NYJC H2 ECON ESSAY QN 3

Question 3 a. Explain how the presence of negative ex ternalities and market dominance can lead to market failure. [10] b. Discuss what policies a government might adopt to achieve a more efficient allocation of resources where market dominance exists. [15] Suggested Answers a. Explain how the presence of negative ex ternalities and market dominance can lead to market failure. [10] Synopsis: Negative externalities & market dominance are sources of market failure and students are required to elaborate on how each of the above factors can cause market mechanism to fail. Using examples would aid in the analysis of the question. 1. Define market failure (highlighting the essential components): a. Workings of free market leads to undesirable outcomes from a societal viewpoint leads to: - Deadweight losses - Total (ie. consumers’ plus producers’) surpluses or societal welfare is not maximized – because of quantities (restricted) or price set - Inefficient allocation of resources b. Hence a market does not fail when the workings of the free market leads to - No deadweight losses - Total (ie. consumers’ plus producers’) surpluses or societal welfare are maximized - efficient allocation of resources 2. Explain how negative externalities cause market failure a. Choose a context of a particular market activity to illustrate a negative externality in production or consumption (application) – eg. negative externality arising from production using example (Power production) b. Define negative externality in context – the actions of producing electricity by parties directly involved (1 st parties) imposes an external cost (EC) on other members of society (3rd parties). c. The free market perspective - Identify objective of the 1st party - to maximize net private benefits where the revenue that they would gain from the level of power production is more than the costs incurred in using/buying resources to produce that level of power (ie. TPB – TPC = max.) - Choosing to produce at output level where MPB=MPC, i.e. Qp. (Pte equilibrium). - When the 1st party produces electricity, they generate negative externality (eg. air pollution & greenhouse gases all of which results in global warming) that imposes external costs for other members of society (3 rd parties). - This external costs (EC) comes in terms of possible harsh weather as a result of global warming and through the harsh weather results in possible poor harvest or ill health which translates into financial or monetary losses for 3 rd parties.

- 3rd parties here refer to the people living in the vicinity of the power station who are not directly involved in the activity of power production by the power stations. - The EC will cause a divergence between private costs and social costs causing the marginal private cost (MSC) curve to be higher than the marginal private benefit (MPC) curve. (See Figure 1) - It should be noted that as a result of the EC imposed, output Qp results in MSC > MPC due to MEC. d. The societal perspective - Identify the objective of the society – to maximise societal welfare or net social benefit, (where TSB – TSC = max.) - Preferred output level is where MSB=MSC, ie. output Qs. - At output Qp, with MSC>MSB, any production adds more to cost than benefits for the society – leading to a deadweight loss (vertical distance) for this unit of production. - This deadweight loss cease to exist once the preferred (optimum) output level is achieved (where MSB=MSC ie. output Qs). - So long as pte/free market output levels (Qp) is greater than optimum output levels (Qs) there is an over-production of the good and an over-allocation of resources. - The shaded region (Figure 1) represents the deadweight loss (or monetary measure of welfare loss) to society when 1 st parties are maximising their net private benefits when externalities exist at Qp resulting in over-production of goods. - Thus, market failure results as there is an over-production of the goods that emits negative externality and resources are inefficiently allocated as such. MPB = MSB MSC = MPC + MEC MPC Cost/ Benefit Deadweight losses due to overproduction MEC Qs Qp Quantity Overprovision Figure 1

3. Brief explanation of market dominance a. The only firm (monopoly) or one of the few firms (in an oligopoly) that has a high level of market control or influence due to: - Large market share or high concentration ratio (ratio of firm’s output to market output) - Level of control or influence synonymous to the level of the barriers to entry - Able to set price or output sold but not both (for a differentiated product) 4. Explain how market dominance can lead to market failure a. The dominant firm’s perspective (ie. the monopoly or one of the oligopolistic firm) - Identify the objective of the firm – To profit maximize (Traditional Theory) - Choosing to restrict output at the level where the additional revenue gained for an additional unit produced (MR) equals the additional costs incurred for that additional unit produced (MC) ie. at QE where MR=MC (Marginalist Principle) (See Figure 2) - Setting output where profits are maximized (MR=MC) results in an equilibrium price set above marginal cost (P>MC) at QE. - Hence the valuation of (or benefits to) consumers for the additional unit of the good produced (P) is greater than the opportunity costs incurred in using resources to produce that additional unit (MC) – the vertical distance represents a degree of consumer or monopolistic exploitation. - The high market share implies firm’s demand curve (AR) is rather demand inelastic. Hence there is a fairly large degree of exploitation for every unit of output produced when there is market dominance by a firm. b. The societal perspective - The objective of society is to maximise societal welfare or total surpluses. - Net social benefit or maximum total surpluses occurs at an output level where the valuation of (or benefits to) consumers for the additional unit of the good produced (P) is equal to the opportunity costs incurred in using resources to produce that additional unit (MC) (ie. Price = Marginal Cost) - The preferred optimum output for the society is at Q S where the price, P1 is determined by the point of intersection of the market demand curve (AR) with the supply curve or the MC in the case where there is no market dominance (ie. in a perfectly competitive market). (See Figure 2). - At output QS and price P1, total societal surpluses (consumers’ and producers’) could be maximized – where P = MC. - Hence so long as the output produced and sold is where P>MC, the output produced (QE) will be less than the socially optimum level (QS) – implying that the consumers’ and producers’ surpluses (total surpluses or societal welfare) are not maximized. There is a deadweight loss to society (Shaded area in Figure 2). - The presence of a deadweight loss to society due to market dominance that led to an under-production (restriction) of output implies that there is market failure and an inefficient allocation of resources. - The high market share implies firm’s demand curve (AR) is rather price inelastic. Hence there is a fairly large degree of exploitation and deadweight loss to society when there is market dominance by a firm or few firms.

[Figure 2] L3 Detailed and well-developed explanation clearly illustrating how negative externality and market dominance lead to market failure. Well supported by the use of relevant examples. 7-10 L2 Limited explanation (listed ideas and not adequately developed) illustrat