RVHS_H1_ECONS_EQ3

2015 H1 Preliminary Examination II (Question 3) a) Explain why the price mechanism fails to allocate resources efficiently in the free market. [10] b) It is generally recognised that the emission of harmful gases by industries generates negative externalities. Discuss the view that a policy of tradable permits is the best that is available to tackle this problem in an economy such as Singapore. [15] a) Explain why the price mechanism fails to allocate resources efficiently in the free market. [10] The free market fails to achieve allocative efficiency in the presence of e xternalities or in the case of public goods. In the case of externalities, there are positive and negative externalities. Positive externalities refer to beneficial side effects of production or consumption on persons other than the consumers and the producers themselves and t he third parties do not make payment to enjoy this external benefit. Negative externalities are harmful side effects of production or consumption on persons other than the consumers and the producers themselves and the third parties are not compensated for the external costs incurred. Consider the situation where by the production/consumption of a good/service gives rise to negative externalities, for example, in th e course of producing goods in factories , smoke and harmful gases are emitted. These factories are only concerned with the ir private costs, which is the c ost of raw materials that they incur from the production of goods but are not concerned with external costs like additional healthcare costs incurred by third parties. As marginal social cost (MSC) is equals to the summation of marginal private cost (MPC) and marginal external cost (MEC), the presence of negative externalities (i.e. MEC > 0) implies that MSC is greater than MPC. Assuming there are no positive externalities, i.e. marginal social benefit (MSB) is equals to marginal private benefit (MPB), the market for this good could be represented in the diagram below. Figure 1: Over-consumption/production due to negative externalities With reference to Figure 1, the production/consumption of the good occurs at Qm, where demand intersects supply or MPB=MPC if left to the free market. When producers/consumers decide how much to produce/consume, they do not take int o account the external costs imposed on third parties (MEC). However, the socially optimal level of output is Qs, given by the intersection of MSB and MSC, since society’s welfare is maximised when MSB=MSC. Since Qm > Qs, there is over - consumption/production of the good if left to the free market , which means that resources are not efficiently allocated as too much resources are being allocated to the production of the good. The welfare loss to society (i.e. deadweight loss) is shown by area ABC. Price/Cost/Benefit Qty SS = MPC O Qs Qm DD = MPB = MSB C B A MEC MSC = MPC+M