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 k