2013 MI H1 Econs Essay Mark Scheme

3 (a) Using appropriate examples, explain why the existence of negative externalities and public good causes market failure. [10] (b) Discuss the various policies which the Singapore government adopts in correcting the market failures above. [15] Suggested answer: Part (A) Intro 1. Define market failure  Less than desirable outcome where resources are not used in the most efficient way. Hence, there is allocative and productive inefficiencies.  Partial market failure: where there is over or under production/consumption which leads to inefficient allocation of scarce resources. This arises when there are externalities.  Define externalities 1. 3 rd party effects on someone not directly involved in the production &/or consumption of a gd. 2. may be negative( external cost or 3 rd party cost) or positive ( ext. benefit or 3rd party benefit) Body 1. State that traffic congestion is a form of partial market failure where there is negative externality  Define negative externalities (by making reference to any e.g.: road congestion, smoking): external cost to 3rd parties who are not directly involved in the production and/or consumption of the good. For example, road congestion generates noise and air pollution that affect the quality of living for residents living near the congested roads or road congestion leads to a delay in arrival time for work for other road users such as passengers on public buses. This could lead to a fall in the revenue for firms when the workers report late for work./ Smoking generates second hand smokers which can cause other non-smokers to have health problems like breathing difficulties.  Because of the presence of negative externa lities, there is a divergence between private costs and social costs by the extent of the external costs. 2. Explain how road congestion/second hand smoke results in negative externalities and hence, market failure.  Diagram showing socially optimal level of consumption (MSC=MSB) and the equilibrium level of consumption without government intervention (MPC=MPB).  Show that there is overconsumption of cars/smoking and hence, welfare loss to society. D E MPC MSC Quantit y C Cost, benefit 0 MPB=MSB Qs Q m

  Assuming that there is no external benefit, marginal private benefit (MPB) is equal to marginal social benefit (MSB). In this case, marginal private cost could include cost of petrol and the depreciation cost of the car for the additional trip, and the time lost when the driver is caught in traffic congestion/ cost of cigarettes, personal health problems. Marginal private benefit could be in terms of the convenience one gets from driving a car/satisfaction from smoking. The private equili brium occurs at MPC equals to MPB, i.e. 0Qm level of traffic flow/smoking in a not crowded place. The social equilibrium occurs at MSC, which is the summation of marginal private cost and marginal external cost, equals to MSB, i.e. 0Qs level of traffic flow. If left alone, the price mechanism will bring about a level of traffic flow that is higher than what is deemed to be socially desirable.  As a result, there is a deadweight or welfare loss to society of area EDC. There is welfare loss because the MSC exceeds the MSB for each additional trip taken beyond 0Qs. Hence, the government should deal with traffic congestion.  When the number of cars exceeds the road capacity, traffic congestion arises, which is a form of market failure. As resources are allocated inefficiently by the market mechanism, the government has to intervene. How Public Goods cause markets to fail:  Private sector will not be willing to provide such public goods as the free rider problem make it difficult to charge people.  Important to highlight the non-excludable and non-rival nature of public goods with the use of appropriate examples  It is impossible for the producer to know w here, when, how much and who to charge and hence no profits can be made.  But public goods are vital or essential to the nation Eg: National Defence, Policing for  keeping law and order ….etc  Provision of public goods results in positive externalities (MSB>MPB),  No resources will be allocated to the production of public goods in the private sector.  Market fails as there is no provision of public goods at all (absence of market). Mark Scheme L3 7-10 Good analysis of welfare loss using relevant marginal cost and benefit concepts, with help of appropriate di agram. Competent explanation with good description of terms and a clear understanding of the concepts involved.. L2 5-6  Shows understanding the market failure which results in welfare loss and/or with little explanation  Diagram is drawn but with errors  Examples are missing but may show some inaccuries; if they are included, concept of external cost is not clearly explained. L1 1-4 Showed little/ some basic concepts. May contain inaccuracies and/or irrelevant information

Part b Introduction  Negative externalities like smoking occurs when there is over consumption of the use of cigarettes. It is again necessary to implement policies to reduce the market failure./ Traffic congestion occurs when there are too many cars on the road, given the road capacity. Therefore, it is necessary to note that policies implemented to reduce the problem of traffic congestion must tackle the problem of car ownership and car usage.  The Singapore government has implemented a range of policies to tackle the problem of smoking. These policies include taxation, moral suasion and education. / The Singapore government has implemented a range of policies to tackle the problem of traffic congestion. These policies include COE, ERP system and improvement of the public transport system. It is important to note that main cause of Singapore’s current traffic congestion problem arises primarily due to excessive car ownership. Body 1. Taxation  Singapore has implemented various forms of taxes to curb the problem of congestion. (a) Motor Vehicle Taxes & Road Tax and tax on complementary good i.e. petrol o Explain how the traffic congestion leads to market failure or deadweight loss using relevant examples and the aid of a diagram (see below). o Taxation is done with the purpose to internalise the external cost to reduce the road usage. This can be achieved by imposing taxes that is equal to marginal external cost. o This policy has been implemented by the Singapore government and can be seen from the taxes on petrol and the imposition of motor vehicles taxes and road taxes. o When the tax is imposed, the MPC curve shifts up by the amount of the tax to the MPC+tax curve. As a result, traffic flow is reduced from 0Qm to the socially optimal level of 0Qs. Evaluation (for both Taxation and ERP, unless otherwise stated) traffic flow (number of cars on the road) costs, benefits MPB = MSB MPC MSC = MPC + tax 0 Qm Qs E C tax

 This policy of taxation is suitable if the country is able to obtain accurate estimates of the level of external cost and hence, the amount of tax or ERP charge. This is because overtaxing or overcharging may result in underutilising of roads while under-taxing or undercharging may still result in congestion. Therefore, for a developing country that has problems in data collection, the amount of tax imposed may not be optimal.  Unit tax on cigarettes to discourage smoking. In Singapore, the total tax as a % of retail price is 69%. The high tax is to reduce the consumption of cigarettes in order to reduce the negative externality. (Theoretical explanation as above). Evaluation  Hard to determine how much to tax  Over- correction may also result in market failure. 2. Direct controls through quotas  In Singapore, the government also uses tradable permits to reduce the problem of conges