NYJC H1 ECONS Q3 suggested answer

1 2017 JC2 H1 Econs Prelim Exam Suggested Answers for Question 3 3 (a) Explain how the existence of merit goods such as art galleries represent market failure. [10] (b) Discuss the view that subsidies to provide free entry to art galleries is the best way to achieve efficient allocation of resources. [15] a) Explain how the existence of merit goods such as art galleries represent market failure. [10] Command Word: Explain Context: Art Galleries Content: Market failure (Merit Goods) Intro: Merit goods are goods that the government feels that the people will under-consume due to poor economic decisions (imperfect information) that they make on their own behalf and that it give rise to positive externalities when consumed. 1: Imperfect Information Due to imperfect information, consumers may not rea lise that making visits to art galleries enhances the quality of life and helps th em to develop their critical thinking, to cultivate creative problem-solving and to commun icate and express themselves effectively. Therefore, they may not visit the art galleries at the socially optimal level. This can shown in the diagram below (Figure 1) wher e consumers perceived the marginal private benefit to be at MPB perceived which is lower than the actual MPB (MPB actual ). Hence, with no government intervention, consumer s will only be concerned about MPB perceived and MPC and visit art galleries at Qc which is belo w the socially optimal level, Qs (where MSC = MSB).

2 Hence, as a result of under-consumption of visits t o art galleries, it result in a deadweight loss of the shaded area as shown in Figu re 1 leading to inefficient allocation of resources and thus market failure. 2: Positive Externality In addition, when merit goods are consumed, it give s rise to positive externalities. When visiting art galleries, consumers are only concerned with the own private benefit (e.g. leisure) and private cost (e.g. entry fee). However, it gives rise to external benefit as well which are the economic benefits to the coun try. Art galleries provide job opportunities directly and indirectly due to touris ts visiting the art galleries and spending in other sectors during their stay in the country. If there is no government intervention, consumers w ill only consider their private benefit (MPB) and private cost (MPC) and consume at Qc (refer to Figure 2), ignoring the external benefit (MEB). The presence of externa l benefit result in the divergence of MSB and MPB and the socially optimal number of v isits to the museums is at Qs where MSB cuts MSC. This leads to an under-consumpt ion of visits to art galleries resulting in the presence of deadweight loss as sho wn by the shaded area shown in Figure 2. Thus, the market has failed as there is u nder-allocation of resources to the visits of art galleries. Figure 1 Qc

3 Conclusion: As the market has failed to allocate resources to the visits of art galleries which is a form of merit goods, it is important that the government intervenes through various ways such as providing subsidies to increase the consumption level to Qs. Marking Scheme L3 For a well-developed explanation of how existence of merit goods such as art galleries represent market failure (both positive externality and imperfect information). 7-10 m L2 Underdeveloped explanation of how existence of merit goods such as art galleries represent market failure. Max 6 marks for candidates who only mentioned about positive externality or imperfect information leading to market failure. 5-6m L1 Descriptive answer lacking in economic analysis and consists of conceptual errors. 1-4m Figure 2

4 b) Discuss the view that subsidies to provide free entry to art galleries is the best way to achieve efficient allocation of resources. [15] Command Word: Discuss Context: Art Galleries Content: Subsidies (Free Entry) to solve market failure arising from the presence of merit goods, alternative policies to subsidies Intro: • Presence of merit goods leads to market failure du e to imperfect information and positive externality. • To achieve efficient allocation of resources, gove rnment has to implement policies to encourage more consumers to visit art galleries. Body: 1: Thesis Subsidies to provide free entry to art galleries is one of the best ways to achieve efficient allocation of resources • By giving subsidies to provide free entry, consume rs will consume up to the point where MPB equates to zero as the cost to them is zero. Cost/Benefit No. of visits to art galleries 0 MSB = MPB + MEB MPB MSC = MPC (Assuming MEC = 0) Qs Qc DWL Figure 3

5 • With reference to Figure 3, when MPB = 0, consumer s will now consume at Qs level which is the socially optimal level of consumption. Thus, the market has achieved efficient allocation of resources. • Nevertheless, this is the best method only if MPB = 0 at the Qs level. 2: Anti-thesis: Limitations of subsidies to provide free entry • As mentioned, it is only the best method if MPB = 0 at Qs level. However, when services are provided for free, consumers tend to overconsume the goods and hence, they will visit the art galleries beyond the Qs level as shown in figure 4. • As Qp > Qs, there is overconsumption of the visits to art galleries and it will create a new deadweight loss of area B as shown in figure 4. The deadweight loss may be even larger than the initial deadweight loss (when there is no government intervention) if Qp is significantly larger than Qs. • Furthermore, the government incurs a large opportu nity costs as the large sum of money that is used to provide free entry can be spent in other areas such as healthcare and education services. Cost/Benefit No. of visits to art galleries 0 MSB = MPB + MEB MPB MSC = MPC (Assuming MEC = 0) Qs Qc A Qp B Figure 4 Overconsumption due to free entry

6 • The government may even experience budget deficit if it has to provide entrance to art galleries for free for a long period of time so as to increase consumption. • Also, by providing it for free may only solve part of the problem due to the presence of positive externality. Providing it for free does not tackle the problem with regard to imperfect information. There may be free entrance but if consumers do not think that it’s beneficial for them, the increase in visiting the museums may be limited. • Therefore, subsidies to provide free entry to art galleries is not the best way to achieve efficient allocation of resources 3: Anti-thesis: Alternative policies should be implemented instead Alternative policy 1: Partial Subsidy • Instead of providing it for free, the government s hould implement partial subsidy. If the government has sufficient information about the external benefit, they can equate the amount of subsidy to be the MEB value instead of providing it for free to avoid overconsumption. • Hence, consumers’ MPC will now fall by the MEB val ue to MPC 1 as shown in figure 5 and it will intersect MPB at Qs level. Thus, the deadweight loss is reduced and efficient allocation of resources is achieved. • Government is also able to adjust the level subsid y over time to ensure the visit to art galleries to be at Qs level. Therefore, this may be a better alternative to free provision. No. of visits to art galleries 0 MSB = MPB + MEB MPB MSC = MPC (Assuming MEC = 0) Qs Qc Figure 5 Cost/Benefit MEB MPC 1 (with subsidy =MEB)

7 • However, the government must have sufficient infor mation and the ability to accurately to measure the value of MEB. Government may over or under subsidise due to imperfect information and the deadweight loss may not be reduced.