respect to the characteristics of these goods. oexplain how imperfect information can lead to market failure • evaluate policies to correct the various sources of market failure @dream

Year 5 H1 Lecture Notes 2018 Why Markets Fail A. MARKET FAILURE 1 INTRODUCTION Markets do many things well, but they do not do everything well. Most people’s practical and moral sense argue for some degree of state intervention to mitigate areas in which markets do not function well and in which state intervention can improve the general social welfare. In this series of lectures, we identify and explain the microeconomic problems that call for and justify the need for government intervention. Microeconomic problems generally fall into two broad categories: (i) allocative inefficiency and productive inefficiency that arise as a result of market failure and (ii) income inequality that arises as a result of letting the market determine the prices of resources and goods. From the point of view of society’s sense of justice and fairness, the free market distribution is inefficient. To correct market failure and reduce income inequality, various government policies may be adopted to improve the market’s allocation of resources. However, it is important to be aware that sometimes, government failure may also result. 2 EFFICIENCY AND EQUITY IN RELATION TO MARKETS Markets are a good way to organise economic activity. However while markets do many things well, they do not do everything well. In practice, markets sometimes fail to allocate resources efficiently or to achieve social goals like income equity. This section of the notes explores in greater depth the shortcomings of the price system as an allocative mechanism and the economic rationale for government intervention in a market economy. Efficient allocation of resources includes allocative efficiency and productive efficiency. Allocative Efficiency: Allocative efficiency is the situation in which the society produces and consumes a combination of goods and services that maximises its welfare. It is achieved when goods and services wanted by the economy are produced in the right quantities. Allocative efficiency is achieved when  Price equals marginal cost of production (P=MC), where society’s valuation of the last unit of good consumed is equal to the opportunity cost in producing that last unit of output  Marginal Social Benefits equals Marginal Social Costs (MSB=MSC), where the additional cost to society of the last unit of output produced/consumed is equal to the additional benefits to society of the last unit of output produced/consumed. Productive Efficiency: how to produce Productive efficiency is achieved when all resources are fully and efficiently utilised and the cost of producing any given level of output is minimised. From a macro-economic perspective: Productive efficiency is achieved when society produces at any point on the Production Possibility Curve (PPC). Productive efficiency is achieved when resources are used to maximum capacity. That means they are fully employed i.e. there is neither unemployment nor under-employment of resources. In this regard, all points on the Production Possibility Curve are productively efficient. Market failure is defined as the failure of the free market to achieve allocative efficiency, resulting in over-allocation / under-allocation of resources relative to the socially efficient level or to achieve social goals such as income inequality. @dream

Year 5 H1 Lecture Notes 2018 Why Markets Fail Dynamic efficiency This occurs in a market over a period of time when changes are occurring at the best rate in the economy. It focuses on changes in the amount of consumer choice available in the markets together with the quality of goods and services available. For example: Is new technology being developed and adopted at the best rate? Are firms reducing costs over time? Dynamic efficiency can be boosted by Research & Development (R&D) spending that leads to improvements in products and the production process; investment in the human capital of the workforce leading to gains in productivity and in product quality which is vital in high value high- knowledge sectors; greater competitive pressures in markets and the transfer of knowledge and ideas across countries. Equitable distribution of goods: For whom to produce It is important to note that efficient resource allocation may not result in an equitable outcome as expected by society. Equity can be defined as fairness in the distribution of economic welfare. Society’s sense of fairness and justice in the distribution and access to essential goods and services, such as education and healthcare services involves value judgement. 2.1 HOW THE FREE MARKET MAY LEAD TO EFFICIENT ALLOCATION OF RESOURCES (Recap of previous set of lecture notes) Allocative Efficiency (1) Demand and supply framework: The free market economy allocates scarce resources according to the forces of market demand and market supply. Assuming perfect competition (i.e. a competitive market) and the absence of other sources of market failure, the equilibrium quantity where supply equals demand typically represents allocatively efficient level of output. The right amount of resources is allocated to the production and consumption of the good from society’s point of view. To use Adam Smith’s famous metaphor, the “invisible hand” of the marketplace leads buyers and sellers in a market, each pursuing only self-interest to maximise the net benefit that society derives from that market. Figure 1 shows the market for corn. The demand and supply curves contain important information about benefits and costs. The demand curve for corn (DD) reflects the value of corn to consumers, as measured by the pric