PJC H2 ECONS P2 Q3

Pioneer Junior College (Economics Department) 1 PJC 2017 H2 Prelim Exam Paper 2 Question 3: The biggest four airlines in America now control 80 % of the market. The US Environmental Protection Agency (EPA) has said that greenhouse ga ses from aircraft endanger human health. Many people in the USA are calling for the use of carbon taxes rather than tradable permits to reduce greenhouse gas emissions. a) Explain how negative externality and market dominance can lead to market failure. [10] Market failure occurs when the free market fails to achieve economic efficiency without government intervention. Allocative efficiency is achieved where Price (P) is equal to Marginal Cost (MC). Market failure could occur due to the presence of negative externalities and market dominance. The presence of negative externality can lead to market failure. Negative externalities are costs borne by third par ties who are not involved in the production or consumption of the good and they are not compensate d for. In the air travel market, the Private Marginal Benefit (PMB) of airlines/producers is the additional revenue they get from the provision of air travel services. The Private Marginal Cost (PM C) borne by the airlines are the fuel and manpower costs of operating a flight. In the free m arket, airlines decide to produce at Qe where PMB=PMC to maximize their welfare. Assuming no posi tive externalities, EMB=0 hence PMB=SMB (Social Marginal Benefit). Negative externalities a rise as the provision of air travel services lead t o the emission of greenhouse gases, which according t o US Environmental Protection Agency (EPA), the emissions endanger human health. Thus residents living near the airport who are the third parties may suffer health problems, such as increased risk of respiratory problems as a result of prolonged exposure to carbon emissions from aircraft. This i ncreased health costs which are third party costs are not compensated for. These External Marginal Co sts (EMC) cause a divergence between Social Marginal Costs (SMC) and PMC by a distance of EMC since SMC=PMC+EMC. The socially optimum level occurs when the addition al cost to society is equal to the additional benefit to society where SMC=SMB for the last unit of air travel service produced at Qs. Since Qe is greater than Qs, there is an over-production of air travel services in the free market. For every additional unit produced between Qs and Qe, SMC>SMB , causing a deadweight loss to society of the shaded area. Thus, negative externalities cause welfare loss and economic inefficiency. Hence negative externalities cause market failure. SMB=PMB PMC SMC Quantity of air travel Cost/Benefit /Price Qs Qe

Pioneer Junior College (Economics Department) 2 Market dominance is another source of market failure as it results in allocative inefficiency. The four airlines in America control 80% of the mar ket. The air travel industry in US exists in an oligopolistic market structure. Oligopolistic firms have high barriers to entry and thus high market power and are able to restrict output and set price higher than marginal cost causing market failure due to allocative inefficiency. With only four airlines providing for most of the a ir travel services in US, there are few substitutes to consumers, making the demand for their air travel s ervices to be price inelastic. With a downward sloping demand curve, they seek to maximize profits and will set output where MC m=MR m at Q 1. Price, P1 exceeds marginal cost, MC 1. Consumers value an additional unit of the air tra vel service more than its marginal cost and welfare can be maximized by i ncreasing output to Q pc and lowering price to P pc, which are the output and price levels of a perfectly competitive market structure. At P pc , price is equal to marginal cost and thus allocative efficiency is achieved. By producing at Q 1 and P 1, deadweight loss of the shaded area is incurred, resulting in market failure. In addition, if the airlines are in a collusive oligopoly, they collude and agree to restrict output and raise prices. They would be behaving like a monopolist in the market, setting prices to maximize profit and the impact on equilibrium price and output leads to allocative inefficiency and this is can also be shown by the same diagram above. Market dominance results in allocative inefficiency and thus causes market failure. Negative externalities and market dominance are sources of market failure in the US air travel market. The US government needs to correct the market failu re and the policy responses will be discussed in (b).

Pioneer Junior College (Economics Department) 3 b) Discuss the alternative policies to tackle the above sources of market failure. [15 ] The sources of market failure in the US air travel market are negative externality and market dominance. The policy responses can include the use of tradable permits, carbon tax and also antitrust policies. One of the policies to correct market failure due to negative externality is the use of tradable permits. The implementation of tradable permit is where a maximum permitted level of emissions is set for a country and the government distributes permits to v arious industries in the economy, allowing them emit up to a specified amount of carbon. US governm ent can consider implementing this policy and distribute permits to the airline industry. It all ows airline industry to trade with the other indust ries on carbon emissions. Airlines that use more efficient methods of product ion will emit less greenhouse gases and hence the EMC in production is lowered, resulting in the dive rgence between SMC and PMC to be reduced. Qs rises and deadweight loss is reduced. These ‘greene r airlines’ can sell the permits to other airlines/firms in other industries who may need to emit more carbon emissions in their production. For firms that are unable to reduce their level of emis sions will have to buy permits to pollute. These fi rms pay for permits to pollute will thus face higher ma rginal cost of production as they need to buy emissions permits to produce additional output. PMC rises to PMC2 and Qty falls (Q2 closer to Qs). There are however limitations to the use of tradabl e permits. The US government faces administrative costs as they still needs to monitor and measure th e amount of greenhouse gas emissions each firm emits when producing their goods and services. It i s also administratively complex as the amount of carbon emissions due to flying is not easy to estimate. It is also important to note that the use of tradab le permits in the US air travel market may result i n unintended consequences. This is so as the US air t ravel market is dominated by a few large airlines, meaning the airlines could potentially exercise the ir market power in the permit market to create distortions in output level. For example, an airlin e could buy up all or most of the permits to push u p permit price so as to increase the cost of producti on for their competitors, either to drive them out of the market or to reduce the market share of their c ompetitors. Such unintended consequences must be addressed if tradable permits are to be used in the US air travel market. Tradable permit is one policy that can be implement ed to tackle the market failure caused by negative externality. One of the policies to correct market failure due to negative externality is the use of taxation. Carbon tax can help reduce emissions. With pollutio n monitoring equipment, the government can impose a tax on airlines, according to how much greenhouse gas they emit. The higher the emissions, the higher the tax. This similarly shifts PMC up to PMC2 as firms face higher costs of production when they need to pay an addit