EJC H2 ECONS Essay3 Suggested ans and mark scheme

1 3 Medical drugs have been marketed at such extraordinarily high prices that many people will simply not be able to afford them. (a) Explain the possible sources of market failure present in the medical drugs market. [10] (b) Discuss how policies to address these sources of market failure may result in unintended consequences. [15] Suggested Answer for Part a Question analysis Approach Command Word Explain Question Type Causes of Market Failure End Point Sources of Market Failure present in medical drugs market Content and Context Content • Market Dominance • Imperfect information • Inequity Context Medical Drugs Market The sources of market failure in the medical drugs market are market dominance, imperfect information and inequity. Source 1: Market Dominance The market for medical drugs are dominated by a few major pharmaceutical firms such as GlaxoSmithKline, Amgen, and Novartis. This results in a situation where monopoly power exists in the market, and each firm in the market faces a downward sloping demand curve. With reference to Figure 1, the firm chooses to produce at output Qe, where MC =MR so as to maximize profits. However, at Qe, the equilibr ium price is higher than its marginal cost i.e. P > MC In other words, society values medical drugs more than what it costs the monopolist (society) to produce it in terms of the opportunity costs of the resources required. The allocative efficient output is achieved at Q s where P=MC. Hence, there is underproduction by the amount Qs - Qe. Too few resources are being allocated to the production of medical drugs, resulting in deadweight loss (area ABC). This leads to market failure.

2 Source 2: Inequity Since the market is only dominated by a few large firms, the demand curve facing each pharmaceutical firm is relatively price inelastic. Thus, the profit maximising price will occur at a relatively high level, and as stated in the preamble, this will result in high prices for medical drugs, some of which may be essential medication. Due to the high prices, such essential medication are not made available to low income families, resulting in market failure. Source 3: Imperfect information Consumers who consume medical drugs may underestimate the benefit of the medical drugs, as they may not have complete knowledge. Consumers may not be aware of how consumption of certain medical drugs (such as vaccinations) can increase chances of survival significantly. In many places around the world, some consumers (known as Anti- vaxxers) have questioned the effectiveness of vaccinations due to dubious research (which has been discredited), and go as far as to refu se being vaccinated. In these situations, consumers’ perceived private benefit of consuming vaccinations is lower than the actual private benefit of consuming vaccinations (MPBPerceived < MPBActual). Source 4: Positive Externalities in Consumption There are positive externalities accrued to those who are not involved in the consumption of medical drugs. An example of this is the benefit that family members and colleagues (who don’t consume the medical drugs) are also less likely to suffer from illnesses. Due to the presence of the positive externality, the Marginal Social Benefit (MSB) is greater than the Marginal Private Benefit (MPB Actual). Figure 1: Market Failure due to market dominance Pe AR = DD MR Quantity of medical drugs Qe Revenue, Cost, Price MC 0 Qs A C Ps B

3 (Combining Sources 3 and 4) In the free market, the market equilibrium is Q P1, determined by the fact that consumers and firms consider only its private benefits and priv ate costs respectively (MPB=MPC). However, the socially-optimal amount is Q S where MSB=MSC. Since Q P1< QS, there will be an under- consumption of vaccines in the free market. At quantity Q P, marginal benefit to society is greater than marginal cost to society. This means that societal welfare could have be gained by increasing quantity up to the socially optimal output of vaccines Q S. This forgone societal welfare is the deadweight loss (shaded area). Hence, the free market causes under- consumption of vaccines, leading to allocative inefficiency and hence market failure. Level descriptors Level Out of 10 marks Descriptors Level 3 8-10 Displays full slew of sk ills across AO1, AO2 and AO3: • Thorough knowledge displayed by explaining the sources of market failure • Clear and coherent analysis, grounded by economic concepts, frameworks and principles • Good use of relevant examples • Considers at least 2 sources of market failure Level 2 5-7 Displays AO1 and AO2 skills: • Answers are relevant to question but undeveloped explanation of sources of market failure • Limited use of examples (Pure theoretical answer will be capped at 5m) • 1 source of market failure (Capped at 5m) • No diagrams (capped at 7m) Figure 2: Imperfect information and Positive externality in consumption in vaccines E F MPC=MSC=SS Quantity of vaccines Cost/benefi t G MPB Perceived=DDimperfect info MPB Actual Qp1 Qs Qp2 MSB

4 Level 1 1-4 Uneven display of AO1 and AO2 skills: • Smattering of points • Many conceptual errors • Fails to address question requirement

5 (b) Discuss how policies to address these sources of market failure may result in unintended consequences. [15] Approach Command Word Discuss how: Balanced answer + EV Question Type Consequences End Point Unintended consequence of policies to address market failure Content and Context Content • Policy to address market dominance and its unintended consequences (limitations) • Policy to address inequity and its unintended consequences (limitations) • Policy to address imperfect information and its unintended consequences (limitations) Context Medical Drugs Market Introduction With reference to part (a), government intervention can help to address market failure due to various sources but these policies often bring about unintended consequences. Body Policy to address market dominance and inequity: Price controls (Marginal cost pricing) How it works: With reference to figure 1, governments can impose a price ceiling = Ps . Producers will no longer be able to charge their original profit maximizing price (Pe), but instead the price ceiling will induce pharmaceutical companies to increase production to Qs. This addresses the allocative inefficiency in the production of medical drugs. At the same time, setting a price ceiling also reduces the price from Pe  Ps and this will increase the affordability of essential medical drugs to low income families, thereby reducing the inequity present in the market for medical drugs. Unintended consequence 1: The imposition of a price ceiling will lower the supernormal profits made by these pharmaceutical companies to become sub-normal profits. Medical drugs are developed through a rigorous and long drawn process of research and development. These R&D processes are often costly, with no certain of success. The reduction in supernormal profits will reduce both the ability and willingness of pharmaceutical companies to undertake such R&D. In the long run, the quality of medical drugs may not improve to as large as an extent as it could have been, worsening consumer welfare. Unintended consequence 2: In the extreme case, the imposition of such price ceilings will cause pharmaceutical firms to shut down if the price ceiling is set below the average cost of the firms in the long run (also if P < AVC in the short run). This will create even greater deadweight loss to society, since production levels will now fall