Market Failure (H1 Economics/ 8823)

Catholic Junior College

H1 Economics (8823)
THEME 2: MARKETS (H1)

2.2 Market Failure

Enduring Understanding

The free market does not always ensure resources are efficiently or equitably
allocated, i.e. in some real-world cases, the free market fails to allocate
resources efficiently or equitably. During these times the government will need
to intervene, albeit with varying degrees of success.

Essential Questions

1. Why does the free market system not allocate resources

efficiently/equitably at certain times?

2. How can the government bring about greater efficiency/equity in the

free market system?

3. Are these intervention methods always effective?

Unit Summary

In the first chapter, we studied the problem of scarcity and how it leads to the
three basic economic questions of what and how much to produce, how to
produce, and for whom to produce. In the second chapter, we went on to
examine how markets allocate scarce resources through the forces of demand
and supply (i.e. the price mechanism). Our analyses also showed how the
price mechanism can lead to allocative efficiency and the maximisation of
social welfare under certain assumptions.

However, free-functioning markets need not necessarily always lead to the

maximisation of social welfare, as in reality, there is usually a misalignment
between private individuals’ and society’s goals. This leads to failure in some
markets as they fail to allocate resources efficiently.

In this unit, students will learn the different sources of market failure. They will
understand that market inefficiencies can arise when consumers and
producers pursue their own self-interest. The result of these inefficiencies is
deadweight loss, and society suffers as a result.

Governments intervene to address such inefficiencies in the market by

determining the optimal societal output which forms the basis of government
intervention. Whether the government ultimately decides to intervene in a
particular market requires the government to go through a decision-making
process, which we will look at in greater detail under Section 5 of this set of
notes.

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Market Failure (H1 Economics/ 8823)

However, due to imperfect information, the government also faces significant

challenges in determining the extent of market failure and the optimal amount
of intervention required. As a result, policy implementations are often made
with imperfect information and uncertainty, and this could lead to a more
inefficient allocation of resources than if the markets were left alone.

With the understanding of the sources of market inefficiencies and the

respective implementations by the government, students will be able to
appreciate the rationale and effects behind certain government actions in the
local and global contexts. They will be able to analyse and evaluate the
implementations proposed in correcting market inefficiencies in the real world.
Students will also understand the complexities and challenges in achieving
society’s ideal outcomes in reality, made evident through the numerous
examples of government failures across the world.

REFERENCES:
1. Economics, John Sloman & Alison Wride, 7th Ed, Ch 11, 12
2. Economics, Parkin, 6th Ed, Ch 18
3. Economics Course Companion, 1st Ed, Blink & Dorton, Ch 13

Compulsory Reading
1. Economics in Public Policy, Tan, et al, 2009, Ch 2

Supplementary Reading
1. Economics in Public Policy, Tan, et al, 2009, Ch 7
2. Economic Review, “Fat of the Land”, Feb 2008, Pg 31-33

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Market Failure (H1 Economics/ 8823)

H1 8823 Syllabus Requirement

1) Explain the meaning of market failure and efficiency.

2) Analyse why markets may not work efficiently.

a. Analyse why the existence of goods and services with positive

and negative externalities, merit and demerit goods and public
goods can lead to inefficiency.
b. Understand that externalities exist when there is a divergence
between private and social costs/benefits.
c. Understand what is meant by deadweight loss when discussing
market failure.

3) Understand that efficient resource allocation may not result in equitable

outcomes.

4) Know that the objectives of government microeconomic policy are to

achieve efficiency in resource allocation and to promote equity.

5) Examine the various methods and decisions that governments could

make in order to improve the functioning of markets and equity.

a. Explain how the various government intervention methods

improve the functioning of markets and/or improve equity
b. Discuss the effectiveness of these government intervention
methods in correcting market failure and their limitations.

6) Understand how governments make decisions in real-world contexts.

a. Non-economic considerations, such as public and political

acceptability, should be taken into consideration when
governments make policy decisions.

7) Discuss that government intervention does not necessarily lead to more

efficient outcomes.

a. Explain that government failure may occur. Government

intervention might introduce further inefficiencies due to high
administrative costs, information gaps and time lags resulting
from red tape and bureaucracies.

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CONCEPT MAP

1. Subsidies
2. Direct Provision
3. Income
Redistribution
Policies

May cause income distributional Inequity

Free market problem

Sources of Market Failure

1. Externalities 3. Public Goods

can be solved by

2. Merit and Demerit Goods

can be solved by

Positive Negative

1. Direct Provision
can be solved by

can be solved by

Same policies as positive and negative

externalities and Public Education is needed to
solve the imperfect information
1. Subsidies 1. Taxes
2. Direct Provision 2. Ban
3. Joint Provision 3. Regulation
4. Legislation 4. Marketable Pollution Permits

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Market Failure (H1 Economics/ 8823)

CONTENT

1 Introduction

2 Government’s Microeconomic Objectives

3 Sources of Market Failure

3.1 Externalities
3.1.1 Negative Externalities
3.1.2 Positive Externalities

3.2 Merit and Demerit Goods

3.2.1 Merit Goods
3.2.2 Demerit Goods

3.3 Public Goods

3.3.1 Characteristics of Public Goods and
Why Free Market Fails in the Provision of Public
Goods
3.3.2 Government Intervention

4 Government Failure

5 Decision Making Process

6 Conclusion

Annex A – Carbon Tax VS Cap-and-Trade

Annex B – Public-Private Partnership

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Market Failure (H1 Economics/ 8823)

Minimum legal age for smoking raised to 19 from Jan 1

From 1st Jan 2019, smokers will have to be 19 years old before they can
light up, up from the current age of 18, while Orchard Road will become
almost entirely smoke-free. Minimum legal age will be raised progressively
every January until 2021, when smokers will have to be at least 21.

"Raising the minimum legal age is part of the Ministry of Health's (MOH's)
ongoing efforts to enhance public health and reduce smoking prevalence in
Singapore," the ministry said. "It aims to prevent youth from picking up
smoking by limiting access to tobacco products, and to further de-normalise
smoking particularly for those below 21."

The ministry added that it remains committed to lowering smoking

prevalence in Singapore through a comprehensive approach to discourage
and reduce the use of tobacco products. This includes public education on
the harms of tobacco use, efforts to encourage tobacco-free living,
legislative restrictions on tobacco advertising and promotion, and fiscal
policies like tobacco taxation.

Adapted from The Straits Times, 30 Dec 2018

Questions
1. Why is there a need for the government to prevent smoking? List
down all the reasons you can think of.
2. What are some measures put in place to prevent smoking? Do you
think they are effective?

E-Scooter: to ban or not to ban?

On November 4 2019, the Singapore government announced that e-

scooters would be banned from footpaths. The ban came amidst a series of
e-scooter related accidents despite measures such as the reduction in
speed limits on footpaths, mandatory registration of e-scooters and
campaigns to promote safe riding habits for e-scooter users. The
announcement created a huge uproar among e-scooters users, especially
food delivery riders who had relied on e-scooters as a mode of
transportation. The led to many people questioning whether the ban was
necessary.

Source: EconsMatters, Curriculum Planning & Development Division,

Issue 1 2020

Questions
1. Why did Singapore choose to ban e-scooters on footpaths?
2. How have other countries deal with the issue of errant behaviours
in the use of e-scooters?
3. What are the alternative policies that countries could implement?

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Market Failure (H1 Economics/ 8823)

1. Introduction

A major focus of this chapter is the decisions that a government has to make
with respect to market failure and this could be in two areas. Firstly, which
markets to intervene in; and secondly, the type and extent of intervention in
each market to achieve the microeconomic objectives of the government -
which are (i) efficiency and (ii) equity. The decision-making framework
presented below is centred on the decisions to be made by the government.

STAGE 1: MAKING A DECISION

When making a decision, the government has to consider the costs and benefits
of each choice available, its own constraints (funds and time available), the
information that it needs to gather, as well as the perspectives of the decision
when viewed by different groups of people in society (e.g. producers and
consumers, lower-income groups, etc.).

STAGE 2: OUTCOMES OF MAKING A DECISION

The government intervenes with the intention of achieving an efficient and

equitable allocation of resources. In other words, these are its intended
consequences of intervention. However, unintended consequences may also
arise due to a variety of reasons, such as imperfect information. For example,
the government may face significant challenges in estimating the real costs of
the market failure. As a result, policy implementations are often made with
imperfect information and uncertainty, and this could, in some instances, lead
to a more inefficient allocation of resources than when the markets are left
alone.

STAGE 3 (The Dynamic Stage): REVISITING A DECISION MADE

When unintended consequences occur due to changes (in the internal or

external environments), the original decisions made by the government may no
longer be optimal and therefore the decision-making process will be revisited
with a new set of considerations. This dynamic process therefore makes it

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necessary for the government to review its decisions whenever its objectives of
efficiency and equity are not achieved.

In Section 5, we will further explore this decision-making process using the

specific context of the healthcare market as an example.

2. Government’s Microeconomic Objectives

The government has two main microeconomic objectives:

(i) Efficiency in allocation of resources

(ii) Equity in wealth and income distribution

The free market may allocate resources efficiently and equitably only if all the
following assumptions hold in the free market:

1. Goods and services sold in the free market are rivalrous in

consumption, and excludable
2. There is an absence of externalities
3. There is perfect competition
4. There is perfect information
5. There is perfect mobility of factors of production
6. There is equitable distribution of income

However, the above assumptions frequently do not hold in the real world and
therefore market fails to achieve efficient allocation of resources, also known as
market failure. Governments need to intervene when there is market failure to
ensure that the allocation of resources is efficient.

3. Market Failure

Definition: Market failure occurs when the free market fails to bring about
an efficient allocation of resources. It occurs where the marginal social
benefit do not equal marginal social cost.

Causes of Market Failure

The following are some common causes of market failure which we will
discuss.

• Negative and positive externalities

• Demerit and merit goods
• Public goods

3.1 Externalities

In earlier lectures, we have learned how the free market equilibrium is

established when quantity demanded is equal to quantity supplied.

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The demand and supply curves contain important information about private
benefits and private costs. The demand curve reflects the value of the product
to consumers, as measured by the prices consumers are willing to pay. That is,
it shows the value to consumers of the last unit of the good consumed. The
demand curve thus reflects the consumers’ additional utility or marginal private
benefit (MPB) at a given quantity consumed.

Similarly, the supply curve reflects the marginal private costs of producing the
good. At any quantity, the supply curve shows the costs in terms of resources
used in producing the last unit of the good. The supply curve therefore reflects
the producers’ additional cost or marginal private cost (MPC) incurred in
producing the last unit of the good.

Price
SS = MPC

E
P

DD = MPB


0 Q Quantity

Figure 1a: Free Market Equilibrium

At the free market equilibrium, the marginal private benefit for the last unit of
the product bought as reflected by the price that consumers are willing to pay
equals the marginal private cost incurred in producing that last unit of the
product and therefore,

MPB = MPC

Where:

➢ Marginal Private Benefit (MPB) is the extra benefit gained by a buyer

from consuming an additional unit of a good or service.

➢ Marginal Private Cost (MPC) is the extra cost of producing an

additional unit of a good or service which is borne by the seller of the
good.

According to the Marginalist Principle as explored in Central Problem of

Economics, this is also the point where the private individual’s net welfare is
maximized.

However, the output where MPB=MPC may not be the socially optimal output
where society’s welfare is maximised. In the free market, private individuals may
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have failed to take into consideration that there may be external costs/benefits
that are incurred by/accrued to third parties who are neither the consumers nor
producers in a particular transaction. These are known as externalities.
Without taking into account any externalities that may have been generated,
the free market equilibrium will not be efficient from the society’s point of view.
Therefore, market failure occurs.

Definition:
An externality is a cost or benefit of production or consumption of a
product that is borne by third parties who are neither the buyer nor seller,
and for which no payment or compensation is made.

In the case of a negative externality, the consumption/ production activity

creates an external cost on third parties. For example, when a factory that
produces garments dumps toxic waste from the dyes they use into the river,
the fishes may die as a result and the fishermen (the third parties) suffer a
loss in catch. They are not compensated for their loss in earnings (i.e. third
parties stand to lose).

In the case of a positive externality, the consumption/ production activity

creates an external benefit on third parties. For example, when a person is
vaccinated against measles, the others around him (the third parties) will
benefit in terms of a lower risk of contracting measles despite not having paid
for the vaccination (i.e. third parties stand to benefit).

The socially efficient equilibrium is established when the Marginal Social Benefit
(MSB) (benefit accrued to the entire society from consuming a good) equals the
Marginal Social Cost (MSC) (cost borne by the entire society from producing a
good), that is:
MSB = MSC
Where:

➢ Marginal Social Benefit (MSB) is the marginal benefit enjoyed by

society, i.e. by the consumer or producer of a good or service
(marginal private benefit) AND the marginal benefit enjoyed by third
parties (marginal external benefit/ MEB). Therefore,

MSB = MPB + MEB

o MEB (positive externality) refers to the benefit from

production/ consumption of an additional unit of a good or
service that is enjoyed by third parties who are neither the
buyers nor sellers of the good/service.

➢ Marginal Social Cost (MSC) is the marginal cost incurred by society

i.e. by the consumer or producer of a good or service (marginal private
cost) and the marginal cost borne by third parties (marginal external
cost/ MEC). Therefore,

MSC = MPC + MEC

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o MEC (negative externality) refers to the cost from production

/ consumption of an additional unit of a good or service that is
borne by the third parties who are neither the buyers nor
sellers of the good/service.

As mentioned above, the output where MSB = MSC is also output where the
society’s net welfare is maximised. This is known as the socially efficient
equilibrium. At this equilibrium, both productive and allocative efficiency are also
achieved.

Why is the output where MSB=MSC the output where society’s net welfare is
maximised?

To simplify the analysis, let us assume that the assumptions stated on page 8
hold. It then follows that MPC=MSC and MPB=MSB.

Reasons are as followed:

There is allocative efficiency as resources are optimally allocated when MSB

= MSC. We cannot increase welfare by allocating more or less resources to
produce the good. At Qs, consumer surplus is maximised at AEPe and
producer surplus maximised at BEPe. The condition for allocative efficiency
can also be expressed as P = MC, where price (P), which reflects society’s
valuation of the benefit derived from the additional unit of the good, is equal
to the marginal cost (MC) to society (in terms of opportunity cost) of producing
that additional unit of the good.

S=MPC=MSC

Pe

D=MPB=MSB

Qs

Figure 1b: Free Market Equilibrium

As show in Figure 1b, for any output level lower than Qs, MSB>MSC. In
other words, society value the benefit gained from an additional unit of good
more than the cost of producing it. From society’s point of view, there is an
insufficient amount of resources allocated to the production of this good.
This results in deadweight loss, which is the loss in social welfare. Welfare
can be increased by diverting more resources to the production of this good.

For any output level higher than Qs, MSC > MSB. In other words, society
values the benefit from an additional unit of the good less than the cost of
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producing it. From society’s point of view, too much of resources are allocated
to the production of this good. Welfare can be increased by diverting
resources away from the production of this good.

Therefore, at output Qs, where MSB=MSC, society values the benefit from
an additional unit of the good is equals to the cost of producing it. From
society’s point of view, the efficient amount of resources is allocated to the
production of this good. Welfare can be maximised here as there is no need
to decrease or increase resources for the production of this good.

3.1.1 Negative Externalities

In this section we will discuss how negative externalities lead to allocative

inefficiency, and therefore, market failure; and how the government can help
the market achieve the socially efficient equilibrium.

Definition:

Negative externalities are spillover costs to a third party who is not

directly involved in the consumption or production of the good itself. These
costs are not taken into account by the consumers or producers of the
good in the market, and are borne by the third party who is not involved in
the transaction (consumption or production) of the good. Negative
externalities are also commonly known as external costs to society.

a) Why is negative externality a source of market failure?

First, let us explore the consequences of the presence of negative

externalities in a market.

In the production or consumption of some goods, negative externalities are

generated. This commonly leads to environmental problems. A heavy
industry, e.g. power production, may result in industrial waste that causes
harm to others in the area. Citing smoking as an example, the consumption
of cigarettes may result in second-hand smoke and thus causing harm to the
health of third parties not involved in the transaction (act of smoking).

When firms make decisions on how much output to produce, or consumers

make decisions on how much to consume, they will only consider their MPC
and MPB in their pursuit of self-interest. They will produce/ consume at the
output where MPB=MPC to maximise their net private benefit. Therefore,
markets produce at an output greater than the socially optimal output, which
leads to allocative inefficiency and market failure.

Let us illustrate the case of market failure arising from over-production of

power due to negative externality using a diagram.

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 Market Failure (H1 Economics/ 8823)

Costs, MSC (Marginal Social

Benefits Cost) = MPC + MEC

Deadweight Loss
B
MEC MPC (Marginal Private
Costs)

MPB (Marginal Private

Benefit) = MSB

0 Qs Qf Quantity of Power
Production
Figure 2: Negative Externality
generated in power production

Seven-Step diagrammatic analysis of Negative Externalities (Figure 2)

Steps Elaboration

Note: The following explanation is from producers’ and production

perspective. Negative externalities can also be a result of over-
consumption by consumers. Do make the change from ‘producers’ to
‘consumers’ and from ‘production’ to ‘consumption’ when explaining
negative externalities from over-consumption.
Step 1: In a free market economy driven by self-interest,
Establish the producers will produce at Qf (Fig.2) where MPB=MPC
free market and their net private benefit is maximised. In this
equilibrium. example, private costs borne by the producer will
include labour costs, overhead costs and equipment.
Private benefit accrued to the firm is the revenue they
are able to enjoy.

Step 2: We will assume there are no external benefits in the

State production of power (MEB = 0), hence MSB=MPB.
assumptions.

Step 3: Producers do not consider the external costs, such as

Explain the environmental pollution during the production of
divergence in power, as well as the adverse health impacts of
context, i.e. people who live nearby.
identify the
third parties The marginal external cost (MEC) generated from
and explain production of power is shown by the divergence

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how they are between MSC and MPC in Figure 2 above, where
affected' MSC (MPC + MEC) is higher than MPC of power
production at all levels of production.

Step 4: The socially efficient equilibrium where society’s

Establish welfare is maximised is at MSB = MSC, and the
socially socially efficient quantity should be Qs.
efficient
equilibrium.

Step 5: Therefore, there is over-production of power by the

State that there amount QsQf under free market forces.
is an over-
production/
over-
consumption.
Step 6: As a result of this over-production by the amount of
Explain how QsQf, MSC exceeds MSB over this output and a
deadweight deadweight loss to society results. This is given by the
loss is reflected shaded area in the diagram.
in diagram.

Step 7: Therefore, the government’s microeconomic goal of

Conclude that allocative efficiency is not achieved and there is
market failure market failure.
is present.

Note: How do we explain the deadweight loss to society?

As shown in step 6, with the over-production by the amount QsQf, the total
social cost incurred at output Qf is represented by the bigger trapezium
QsABQf. The total social benefit at output Qf is represented by the small
trapezium at QsACQf. Thus, we can see that by overproducing at Qf,
producer incurs more social cost than social benefit and therefore a net
welfare loss represented by triangle ABC is resulted, as shown in Figure 2.

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Self-Assessment 1

Apply the 7-step analysis above to the case of cigarette smoking.

(negative externality due to over-consumption)

1. Establish the free market equilibrium.

2. State assumptions.

3. Explain the divergence in context, i.e. identify the third parties

and explain how they are affected.

4. Establish socially efficient equilibrium.

5. State that there is an over-production/over-consumption.

6. Explain how deadweight loss is reflected in diagram.

7. Conclude that market failure is present.

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SUMMARY

In the case of negative externalities, the free market output (Qf, where
MPB=MPC) is greater than the socially efficient output (Qs, where MSB=MSC).
There is over-allocation of resources to the production or consumption of this
good, leading to market failure. Allocative efficiency is not achieved given the
existence of a deadweight loss.

b) Government Intervention

Where negative externalities exist, the government intervenes to achieve an

efficient allocation of resources by trying to decrease production or
consumption.

There are many ways the government may intervene to correct market failure
caused by negative externalities.

1) Laws and Regulation

2) Ban
3) Tax
4) Marketable Pollution Permits

1) Laws and Regulation

Laws and regulations could be used to reduce (i) output; or (ii) external costs.

(i) Laws and regulations in the form of output quotas to compel producers to
reduce output to the socially optimum output of Qs where MSB=MSC (refer
to Figure 2).

(ii) Laws and regulations to reduce external costs. Diagrammatically, MSC

curve will fall, shifting closer to the MPC curve. Examples of such
regulations include:

o Requiring firms to adopt a particular technology to reduce harmful

emissions, e.g. requiring vehicles to be fitted with catalytic converters.
o Making it mandatory for power plants to replace unfiltered power
generators with natural gas pipelines that pollute less.
o For example, laws and regulations were passed to regulate the use of
e-scooters in Singapore - reduction in speed limits on footpaths,
mandatory registration of e-scooters and campaigns to promote safe
riding habits for e-scooter users. This helps to reduce the possible
negative externalities (external costs) arising from the use of e-scooters.

Both output quota and laws to reduce external costs force

consumers/producers to consume/produce at the socially optimal output and
hence eliminating deadweight loss and achieving allocative efficiency.

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Advantages and Disadvantages of Laws and Regulation

Advantages Disadvantages / Limitations

 Depending on the amount of  As compared to approaches such
negative externalities present, as taxes (explored below), imposing
penalties (e.g. fine, jail laws and regulations is considered a
sentence) may be imposed on blunt weapon as it does not give
the firms/ individuals that do firms the flexibility to reduce the
not adhere to the law and external cost in the most cost-
regulation. This means that effective manner.
the costs of implementing
and monitoring this measure  Penalties imposed must be hefty
will be lower as firms/ enough to deter violations – such
individuals will be more willing that only occasional checks are
to adhere to the regulation in necessary to ensure that regulations
order to avoid punishment. are being followed. If penalties are
not severe enough, more frequent
 If the penalties are sufficiently checks by the regulatory authority
severe, the results of laws and would be required and this may raise
regulations are much more the costs of monitoring. Society
certain than taxes, which still gains only if the benefits outweigh
provide consumers/ the costs of implementing this
producers the choice to measure.
maintain their level of
consumption/ production if  It is difficult to estimate the
they are willing to incur the external costs and set an
costs of the taxes. appropriate quota to achieve the
social optimum level.

 Measures to reduce marginal

external costs depends on the
governments’ knowledge of the
market and available technology. If
the government is not well informed
or kept abreast of technological
changes, they may impose outdated
and ineffective measures.

Example of laws and regulation in Singapore

• Smoking (Prohibition in certain Places) Act

Smoking is prohibited at the following places
o All air-conditioned offices
o All schools including junior colleges, polytechnics, training
institutes, air-conditioned and enclosed areas in Universities
o All bus shelters and interchanges, public pools and toilets,
community clubs and open-air stadiums
o Public places i.e. entertainment outlets

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Advantages and Disadvantages of Smoking Act

Advantages Disadvantages / Limitations
 Simple to stipulate  Regulations coerce smokers to
 relatively easy to follow the laws strictly; there is
administer and enforce. no incentive to reduce smoking
Therefore those who do eg. at non-restricted areas.
not obey will be severely  Limited manpower to monitor at
punished – fined; a form every restricted areas.
of direct control

2) Total Ban

A total ban is an outright restriction of output where the quantity produced will
now be 0. This eliminates all external costs, because zero units of the good is
produced.

Ideally, the government should ban the product only if the MSC is greater than
MSB for all output levels as seen in Figure 3 below. The negative externality
from guns consumption is so large that MSC exceeds MSB at all output levels.
MSC and MSB do not intersect, i.e. the socially efficient amount of guns to be
consumed is zero. It is more optimal to ban the good, as any non-zero
consumption of guns would result in an inefficient resource allocation for
society.

Cost, Benefit

MSC

MPC
MEC

MPB = MSB

0 Qf Quantity of Guns
Figure 3: A socially efficient ban
Banning of shisha in Singapore

SINGAPORE: Starting Feb 1, buying, using and possessing tobacco

products like e-cigarettes, shisha and chewing tobacco will be illegal, the
Ministry of Health said on Friday (Jan 26).

The new prohibitions on such "emerging and imitation" tobacco products are
part of the first phase of amendments to the Tobacco (Control of

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Market Failure (H1 Economics/ 8823)

Advertisements and Sale) Act, which were passed in Parliament in

November last year.

Under the changes, anyone found in possession of, purchasing or using the
prohibited products will face a fine of up to S$2,000. Currently, only those
caught importing, selling or distributing prohibited products are punished.

"(Members of) the public are encouraged to discard any prohibited tobacco
products that they currently have in possession," the ministry said.

Those caught importing, selling and distributing the products face a fine of
up to S$10,000 and up to six months' jail for a first offence. Repeat offenders
can be fined a maximum of S$20,000 and jailed for up to one year.

This is done to better protect our population from the harms of emerging and
imitation tobacco products.

Adapted from CNA 26th February 2018.

Private consumption of shisha in Singapore is strictly banned since any quantity

of private consumption may result in large negative externality e.g. lung related
cancers to innocent third party. This causes a divergence between MPC and
MSC to be so large that a ban on shisha is required.

Self-Assessment 2

What other examples of goods or services can you think of where the
production or consumption of it has been banned due to the extremely large
negative externalities involved?

Goods should not be banned when the negative externalities generated

do not cause such a great divergence such that MSC exceeds MSB at all
output levels. This means there is still a positive socially efficient output level
that should be produced. If the government still insists on banning the good, the
ban in this case will be an inefficient ban. Such an example is given below.
Cost, Benefit MSC

Area
MPC
A
Area B

MPB= MSB
0 Qs Qf Quantity of Good

Figure 4: A ban that is socially inefficient

© Catholic Junior College Economics Department 2020 19
Market Failure (H1 Economics/ 8823)

As can be seen from Figure 4 above, MSC does not exceed MSB at all levels
of output, i.e. Qs (where MSC=MSB) is greater than zero. There is still a positive
quantity of the good that is socially efficient if it is produced/ consumed.

Hence, by completely banning the good, potential net benefit from producing/
consuming the good would be lost and this is represented by area A in Figure
4. In the example above, banning the good would have resulted in a deadweight
loss of Area A, which would be larger than the deadweight loss of Area B that
would have been generated if the government had not intervened and had
allowed the free market to prevail at Qf. The ban would have created an even
larger welfare loss (A) than at free market equilibrium (B). Hence, a total ban
would be more inefficient than leaving it to the free market.

Food for Thought:

What happens when Area A is smaller than Area B? Should the government
still proceed with the ban?

Diagram Drawing Edition: Ban

Watch how these diagrams are drawn, step-by-step,

and learn when to use this diagram in your exams!

Advantages and Disadvantages of Total Ban

Advantages Disadvantages / Limitations

 A total ban is easy for  Where MSC does not exceed
government to spot, monitor MSB for all output levels,
and enforce. banning the product that gives
rise to external costs will involve
a greater welfare loss than if it
were left to the free market. As
long as the social optimal output
is more than zero, a ban will
result in a loss in welfare shown
by Area A in Figure 4. If Area A
is greater than Area B, then a
ban will result in greater welfare
loss than if the government had
not intervened.

© Catholic Junior College Economics Department 2020 20

Market Failure (H1 Economics/ 8823)

Self-Assessment 3

1. A good should not be banned just because it generates negative

externalities. True or false?

2. Which of the following best justifies your answer above?

a. When MSC does not exceed MSB for all output levels, this
means that there may be positive externalities to be enjoyed.
b. When MSC does not exceed MSB for all output levels,
consumption/production of this good/service at the correct
level will still yield a net benefit to society.

3) Tax

A tax levied to reduce the extent of over-consumption/ production of goods. It

forces the consumer or firm to internalise the external cost by imposing a tax
equal to the marginal external costs incurred at Qs.

Cost, Benefit MSC = MPC*=MPC + tax

MPC
P3
P1

P2 Per unit Tax = MEC at Qs

MPB= MSB (assuming MEB=0)

0 Qs Qf Quantity of Good
Figure 5: Effect of a tax in correcting negative externality

Diagrammatic analysis of a tax to address negative externality Figure 5

1. The free market originally consumes/produces at Qf where MPC=MPB.

2. A tax equal to the marginal external cost at Qs (P2P3 per unit) is imposed
by the government. The tax makes the private firm/consumer internalise
the negative externality in their decision making.

3. This causes the firm/consumer’s new MPC to shift up to MPC*.

4. As a result, the firm/consumer reduce the consumption/produciton to Qs

where the new MPC = MPC*=MPB, to maximise their net benefit.

5. The socially efficient output level QS is achieved and the deadweight

loss is eliminated.

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Market Failure (H1 Economics/ 8823)

6. There is also a change in prices in the market. The equilibrium price

was initally at P1 but increases to P3 as a result of the tax. The increase
in price would reduce the quantity demanded, reducing the equilibrium
quantity towards Qs.

Examples of taxes in Singapore:

Tax on cigarettes, tax on alcohol, entry levy to enter legal casinos, Electronic
Road Pricing (ERP) on the use congested routes and carbon tax on producers.

Tax on cigarettes in Singapore

SINGAPORE - Cigarettes have become more expensive here following a 10

per cent increase in excise duty on all tobacco products, but experts are
divided on whether this will reduce the number of smokers.

The increase in tobacco taxes was announced by Finance Minister Heng

Swee Keat during his Budget speech on Monday (Feb 19), and took effect
the same day.

Prices of popular cigarette brands are set to increase by at least $1 tomorrow,

although some retailers have already raised them.

The amount of revenue collected by Singapore Customs for tobacco customs

and excise duties each year from 2014 to 2017 was slightly above $1 billion.

"High prices can stop young people from taking up smoking and encourage
current smokers to quit or smoke less, especially those with limited
disposable incomes," said Professor Tikki Pang, a visiting professor at the
Lee Kuan Yew School of Public Policy at the National University of
Singapore.

According to WHO, on average, a 10 per cent price increase on a pack of

cigarettes would be expected to reduce demand for cigarettes by about 4 per
cent in high-income countries and by about 5 per cent in low- and middle-
income countries.
Adapted from Strait Times, 21st February 2018

© Catholic Junior College Economics Department 2020 22

Market Failure (H1 Economics/ 8823)

Self-Assessment 4

Explain what happens when a tax is imposed on the generation of

electricity.

1. Establish the free market equilibrium.

2. Determine and explain size of tax to be imposed by

government.

3. Explain what happens to the MPC as a result of the tax.

4. Establish the socially efficient equilibrium.

5. Explain how market failure is resolved.

6. Explain what happens to equilibrium prices.

Diagram Drawing Edition: Tax

Watch how this diagram is drawn, step-by-step, and

learn when to use this diagram in your exams!

© Catholic Junior College Economics Department 2020 23

Market Failure (H1 Economics/ 8823)

Advantages and Disadvantages of Tax

Advantages Disadvantages / Limitations

 A tax is a market-oriented tool, i.e.  Imposing a tax equal to the
still allows the market forces to marginal external cost
operate in allocating resources. requires accurate
Taxes help to motivate reduction in valuation which in reality is
production and consumption and hard to estimate.
hence improve resource o An over-valuation of the
allocation. external cost means
that output is below
 Furthermore, if taxes are social optimum and
implemented on the pollution itself society’s welfare is not
(e.g. carbon tax), it encourages maximised. An under-
firms to clean up the pollution in the valuation of external
most cost-effective way cost will also not
possible (i.e. to find the cheapest maximise society’s
way of cleaning up). Firms have welfare as the output is
the choice between cleaning up reduced but the tax is
the pollution and paying the tax, not sufficient to reduce
e.g.: output to the social
o Firms with a higher cost of optimal level.
cleaning up will prefer to pay the
tax, since paying the tax is  Where demand is price
cheaper for the firm. inelastic, the tax to reduce
o Firms with a lower cost of over-consumption or over-
cleaning up will prefer to reduce production may be
pollution substantially to avoid ineffective unless the tax is
paying the tax. very high. High taxes may
o Either way, the socially optimal lead to political losses for the
output level of pollution is ruling government.
achieved in the most cost-
effective manner for the firms.

 Taxes increase government

revenue which is a source of funds
to finance economic, social and
community development projects
(e.g. build/enhance the
infrastructure).

4) Marketable Pollution Permits

If pollution can be easily monitored and polluters easily identified, the

government may choose to allocate pollution permits to reduce pollution. This
is also known as the ‘cap-and-trade’ scheme. Marketable pollution permits
attempt to align private firms’ incentives with societal optimality. We shall see
this in action using the numerical example below.

Two power generating firms, Firm A and Firm B, are producing 20 units of a
particular pollutant each – 40 units of pollutant in total.

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Market Failure (H1 Economics/ 8823)

o Let us assume the government wants to reduce pollution by a total of 8

units.
o Each firm is given a permit to emit up to 16 units of that particular
pollutant – 32 units of pollutant in total.
o If Firm A is able to reduce its pollutants to 14 units, then, it would be
given a credit of 2 units.
o If Firm B can reduce its pollutants to 18 units, it will buy 2 units from
Firm A at a price that is mutually beneficial (i.e. at a price above the cost
of emission reduction to Firm A and below the cost of emission
reduction to Firm B).
o The total reduction in pollutants is still 8 units; Firm A reduces its
pollutants by 6 units and firm B by 2 units.

One example of marketable pollution permits is the EU emissions trading

system.

EU’s Emissions Trading System

The European Union's Emissions Trading System (ETS) is the world's

biggest scheme for trading greenhouse gas emissions allowances.
Launched in 2005, it covers some 11,000 power stations and industrial plants
in 30 countries, whose carbon emissions make up almost 50% of Europe's
total. A cap on the total emissions allowed within the scheme is set, and
allowances adding up to the cap are provided to the companies regulated by
the scheme. Companies can trade their allowances, providing an incentive
for them to reduce their emissions.

In a basic sense the ETS has worked. It has set a cap on half of Europe's
carbon emissions, which were previously unregulated, and the companies
covered by the scheme are no longer free to pollute. Carbon has a price and
this influences the economics of burning fossil fuels.

For example, burning coal creates more carbon pollution than burning gas,
so coal plant operators need more permits. The higher the price of the
permits, the more expensive it is to use coal rather than gas. Power
companies choosing how to generate electricity therefore have an extra cost
associated with the more polluting options, so they'll choose gas over coal
more of the time.

Putting precise numbers on how far the ETS has worked in practice is
difficult, as it means estimating what the level of pollution would have been if
the ETS was not in place. It is likely, however, that in its first few years, the
scheme was responsible for turning an anticipated increase in emissions into
a decline of 2.5-5%. One in-depth study analysed background emissions,
economic trends and weather patterns, and concluded that between 2005
and 2007 the ETS reduced emissions by 120-300m tonnes, with a best
guess of 210m tonnes across Europe.

The Guardian, 7th June 2011

Both taxes and marketable pollution permits are examples of policies that place
a price on the right to pollute. Just as markets allocate goods to buyers who
value them most highly, a tax or pollution permit allocates the right to pollution

© Catholic Junior College Economics Department 2020 25

Market Failure (H1 Economics/ 8823)

to consumers/firms that face the highest cost of reducing it. See Annex A for an
article on the comparison of the two policies.

Advantages and Disadvantages of Marketable Pollution Permits

Advantages Disadvantages / Limitations

 Emission reduction at lower  It may reduce the pressure on richer
cost: By allowing firms to factories to reduce their emissions as
trade in pollution permits, they can buy the rights to pollute,
pollution can be reduced thus causing pollution to be
more in firms (e.g. Firm A) concentrated in these geographical
that are best able to do it at a areas.
lower cost, i.e. this policy  Legislation dealing with pollution
allows flexibility and is not a might be affected by political
blunt tool like an output reasons. The legislation imposed
quota. Firm A in our example might be imposed in a way whereby
is more efficient at pollution it does not punish the firms that
reduction, and is rewarded in pollute that much as expected.
doing so as it can sell the Government has to consider views
excess permits. from both sides in terms of
consumers as buyers and producers
as firms. Government needs to strike
a balance here.

The Adventures of Huck the Duck and Fin the Fish

Watch how negative externalities and government

policies are represented in this student-made video!
This video won the EDB Short Film Competition in
2009.

© Catholic Junior College Economics Department 2020 26

Market Failure (H1 Economics/ 8823)

3.1.2 Positive Externalities

In this section we will discuss how positive externalities generated lead to

market failure, and how the government can help the market to achieve the
socially efficient equilibrium by applying various methods of intervention.

Definition:

Positive externalities are spillover benefits to a third party who is not

directly involved in the consumption or production of the good/service
itself. These benefits are not taken into account by the consumers or
producers of the good/service in the market, but are enjoyed by the third
party who is not involved in the transaction (consumption or production) of
the good/service. Positive externalities are also commonly known as
external benefits to society.

a) Why is positive externality a source of market failure?

Let us now explore the consequences of the presence of positive externalities

in a market.

Positive externalities are generated in the production/consumption of some

goods and services. For example, when a person gets a vaccination for flu,
he derives private benefit as he is less likely to contract the sickness. Other
people around him (third parties) benefit as well, because they are also less
likely to be infected. Hence, they enjoy the external benefit without paying for
the vaccination.

When producers/ consumers make decisions on how much goods/ services

to produce/consume, they will only take consider their MPB and MPC in the
pursuit of self-interest. They produce/ consume at the output where
MPB=MPC to maximise their net private benefit. Therefore, markets produce
at an output lower than socially optimal output, which leads to allocative
inefficiency and market failure.

Some markets that exhibit this feature of external benefits are:

(i) Education;
(ii) Healthcare; and
(iii) Research & Development.

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 Market Failure (H1 Economics/ 8823)

Let us illustrate market failure arising from the case of vaccination using a
diagram.

Costs,
Benefits

Deadweight Loss
B
MSC = MPC

MEB
C

A MSB = MPB + MEB

MPB

0 Qf Qs Quantity of
vaccination

Figure 6: Positive Externality generated in consumption of vaccinations

Seven-step diagrammatic analysis of Positive Externalities (Figure 6)

Steps Elaboration

Note: The following explanation is from consumers’ and consumption

perspective. Positive externalities can also be a result of under-production
by producers. Do make the change from ‘consumers’ to ‘producers’ and
‘consumption’ to ‘production’ when explaining positive externalities from
under-production.
Step 1: A consumer who receives a vaccination against the flu
Establish the will enjoy the marginal private benefit of being protected
free market against the disease. Private costs borne by the
equilibrium. individual will include fees paid to get the vaccination.
In a free market economy, driven by self-interest,
individuals will consume at Qf where MPC=MPB and
their net private benefit is maximised.

Step 2: We will assume there are no external costs in the

State consumption of vaccinations (MEC=0), hence
assumptions. MSC=MPC.

Step 3: Consumers of vaccination do not consider the external

Explain the benefits enjoyed by third parties are not taken into
divergence in account. For example, the co-workers and family
context, i.e. members (third parties) benefit as they are less likely to
identify the contract flu from the vaccinated individual. The marginal

© Catholic Junior College Economics Department 2020 28

Market Failure (H1 Economics/ 8823)

third parties external benefit (MEB) generated from consumption of

and explain vaccinations is shown by the divergence between MSB
how they are and MPB in Figure 6 above, where MSB (MPB + MEB)
affected' is higher than MPB of vaccination at all levels of
consumption.

Step 4: The socially efficient equilibrium where society’s

Establish welfare is maximised is at MSB = MSC, and the socially
socially efficient quantity should be Qs.
efficient
equilibrium.

Step 5: Therefore, there is under-consumption of vaccination

State that by the amount QfQs under free market forces.
there is an
over-
production/
over-
consumption.
Step 6: As a result of this under-consumption by the amount of
Explain how QfQs, MSB>MSC, meaning net benefit can be gained if
deadweight more education is consumed. Since the allocative
loss is efficient or social optimum quantity is Qs where
reflected in MSB=MSC, at any output between Qf and Qs there is a
diagram. potential net welfare gain for society should these units
be consumed. The loss of this potential net welfare gain
is given by the shaded area in the diagram.

Step 7: Therefore, the government’s microeconomic goal of

Conclude that allocative efficiency is not achieved and there is market
market failure failure.
is present.

Self-Assessment 5

Give examples of some private benefits and positive external benefits

that may arise from the consumption of education?
Market Marginal Private Marginal External
Benefit Benefit

Education

© Catholic Junior College Economics Department 2020 29

Market Failure (H1 Economics/ 8823)

Self-Assessment 6

Apply to 7-step analysis to explain how the market failure occurs in

the case of research and development (positive externality due to
production)

1. Establish free market equilibrium.

2. State assumptions.

3. Explain the divergence in context. i.e. identify the third parties

and explain how they are affected

4. Establish socially efficient equilibrium.

5. State that there is an under-production/under-consumption.

6. Explain how deadweight loss is reflected in diagram.

7. Conclude that market failure is present.

SUMMARY

In the case of positive externality, the free market output is less than the
socially efficient output. Too little resources have been allocated to the
consumption or production of this good, leading to market failure. Allocative
efficiency is therefore not achieved given the existence of a deadweight loss.

b) Government Intervention in the presence of Positive

Externalities

In the case of positive externalities, the free market output is less than the
socially efficient level. Therefore the government intervenes to achieve an
efficient allocation of resources by trying to increase production or consumption.
© Catholic Junior College Economics Department 2020 30
 Market Failure (H1 Economics/ 8823)

There are many ways the government may intervene to correct market failure
in markets with positive externalities:

1) Subsidies
2) Direct Provision
3) Joint Provision
4) Legislation

1) Subsidies

Subsidies lower marginal private costs to encourage more

consumption/production.

Costs, Benefits

MPC = MSC (assuming MEC=0)

MPC*= MPC with subsidy

P3
P1 Subsidy = MEB at Qs
P2
MSB=MPB+MEB

MPB
O Qf Qs Quantity of good

Figure 7a: Effects of a per unit subsidy in correcting positive externality

Diagrammatic analysis of Figure 7a (Example of Primary and Secondary
Education in Singapore)

1. Establish the free market equilibrium for Primary and Secondary

Education in Singapore.
In the absence of government intervention, the free market originally
consumes at Qf where MPC=MPB. For example, the MPB received by
students is the knowledge they gain through education, while the MPC
borne by students would be the school fees that they have to pay.

2. Determine and explain the size of subsidy to be provided by the

government.
A subsidy equal to the marginal external benefit at Qs (P2P3 is the
subsidy per unit) is provided by the government. For example, a student
attending school pays only a small portion of the school fees, while the
rest is paid for by the government to the school.

3. Explain what happens to the MPC as a result of the subsidy

provided.
Such a subsidy will result in the MPC of students going to school to fall
by the extent of the subsidy. This causes the students’ MPC to shift right
to MPC*.
© Catholic Junior College Economics Department 2020 31
Market Failure (H1 Economics/ 8823)

4. Establish the socially efficient equilibrium.

As a result, students will consume education up to the output where
MPB = MPC* at Qs as this maximises their net private benefit. In other
words, the fall in equilibrium price from P1 to P2 motivates an increase
in consumption from Qf to Qs, which is the socially efficient output.

5. Explain how market failure is resolved.

Therefore, by subsidising school fees, the government allocates more
resources in the consumption of education to solve the problem of
under-consumption caused by positive externalities.

6. Explain what happens to equilibrium price.

As mentioned earlier, there is a fall in equilibrium price of education from
P1 to P2, as a result of the subsidy.

Example of subsidies for vaccinations in Singapore

All childhood vaccinations to be subsidised at polyclinics

and CHAS GPs by end of 2020

All polyclinics vaccinations under the National Childhood Immunisation

Schedule (NCIS) will be subsidised for Singaporeans by the end of 2020,
and the subsidies will be extended to general practitioner clinics under the
Community Health Assist Scheme (CHAS).

This was announced by the Ministry of Health (MOH) on Wednesday (Aug

28), as part of efforts to make childhood preventive healthcare more
affordable and accessible.

With the changes, vaccinations for pneumococcal disease and human

papillomavirus (HPV) will be subsidised as well - at both polyclinics and
CHAS GPs.

For vaccinations recommended for personal protection, such as the one

against pneumococcal disease, take-up rates are “much lower”, said MOH,
although they offer significant protection against disease.
CNA, 28th August 2019

Diagram Drawing Edition: Subsidy

Watch how this diagram is drawn, step-by-step, and

learn when to use this diagram in your exams!

© Catholic Junior College Economics Department 2020 32

Market Failure (H1 Economics/ 8823)

Advantages and Disadvantages of Subsidies

Advantages Disadvantages / Limitations
 Subsidies are market-  Hard to obtain an accurate
oriented tools, i.e. they still valuation of the external benefit.
allow markets to operate Therefore, the government may not
according to market forces. know the optimal amount of subsidy
Subsidies help to motivate to give to attain the socially efficient
increases in production and output. The government may over-
consumption, and hence subsidise leading to over production
adjust and direct more or consumption. It may under-
resources into the industries subsidise and fail to solve the
affected to solve under- problem of under-consumption or
consumption/ under- production completely.
production. This results in
fewer distortions in the market  High government expenditure is
and increases efficiency of required to provide the subsidy. This
how markets work. is not only a drain on government
resources but may require higher tax
rates such as for income taxes to
finance the subsidy. High income
tax rates are known to discourage
workand investment in the country.

2) Direct Provision at Zero Price

Alternatively, the government could directly provide the goods/services at

the socially efficient quantity (Qs) and at zero price, or they could pay private
firms to provide at Qs. Typically, this is a policy used for public goods (refer to
Section 3.3) but there are some other cases (notably merit goods, see Section
3.2) where direct provision can be used.

Direct provision ensures that the government controls both the level of
production as well as the price charged for the good/service.

Examples include universal healthcare, like the National Health Service (NHS)
in the UK; and education, like in Finland. Under such a policy, the government
© Catholic Junior College Economics Department 2020 33
Market Failure (H1 Economics/ 8823)

provides the goods for free or at a price close to zero (i.e. the government may
or may not provide the good/service free of charge).

Advantages and Disadvantages of Direct Provision at Zero Price

Advantages Disadvantages / Limitations

 Direct provision can  When the government produces the good
help to ensure directly, it may not be able to produce as
equitable access to efficiently as private firms.
all consumers if the o Without the profit motive, public
government chooses organizations lack the incentive to
not to charge minimise costs and hence they tend
consumers. All to be productively inefficient.
individuals, o As a result, resources are wasted
regardless of their during production, which worsens the
socioeconomic situation.
background, have
equal access to  Without market pricing and costing to guide
consume these the state, mismanagement can occur
goods. resulting in misallocation of resources and
poor quality of services provided.
o It is not uncommon for teachers,
doctors and nurses in state-run
institutions to be paid below market
rates and to be overworked.
o This may lead to a lack of such qualified
labour and will then lead to chronic
shortages and poor quality.

 It is very expensive to provide at zero price.

The finance for provision of such goods
comes from taxation. Imposing higher
income tax rates may act as a disincentive
to work.
 Government incur opportunity cost in other
areas of needs and cannot spend on it.

 As it may be difficult to attach a monetary

value to the positive externalities generated,
the government may not know the socially
efficient quantity to provide.

 If the government chooses to provide the

good for free or at very low price, over-
consumption of such goods could occur,
which might result in a larger (than free
market) deadweight loss. See explanation
below.

© Catholic Junior College Economics Department 2020 34

 Market Failure (H1 Economics/ 8823)

Example of direction provision (provided for free)

Free entry to museums

When free year-round entry to national museums and heritage institutions was
introduced in 2013 for Singaporeans and permanent residents, the aim was for
museums to become anchors of community life and foster a greater sense of
cultural identity and belonging.

The initiative came at a time when society was grappling with an influx of
foreigners and some residents felt a sense of disorientation.

However, the move has also contributed to efforts by the museums to reach out
to the public and encourage appreciation of culture and the arts.

The increase in museum-goers here suggests a bigger captive audience for the
institutions' efforts to nurture understanding and appreciation of culture and the
arts.

Even so, Mrs Rosa Daniel, chief executive of the heritage board, points out, "to
sustain true interest and passion, and to make museum- going a part of the
Singapore way of life, we need to keep the quality of our offerings high, and the
museum experience meaningful".

The Straits Times, 18th July 2016

Diagrammatic analysis of when direct provision at zero price is not optimal

Assume that the government directly produces the good and they do not charge
consumers for the good (zero priced good).
Costs/ Benefits

MSC = MPC

MSB
MPB

0 Qf Qs Q' Quantity of good

Figure 8: Over-consumption of zero priced good

The socially optimal level of output is where MSB = MSC i.e. output Qs. If the
good is provided for free (at zero price), consumers will consume at Q’ where
© Catholic Junior College Economics Department 2020 35
Market Failure (H1 Economics/ 8823)

MPB = MPC = 0 (Fig. 8), i.e. where MPB intersects the x-axis, to maximise their
net private benefit.

• Since MSC > MSB between Qs and Q’, there is a net loss to society and
the resulting deadweight loss is shown by Area A.
• On the other hand if the good was supplied by the free market without
government intervention, consumption will be where MPB = MPC at
output Qf. The resulting deadweight loss will then be Area B.

In the case illustrated above, since Area A is bigger than Area B. direct provision
of this good for free at Q’ would lead to an even greater inefficiency compared
to a purely free market outcome.

Diagram Drawing Edition: Direct Provision

Watch how these diagrams are drawn, step-by-step,

and learn when to use these diagrams in your exams!

3) Joint Provision

Another way of intervention by the government would be through joint provision.

Rather than the government providing the entire quantity Qs (as explored in
direct provision above), the government will only provide QfQs to make up
for the shortfall in the market as shown in Figure 7. The government can
choose to provide the shortfall directly or pay private firms to do so. Additionally,
this shortfall can be provided free, or at subsidised rates. Unlike direct provision
where the government is the sole provider (or payer), joint provision means
there are both private and public providers of a good.

In Singapore, healthcare is provided under a joint provision model. There are

private hospitals and clinics, such as the Raffles Medical Group, a private
healthcare company operating in Singapore and Asia. The government makes
up the shortfall through government provision, in the form of government
restructured hospitals (e.g. Tan Tock Seng Hospital) and polyclinics, which are
highly subsidised. This is an example of joint provision where both the public
and private sectors provide the good. Another example of joint provision is the
Public-Private Partnership, where there are long-term partnering
relationships between the public and private sector in order to deliver services
(see Annex B for elaboration).

Joint provision is typically used when there are already private firms operating
in the market. This is not possible for certain types of goods (see Section 3.3
Public Goods). Furthermore, when the under-consumption is very large, it might
make more sense for the government to take over the entire production of the
good in order to reap economies of scale1, or for reasons such as to ensure
equity.

Advantages and Disadvantages of Joint Provision

1 Economies of scale refer to cost-savings as a result of large-scale production.

© Catholic Junior College Economics Department 2020 36
Market Failure (H1 Economics/ 8823)

Advantages Disadvantages / Limitations

 Just like direct provision, the  If the government chooses to
government is better able to provide the QfQs output gap
achieve equity goals as it is now directly, the limitations are the
a producer of the good and can same as the previous section (see
determine price levels. above, direct provision).
o However, the limitations only
occur for a smaller level as
 Joint provision allows a lighter the private firms produce the
burden on the government as rest of the output (OQf) and
compared to direct provision as the wastage by the public
the government produces a sector is lower.
lesser amount of the good.

 Under joint provision, different

producers are allowed to
produce leading to added
variety for consumers as they
can choose between consuming
private or public services.

 The presence of the private

sector creates competition for
the government enterprise and
reduces inefficiency.

4) Legislation

For goods with external benefits, the government could increase consumption/
production by using laws to compel consumers or firms to consume or produce
up to the socially efficient output (Qs in Figure 6). For example, the government
can make education compulsory up to a certain age. Primary and secondary
education is compulsory in Singapore.

Advantages and Disadvantages of Legislation

Advantages Disadvantages / Limitations

 Legislation will force the  Administrative cost is incurred
consumption/ production to be in the form of law enforcement
at the socially efficient output and monitoring to ensure
where MSC=MSB. The consumers/ firms abide by the
outcome is certain. In order to regulations.
ensure that the laws are
followed, the government  Political costs may be
usually imposes a penalty involved– Consumers or firms
everytime the consumption/ may be unhappy when forced to
production deviates from the follow the regulation and this
socially efficient level of output. could lead to election losses.

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Market Failure (H1 Economics/ 8823)

3.2 Merit and Demerit Goods

Merit and demerit goods lead to market failure because the government
deems that the consumption of such goods is not at socially optimal
level (either over-consumed or under-consumed). Therefore, the society
would be better off if those goods are consumed at the appropriate level.

3.2.1 Merit Goods

Definition:
Merit goods or services are deemed by the government (or society) to be
desirable and under-consumed.

Examples include:
i) Healthcare and its related products (e.g. insurance); and
ii) Education.

Reasons for Government Intervention

Under-consumption occurs because of two primary reasons:
i) Existence of positive externalities in consumption, AND
ii) Imperfect information of consumers

Note: While merit goods also generate positive externalities, the merit good
argument is slightly different because the focus is not only on external benefits
but also on consumers undervaluing private benefits due to imperfect
information.

i) Existence of positive externalities in consumption

Consumption of merit goods may also generate positive externalities.

As explained earlier, when left to the free market, it is likely that merit
goods will be under-consumed because consumers do not take into
account the external benefit for third parties that can result from
consumption of goods, such as education and health services.

ii) Imperfect information of consumers

If left wholly to the private sector, the government believes that merit
goods will be further under-consumed because individuals undervalue
their own private benefits from consuming such goods. Examples of
imperfect information that exist in the market for education and
healthcare insurance include:

• Imperfect information about education: Parents who are poorly

educated may themselves be unaware of the long-term benefits that
their children might derive from a proper education.
• This causes them to underestimate the long-term gains from a
proper education. In other words, they perceive the marginal private
benefit from consuming education to be lower than it actually is
(perceived MPB < actual MPB), and therefore consumption of
education will be lower than what it should be.
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Market Failure (H1 Economics/ 8823)

• Imperfect information about healthcare insurance: A young,

healthy man may underestimate the probability of him falling
seriously ill, and so fails to consider that as he ages, the chances of
him becoming ill increases significantly.
• Since medical insurance premiums incur additional private cost
currently but pay benefits only in the event of any future illness, this
young, healthy man will be less likely to buy any medical insurance
currently as he thinks that he is still young and healthy.
• Left to the free market, many people will under-consume health
insurance (as perceived marginal private benefit is less than the
actual marginal private benefit).
• As a result, when they are hit by illnesses and have to pay large
medical bills, they may be unable to afford the bill and cause
financial difficulties for their families or even the state (should the
state have to help pay for the bill).

Let us illustrate with a diagram how market failure arises in the case of
education due to imperfect information.

Costs/Benefits
MPC=MSC
Deadweight
Info Gap Loss

MSB=MPBactual

MPBperceived

0 Qf Qs Number of years of
education
Figure 9: Imperfect Info in Merit Good - Education

Diagrammatic analysis of Imperfect Information (Under-Consumption)

(Figure 9) (Example of Education)
Steps Elaboration

Step 1: Establish Due to imperfect information and ignorance of

the free market consumers about the actual benefits of education,
equilibrium. MPBperceived is less than MPBactual. Therefore,
consumers will under-consume education at Qf,
where MPBperceived=MPC.

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Market Failure (H1 Economics/ 8823)

Step 2: We will assume there are no external costs in the

State assumptions. consumption of education (MEC=0), hence
MSC=MPC. In this diagram, we also assume that
there are no positive externalities, therefore
MPBactual=MSB.

Step 3: The socially efficient equilibrium where society’s

Establish socially welfare is maximised is at Qs, where MSC = MSB
efficient = MPBactual. Allocative efficiency is achieved.
equilibrium.

Step 4: Explain the Being myopic, consumers tend to not see the
divergence (info long-term benefit of having education. They
gap). cannot foresee the benefits of having more
education which will earn them much higher
income in the future.

Step 5: Therefore, there is under-consumption of

State that there is an education by the amount QfQs due to imperfect
under-consumption. information.

Step 6: As a result of this under-consumption by the

Explain how amount of QfQs, there is a deadweight loss of the
deadweight loss is shaded area.
reflected in
diagram.

Step 7: Therefore, the government’s microeconomic

Conclude that goal of allocative efficiency is not achieved and
market failure is there is market failure.
present.

Note:
The under-consumption of merit goods is due to both positive externalities
(i.e. consumers are indifferent towards the external benefits enjoyed by third
parties) and imperfect information (i.e. ignorance about private benefits).
However, students should not explain both causes of under-consumption using
the same diagram; students should explain both causes separately before
concluding that the under-consumption of merit goods is due to both causes

iii) Methods of Government Intervention

The government intervenes by taking measures to reduce or eliminate under-

consumption of merit goods due to both positive externalities and imperfect
information. These measures employed, i.e. (1) subsidies, (2) direct and (3)
joint provision, and (4) legislation, are the same as the measures employed
in correcting positive externalities in Section 3.1.2b. However, the
government also needs to educate the public to address imperfect
information. The only policy that addresses imperfect information directly is
(5) public education.

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Market Failure (H1 Economics/ 8823)

5) Public Education

Public education involves the use of advertisements and campaigns to educate

the public. Unlike the use of public education in encouraging consumers to
voluntarily internalise the positive externality (i.e. providing information about
external benefits), the use of public
education in the case of imperfect
information is to provide the public with the
information regarding private benefits that
they lack. This will bridge the information
gap between MPB perceived and MPB
actual. Therefore, consumers will increase
consumption up to Qs where MPC=MPB
actual and allocative efficiency is achieved
as shown in Figure 9.

For example, this can be done through

information campaigns designed to change
consumer choices – e.g. Breast Cancer
Campaigns conducted by the Singapore Cancer Society that encourages
women to go for preventive screenings by providing them with information
about the full benefits of such screenings to themselves.

Advantages and Disadvantages of Public Education in solving imperfect

information

Advantages Disadvantages / Limitations

 This policy directly  The problem of public education is
addresses the root that it depends on consumers’
cause of imperfect willingness to be educated. As a
information, in that it result, the ability of the policy to
seeks to directly educate correct the problem is dependent
the consumers/ on the population’s
producers of the actual receptiveness to the public
private benefits, thereby education.
increasing their
perceived marginal  A second problem is that the
private benefit up government may also lack perfect
towards the actual information about the issue and
marginal private benefit. not be able to determine the
extent of imperfect information
that exists.

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Market Failure (H1 Economics/ 8823)

Conclusion

Merit goods or services are deemed by the government (or society) to be

desirable and under-consumed. As a result, the government has to look at
how to increase consumption. Just like goods with positive externalities, the
solutions are similar. However, the under-consumption of merit goods is a
result of both positive externalities as well as imperfect information.

Therefore, to resolve the market failure caused by merit goods, the government
requires the use of policies targeting both positive externalities as well as
imperfect information.

Self-Assessment 7

What is the difference between merit goods and goods that generate
positive externalities in consumption?

The Anti-Vaccine Movement: A Lesson in Ignorance

Parents want what is best for their children. In the modern era where many
first world families with the means to do so pursue healthy lifestyles
centered on organic food, natural household care products, and
homeopathic remedies, some have begun to question the safety and
regulation of vaccines. Despite consistent and clear evidence proving the
contrary, advocates continue to link vaccines to developmental disabilities
such as autism. This mindset goes beyond mere ignorance; it is recklessly
irresponsible and places entire communities at risk.

Perhaps the most recognizable and widely distributed of anti-vaccine

arguments is the supposed link between the vaccination of children under
two and the development of autism. The movement has found a martyr in
Andrew Wakefield, the man who in 1998 published a study linking the
measles mumps and rubella (MMR) vaccine to the onset of developmental
disabilities. Wakefield examined twelve boys who had been diagnosed
with autism around the time they received the MMR vaccine and
concluded that the correlation indicated causation. This singular study set
off a wave of seemingly untenable public response and backlash against
vaccination. It struck a chord with parents of autistic children who were
desperate for any explanation for their children’s disability and spurred fear
among parents everywhere that they were unknowingly damaging their
children while trying to protect them.

The backlash against Wakefield was immediate and widespread in the

medical community. All efforts to replicate his research failed, and study
after study showed that there was no link between the MMR vaccine and
autism.

Adapted from Yale Global Health Review, 25 Jan 2016

Question
1. What is the source of market failure mentioned in the article?

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Market Failure (H1 Economics/ 8823)

3.2.2 Demerit Goods

Definition:

Demerit goods or services are deemed by the government (or society) to

be undesirable and over-consumed.

Examples include:
i) Drugs ii) Tobacco/Cigarettes
ii) Gambling iv) Alcohol

Reasons for Government Intervention

Over-consumption occurs because of two primary reasons:

i) Existence of negative externalities in consumption; AND
ii) Imperfect information of consumers.

Note: While demerit goods also generate negative externalities, the demerit
good argument is slightly different because the focus is not only on external
costs but also on consumers undervaluing private costs due to imperfect
information.

i) Existence of Negative Externalities in Consumption

Consumption of demerit goods may also generate negative third party

effects. As mentioned in earlier sections, private individuals are indifferent
towards these third party effects and therefore, if left to the free market,
the good will be over-consumed and this will lead to allocative inefficiency
and welfare loss to society.

ii) Imperfect information of consumers

If left wholly to the private sector, the government believes that demerit
goods, such as alcohol and cigarettes (often termed ‘sin goods’), will be
over-consumed because individuals underestimate their private cost,
e.g. the medical costs of addressing ill effects on their own health from
consuming such goods. Examples include:

• Imperfect information about alcohol: Individuals who consume

alcohol on a regular basis often underestimate the negative effects of
alcohol on their own health. They underestimate the possibility of
getting heart diseases, stroke, liver cirrhosis, cancers of the mouth,
oesophagus, throat, liver, breast, and a weakened immune system.
In other words, they underestimate their own private costs, i.e.,
the perceived marginal private cost of consuming alcohol is lower
than the actual marginal private cost of consuming alcohol, and
therefore consumption of alcohol would be higher than what it should
be.

• Imperfect information about cigarettes: Individuals who consume

cigarettes on a regular basis often underestimate the negative effects
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 Market Failure (H1 Economics/ 8823)

of cigarettes on their own health. They ignore the possibility of getting

cancer of almost every organ, heart diseases, stroke, diabetes,
impotence and early death. In other words, they underestimate their
own private costs.

Let us illustrate this market failure using a diagram.

Costs/Benefits

MPCactual = MSC

Deadweight
Loss MPCperceived

Info Gap

MPB= MSB
Quantity of cigarettes
0 Qs Qf

Figure 10: Imperfect Info in Demerit Good - Cigarettes

Diagrammatic analysis of Imperfect Information (Over-consumption)

(Figure 10) (Example of cigarettes)

Steps Elaboration

Step 1: Due to imperfect information of consumers about the

Establish the actual costs of cigarettes, MPCperceived is less than
free market MPCactual. Therefore, consumers will over-consume
equilibrium. cigarettes at Qf, where MPCperceived=MPB.

Step 2: We will assume there are no external benefits in the

State consumption of cigarettes (MEB=0), hence
assumptions. MSB=MPB. In this diagram, we also assume that
there are no negative externalities, therefore
MPCactual=MSC.

Step 3: The socially efficient equilibrium Qs is at output

Establish where society’s welfare is maximised is at MSB =
socially efficient MSC = MPCactual, where allocative efficiency is
equilibrium. achieved.

Step 4: Explain Being myopic, consumers tend to not see the long-
the divergence term cost of smoking which will worsen their health
(info gap) and life expectancy in the long run.

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Market Failure (H1 Economics/ 8823)

Step 5: Therefore, there is over-consumption of cigarettes

State that there by the amount QsQf due to imperfect information.
is an over-
consumption.
Step 6: As a result of this over-consumption by the amount
Explain how of QsQf, , there is a deadweight loss of the shaded
deadweight loss area.
is reflected in
diagram.

Step 7: Therefore, the government’s microeconomic goal of

Conclude that allocative efficiency is not achieved and there is
market failure is market failure.
present.

Note:The over-consumption of demerit goods is due to both negative

externalities (i.e. consumers are indifferent towards the external costs incurred
by third parties) and imperfect information (i.e. ignorance about private costs).

However, students should not explain both causes of under-consumption using

the same diagram; students should explain both causes separately before
concluding that the over-consumption of demerit goods is due to both causes.

Therefore, there is a need for government intervention in the case of demerit

goods.

iii) Methods of Government Intervention

The government intervenes to correct market failure by taking measures to

reduce or eliminate over-consumption of demerit goods caused by both
negative externalities and imperfect information. These measures
employed, i.e. (1) taxes, (2) bans, and (3) regulations2, are largely the
same as the measures employed in correcting negative externalities in
Section 3.1.1b. However, the government also needs to educate the public
to address imperfect information.

5) Public Education

Similar to what was mentioned above, public education involves the use of
advertisements and campaigns to educate the public.
Unlike the use of public education in discouraging
consumers/ producers to voluntarily internalise the negative
externality (i.e. providing information about external costs),
however, the use of public education in the case of
imperfect information is to provide the public with the
information regarding private costs that they lack. This

2Marketable pollution permits are not considered to be a policy dealing with demerit
goods since this policy is more for dealing with negative externalities generated from
production, while negative externalities generated from demerit goods are from
consumption activities.
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Market Failure (H1 Economics/ 8823)

bridges the information gap between MPC actual and MPC perceived.
Consumption will fall to Qs where MPC actual= MPB.

For example, this can be done through information campaigns designed to

change consumer choices – e.g. compulsory labelling on cigarette packs to
inform smokers of the exact damage that is done to their health each time they
smoke.

Advantages and Disadvantages of Public Education in solving the problem

of imperfect information

Advantages Disadvantages / Limitations

 Public Education directly  The problem of public education is
corrects problem of that it depends on consumers’
imperfect information, in willingness to be educated. As a
that it seeks to directly result, the ability of the policy to
educate the consumers of correct the problem is dependent
the actual private cost, on the population’s receptiveness
thereby increasing their to the public education.
perceived marginal private
cost towards the actual  A second problem is that the
marginal private cost. government may also lack perfect
information about the issue and not
be able to determine the lack of
information. As a result, it might not
be able to determine social optimal
output.

Conclusion

Demerit goods or services are deemed by the government (or society) to be

undesirable and over-consumed. As a result, the government has to look
at how to decrease consumption. Just like goods with negative externalities,
the solutions are similar. However, the over-consumption of demerit
goods is a result of both negative externalities as well as imperfect
information. Therefore, to resolve the market failure caused by demerit
goods, the government requires the use of policies targeting both negative
externalities as well as imperfect information.

Self-Assessment 8

What is the difference between demerit goods and goods that generate
negative externalities in consumption?

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Market Failure (H1 Economics/ 8823)

3.2.3 Evaluation Criteria of Government Intervention – FEAST

Framework

Now that we have covered the policies government use in tacking market failure
due to presence of externalities (positive and negative) and merit/demerit
goods. It is imperative for us to evaluate these policies to determine the best fit
through the use of a criteria – FEAST.

FEAST stands for Feasibility, Effectiveness, Appropriateness, Side-Effects and

Time Lags. The definitions / descriptions of each part are shown below:

Criteria of Evaluation Definitions / Descriptions

Refers to the extent which the policy can be
carried out by the government
• Manpower and financial resources need by
Feasibility government to implement and monitor (to
ensure compliance)
• Amount of information available/needed by
government to implement policy, e.g. about
MEB or MEC.

Refers to the extent to which the policy, if

implemented, can solve the problems or can
achieve the stated goal/meet the objectives of
Effectiveness the policy-maker
• Certainty of results (depends on whether
consumers have choice to defer from the
policy)
• Ability to reduce deadweight loss

Refers to whether the policy is tackling the root

cause of the problem or simply targeting the
Appropriateness symptoms
• Have to identify the root cause/s first

Refers to any unintended consequence

(positive and negative) the policy might have
on other objectives of the firm or govt adopting
Side Effects the policy or measure in others, the conflict of
goals
• Positive & negative side effects on: government
revenue, consumer sovereignty

Refers to how long it takes for the policy to take

Time Lag effect
• Need to consider short-run vs long-run effects
of policies

The FEAST framework is to be applied when deciding which policy / policies

are the best in addressing the source/s of market failure. It is important to
define the criterion / criteria used, and it is not supposed to replace the
explanations of how each policy works. Some examples are consolidated in
the following for your reference.
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 Market Failure (H1 Economics/ 8823)

1. Evaluating policies used to reduce over-consumption/production of goods due to negative externalities and imperfect information
(For the purpose of this illustration, we will use the consumption perspective. However, students may apply this to production perspective as well)

Tax Laws & Regulation Total Ban Public Education

E.g. Alcohol/cigarette tax, ERP, carbon tax, E.g. Quotas (COE, tradable permits), Age ban on E.g. Hard drugs like Heroin, CFC, E.g. public social campaigns,
Criterion / Policy casino entry levy alcohol & cigarettes, Regulating level of carbon monoxide emissions moral suasion, warning labels
*Should be equivalent to MEC to force emissions, compulsory catalytic converters in on cigarette packets, Car-Free
consumers/producers to internalise third cars Day, advertisements
party costs to be fully effective*
Feasibility • Might be unfeasible because government • Non-quota regulations are easy to • Resources will need to be • Very easy to implement –
Refers to the does not have info about firms’ MEC and implement as not much information required. devoted to monitoring and not complex and not much
extent which the firms are unlikely to reveal their MEC Government does not need to know level of ensuring compliance. Feasibility resources needed unless
policy can be hence government, might end up over- MEC. Government just needs to regulate the will depend on context. E.g. government wants to
carried out by the /under-taxing, which does not eliminate output close to Qs. Some information regulating cigarette ban based launch a very elaborate
government DWL and achieve full AE. There could still needed about Qs but less complex than on age/geography in Singapore marketing campaign.
be over- or under-consumption. Difficult information about MEC. is easy due to urban
• Manpower for government to estimate MEC on their environment. However, • Not much information
and financial own (e.g. difficult to know who caused the • Regulation will be standardized for whole regulating forest fires in needed to carry out
resources air/water pollution when government only industry hence easy to implement than taxes Indonesia is difficult and campaigns. Government
need by knows total level of pollution in that vary according to output of individual unfeasible due to expanse of can pay private advertising
government environment). firms. It will also be easy for consumers and forests. agencies to implement.
to implement producers to understand.
and monitor • MEC can change over time but it is • Not much information needed.
(to ensure unfeasible for tax rates to keep changing • Resources will need to be devoted to Policy is not complex and easy to
compliance) over time. Every firm might individually monitoring and ensuring compliance. implement and easy for
contribute to varying extents to MEC but it Feasibility will depend on context. E.g. consumers and producers to
• Amount of is difficult for the government to set regulating cigarette ban based on understand.
information different tax rates for different firms and age/geography in Singapore is easy due to
needed by keep monitoring their contribution to MEC urban environment. However, regulating • Monitoring costs likely to be
government and keep adjusting tax rates accordingly. forest fires in Indonesia is difficult and higher than regulation or tax as
to implement This might become difficult for consumers unfeasible due to expanse of forests. propensity for black markets to
policy and firms to understand as they become emerge is greater hence
too complex. • Quota-based regulations (e.g. COE and government need to devote more
tradable permits) are highly complex. resources to cracking down (e.g.
Government needs a lot of information and illegal drugs smuggling).

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 Market Failure (H1 Economics/ 8823)

• Government will need to devote resources expertise in terms of human resource to set
to monitoring and ensuring that up a system sound quota system.
consumers comply with taxes and not Government needs to know the level at
evade tax but this should be less that which quota should be set, and how to
required from total ban as there would not allocate permits/COEs. Therefore, such
be a black market hence lower propensity systems are more common in Developed
for black market smuggling. Countries than Less Developed Countries.

• However, taxes do not require high levels

of resources from government to
implement. On the contrary, it adds to the
government’s revenue hence they are
feasible in terms of financial burden on
government.
Tax Laws & Regulation Total Ban Public Education
E.g. Alcohol/cigarette tax, ERP, carbon tax, E.g. Quotas (COE, tradable permits), Age ban on E.g. Hard drugs like Heroin, CFC, E.g. public social campaigns,
Criterion / Policy casino entry levy alcohol & cigarettes, Regulating level of carbon monoxide emissions moral suasion, warning labels
*Should be equivalent to MEC to force emissions, compulsory catalytic converters in on cigarette packets, Car-Free
consumers/producers to internalise third cars, liquor control zones Day, advertisements
party costs to be fully effective*
Effectiveness • Can be very effective in reducing DWL if • As long as penalties are sufficiently severe, • Can be effective in terms of • Might not be very effective
Refers to the tax is equivalent to MEC. regulation can be very effective. certainty of results. Consumers as consumers have free
extent to which have no choice at all choice and do not incur
the policy, if • However, a rise in price due to tax would • Results are certain as government will • Easier to monitor than regulation additional costs even if they
implemented, can bring about a less than proportionate fall in decide on the level of output and consumers – easy for government to detect persist to consume at Qf.
solve the Qd as PED of good may be less than 1 must comply or suffer penalties. Consumers flouting of rules as no levels of • Habits and consumption
problems or can (e.g. cigarettes) hence unless tax is set have no choice over level of consumption. consumption are acceptable (e.g. patterns and difficult to
achieve the very high, it may not bring about a total ban of cigarettes vs. change.
stated goal/meet sufficient fall in Qf such that it would be at • Effectiveness is contingent on close regulating age and having to • Hence completely in
the objectives of Qs. monitoring and supervision. This is check NRIC of consumer who effective if the over-
the policy-maker subjected to context (e.g. size of country). might use NRIC of friend). consumption is mostly due
• Results of tax is uncertain hence tax may As long as government is able to monitor to apathy (consumers
• Certainty of not be fully effective as consumers have and ensure compliance, policy can be very • However, while total ban can already know about true
results the choice to decide whether to cut back effective. definitely reduce consumption, it MPC but do not care about
(depends on on consumption. They may decide that cannot lead to complete

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 Market Failure (H1 Economics/ 8823)

whether they are willing to pay the high taxes and • However, government must be able to elimination of DWL. There will MEC) rather than ignorance
consumers still continue to consume (e.g. demand identify Qs and regulate in such a way that still be DWL due to under- of true MPC.
have choice) very price inelastic). E.g. car usage is still output will be at Qs. consumption. This DWL of
• Ability to very high and traffic jams common in SG under-consumption might
reduce DWL despite ERP. outweigh the original DWL due to
over-consumption.
E.g. in UK 5% of pollution tax offenders are
repeat offenders - a sign that taxes might not
be high enough; less costly for these firms to
pay taxes than to use green technology.
Tax Laws & Regulation Total Ban Public Education
E.g. Alcohol/cigarette tax, ERP, carbon tax, E.g. Quotas (COE, tradable permits), Age ban on E.g. Hard drugs like Heroin, CFC, E.g. public social campaigns,
Criterion / Policy casino entry levy alcohol & cigarettes, Regulating level of carbon monoxide emissions moral suasion, warning labels
*Should be equivalent to MEC to force emissions, compulsory catalytic converters in on cigarette packets, Car-Free
consumers/producers to internalise third cars Day, advertisements
party costs to be fully effective*
Appropriateness Tax is appropriate to deal with negative Regulation is inappropriate to deal with both Same as regulation. Public education is appropriate
Refers to whether externalities negative externalities and imperfect information to deal with imperfect
the policy is • Root cause of externalities is information because it address
tackling the root indifference towards third parties It does not deal with the indifference towards the information gap between
cause of the which leads to MEC. third parties as it does not address the MEC actual and perceived MPC.
problem or simply • Tax is targeted at the indifference • When government regulates, it does not • Consumers will become
targeting the towards to third parties as it should be try to force consumers to care about the more aware of the true
symptoms equivalent to the MEC hence it forces third party costs by making them MPC and hence reduce
*have to identify consumers to internalise the MEC internalise the MEC (as what would consumption to Qs.
root cause of hence reduce consumption levels. have be done through taxation)
problem first* • Regulation simply forces consumers to Public education is
Tax is inappropriate to deal with imperfect consume at a certain level – consumers inappropriate to deal with
information still do not care about third party costs. negative externalities because it
• Root cause of imperfect information is does not address the root cause
ignorance about private costs. Hence Does not deal with root cause of imperfect of apathy
by forcing consumers to internalise information which is ignorance • Consumers already know
the MEC through tax, it does not help • Consumers still do not know the actual MPC the actual MPC and the
consumers by raising awareness. It *Ban on cigarette advertisements is a form of over-consumption is
simply forces unknowing consumers regulation but deals with the root cause of

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 Market Failure (H1 Economics/ 8823)

to pay more and hence they might still ignorance because it prevents misinformation. because consumers do not
over-consume the good. Singapore and many countries ban such ads* care about the MEC.
Tax Laws & Regulation Total Ban Public Education
E.g. Alcohol/cigarette tax, ERP, carbon tax, E.g. Quotas (COE, tradable permits), Age ban on E.g. Hard drugs like Heroin, CFC, E.g. public social campaigns,
Criterion / Policy casino entry levy alcohol & cigarettes, Regulating level of carbon monoxide emissions moral suasion, warning labels
*Should be equivalent to MEC to force emissions, compulsory catalytic converters in on cigarette packets, Car-Free
consumers/producers to internalise third cars Day, advertisements
party costs to be fully effective*
Side Effects Positive side effects Positive side effects Same as regulation. No significant positive or
Refers to any • Raises revenue for government which can • Quota-based regulations can raise revenue negative side effects.
side-effects the be used to reduce MEC further (e.g. for government but other forms of In addition:
policy might have engage in pollution control) or launch regulations cannot. Negative side effects It does cost government to
on other campaign to deal with imperfect • Total ban cannot eliminate DWL implement public education but
objectives of the information. Negative side effects fully. There will still be allocative it is unlikely to be a huge
firm or • Does not impede the free market as • Impedes free market and hence price inefficiency. Furthermore, total financial burden.
government market forces and demand and supply can adjustment process may not be able to clear ban MIGHT lead to GREATER
adopting the still operate to clear surpluses and surpluses and shortages – make lead to DWL due to under-consumption
policy or measure shortages. black market and crime hence greater costs (draw graph to show greater
in others, the • Does not deny consumers of their choice on society and taxpayers. DWL due to total ban as
conflict of goals and consumer sovereignty – they can still compared to free market)
choose whether to consume or not. • Denies consumers of their consumer
• Positive & sovereignty as they cannot choose whether
negative side Negative side effects to consume or not.
effects on: • (if imposed on producers due to negative
government externalities from production) Might raise • (if imposed on producers due to negative
revenue, the cost of production for producers externalities from production) Might raise the
consumer reduce their profits – and they may then cost of production for producers reduce their
sovereignty retrench workers which leads to profits – and they may then retrench workers
unemployment (full employment is a which leads to unemployment (full
macroeconomic goal of government) employment is a macroeconomic goal of
government).

• May incur additional costs for government to

policy, monitor and prosecute offenders (e.g.
the case for marijuana legalisation in many

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states in USA is that the negative effects are

not dissimilar to alcohol and the
regulation/ban leads to a buoyant black
market and active smuggling and drug
mafias which costs the government greatly
to crack down).

Negative Side Effect of COE by only regulating

car ownership without regulating car usage
• COE prices have created high sunk costs for
car ownership. After consumers incur high
sunk costs for purchasing the car and the
MPC of car journeys is relatively low (e.g.
petrol costs, parking charges etc).
Therefore, it encouraged car owners to drive
more to justify the high sunk costs. This
caused even greater over-consumption and
DWL hence greater allocative inefficiency
and MF.
Tax Laws & Regulation Total Ban Public Education
E.g. Alcohol/cigarette tax, ERP, carbon tax, E.g. Quotas (COE, tradable permits), Age ban on E.g. Hard drugs like Heroin, CFC, E.g. public social campaigns,
Criterion / Policy casino entry levy alcohol & cigarettes, Regulating level of carbon monoxide emissions moral suasion, warning labels
*Should be equivalent to MEC to force emissions, compulsory catalytic converters in on cigarette packets, Car-Free
consumers/producers to internalise MEC to cars Day, advertisements
be fully effective*
Time Lag • Tax takes time because the extent to • Works very fast as consumers and Same as regulation. • Takes very long to work
Refers to how which Qd will fall due to increase in price producers have no choice. They need to because habits are hard to
long it takes for depends on PED of the good. In the short adhere by the law within given time frame by change. Also, it takes time
the policy to take run, PED<1 hence consumers are unlikely the government. for people to bridge their
effect. (i.e. need to be able to change consumption patterns • Not subjected to PED. information gap. It also
to consider short- or kick off addiction. However, in the LR, takes time for information to
run vs long-run PED>1 hence Qd will fall more than be transmitted to all
effects of proportionately due to increase in price consumers.
policies) brought about by tax.

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2. Evaluating policies used to reduce under-consumption/production of goods due to positive externalities and imperfect information
(For the purpose of this illustration, we will use the consumption perspective. However, students may apply this to production perspective as well)

Subsidies Legislation Direct Provision and Providing for Public Education

E.g. Means-tested hospitalisation subsidy in E.g. Compulsory education and vaccination. free E.g. public social campaigns,
Criterion / Policy SG, subsidised education in SG, SkillsFuture Australia is punishing parents who do not E.g. free entrance to museums and moral suasion
(subsidies for skills training) vaccinate their children by cutting their welfare galleries in SG & London, free
*Should be equivalent to MEB to enable benefits morning off-peak MRT travel,
consumers/producers to internalise third education in European countries
party benefits to be fully effective* (Sweden), NHS provides healthcare
for free in UK
Feasibility • Requires substantial levels of government • Does not require substantial information or • Most limited in terms of feasibility • Most feasible as the least
Refers to the financing finances from government. o Requires extremely high amount of resources
extent which the o Universal subsidies (equal level of levels of government required.
policy can be subsidies given to all) will be much • However, typically, if government compels financing and hence taxes
carried out by the more taxing on government than consumers to consume merit goods, they • Almost impossible for LDCs to
government means-tested subsidies (subsidies must also subsidise or provide for free. If implement.
which vary according to income not, low-income consumers will not be able • It does not mean that
• Manpower levels of consumers). to comply regardless of the severity of government has to be the
and financial o Unfeasible for governments that penalties. producer. It may pay private
resources already have high levels of fiscal o E.g. unlikely that government would firms to produce it for free for
need by debt (e.g. USA, Japan, PIGS- compel parents to send children to consumers.
government Portugal, Ireland, Greece, Spain). school without helping them financially. o E.g. SMRT is paid by
to implement Many of these governments are o Therefore, feasibility of this policy also government to provide free
and monitor cutting back on subsidies. predicates on feasibility in terms of morning off-peak train rides
(to ensure subsidy/free provision. o However, governments
compliance) • Government needs to know the level of • E.g. it is unlikely for government to make often take on the role of
MEB. If MEB is not estimated accurately, it higher education compulsory as it is direct provision when
• Amount of might lead to under- or over-subsidisation extremely demanding financially for providing it for free (e.g.
information and hence under- or over-consumption. government to provide university education NHS) and this would
needed by DWL still exists and AE still not achieved. for free. require high levels of
government Evaluation: can DWL ever be completely expertise and information
to implement eliminated in the real world or should we (e.g how to run an effective
policy look at improvement in AE? hospital network; how many
doctors to hire etc).

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Subsidies Legislation Direct Provision and Providing for Public Education

E.g. Means-tested hospitalisation subsidy in E.g. Compulsory education and vaccination. free E.g. public social campaigns,
SG, subsidised education in SG, SkillsFuture Australia is punishing parents who do not E.g. free entrance to museums and moral suasion
Criterion / Policy (subsidies for skills training) vaccinate their children by cutting their welfare galleries in SG & London, free
*Should be equivalent to MEB to enable benefits morning off-peak MRT travel,
consumers/producers to internalise third education in European countries
party benefits to be fully effective* (Sweden), NHS provides healthcare
for free in UK
Effectiveness • Can be very effective if subsidies are • Can be very effective as results are certain – • Can be the most effective as • Effectiveness is likely to be
Refers to the equivalent to MEB. consumers do not have the choice as it is consumers do not have limited as habits and mind
extent to which mandated by law. affordability problems. sets are hard to change.
the policy, if • However, results are uncertain • As long as penalties are severe enough, • Consumers will be most
implemented, can o Consumers may not increase compliance would be high and hence incentivised to consume since it’s
solve the consumption despite the subsidies consumption levels would be raised. free.
problems or can being given because they can still
achieve the exercise their choice
stated goal/meet Studies have shown that the poor still do
the objectives of not access healthcare as much as the rich
the policy-maker despite being heavily subsidised or even if
healthcare were free. This is because
• Certainty of many low-income consumers tend to work
results part-time jobs that pay by the hour and
(depends on have no sick leave. If they don’t work, they
whether don't get paid. Hence the opp cost of
consumers visiting the doctor is their livelihood
have choice) (wages) as compared to middle- or high-
• Ability to income consumers who get sick leave (i.e.
reduce DWL still get paid a monthly wage despite
taking sick leave to see the doctor).
Subsidies Legislation Direct Provision and Providing for Public Education
E.g. Means-tested hospitalisation subsidy in E.g. Compulsory education and vaccination. free E.g. public social campaigns,
SG, subsidised education in SG, SkillsFuture Australia is punishing parents who do not E.g. free entrance to museums and moral suasion
Criterion / Policy (subsidies for skills training) vaccinate their children by cutting their welfare galleries in SG & London, free
benefits morning off-peak MRT travel,
education in European countries

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*Should be equivalent to MEB to enable (Sweden), NHS provides healthcare

consumers/producers to internalise third for free in UK
party benefits to be fully effective*
Appropriateness • Appropriate for dealing with positive • Does not address the indifference towards • Can be argued that this • Appropriate for dealing with
Refers to whether externalities as it addresses the third parties or ignorance. addresses apathy ignorance due to imperfect
the policy is indifference towards third parties of o Providing it for free works information.
tackling the root consumers. similar to a subsidy – it • Does not deal with apathy
cause of the o Subsidies help consumers internalise constitutes a ‘complete hence does not tackle root
problem or simply the third party benefits hence they subsidy’ and hence helps cause of externalities.
targeting the now account for MEB when making consumers internalise the
symptoms consumption decisions. MEB.
• *have to • Inappropriate for dealing with imperfect o However, it does not take
identify root information as it does not address the into account the true value
cause of ignorance of consumers. of MEB like a subsidy does.
problem first* It simply provides all
consumers with full
subsidies and hence likely
to lead to over-consumption
(side effect).

• Does not address ignorance.

Subsidies Legislation Direct Provision and Providing for Public Education
E.g. Means-tested hospitalisation subsidy in E.g. Compulsory education and vaccination. free E.g. public social campaigns,
SG, subsidised education in SG, SkillsFuture Australia is punishing parents who do not E.g. free entrance to museums and moral suasion
Criterion / Policy (subsidies for skills training) vaccinate their children by cutting their welfare galleries in SG & London, free
*Should be equivalent to MEB to enable benefits morning off-peak MRT travel,
consumers/producers to internalise third education in European countries
party benefits to be fully effective* (Sweden), NHS provides healthcare
for free in UK
Side Effects Negative side effects Negative side effects Negative side effects • No side effects
Refers to any • May cause government to incur high fiscal • Eliminates consumer sovereignty hence • Almost always leads to over-
side-effects the debt and hence fall in other forms of social consumers no longer have the ability to consumption and wastage
policy might have spending. choose what they wish to consume/not o Over consumption beyond
on other • Incur high opp cost in terms of other forms consume. Qs leads to DWL, allocative
objectives of the of social spending – may cause under-

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firm or govt consumption of other merit goods and o E.g. parents cannot choose what is inefficiency and MF (show
adopting the hence allocative inefficiency and market best for their children. They may argue on diagram)
policy or measure failure. that they vaccines have side-effects • Other side effects similar to
in others, the • May require government to impose high and can now not protect their children subsidies but more severe.
conflict of goals taxes on economy to finance subsidies against these side effects
and this raises cost of production for firms • Tends to also involve subsidies/provision for *Singapore almost does not provide
• Positive & (can link to macro effects too). free hence also leads to side effects of those any merit good for free. Most requires
negative side • Hard to withdraw in future as consumers policies. some form of co-payment from
effects on: become too accustomed to receiving consumers to prevent
government these benefits (e.g. Quebec in Canada, overconsumption/wastage.
revenue, UK, USA states face strong resistance
consumer from citizens against cuts to higher Positive side effects
sovereignty education subsidies). • Similar to means-tested
subsidies: can help to increase
Positive side effects equity in terms of access to
• Does not impede consumer sovereignty. social benefits and merit goods
• Does not impede free market forces which • However, many argue that this
will still clear market and prevent exacerbates equity because the
surpluses and shortages. rich also get to enjoy these
• Means-tested subsidies help to promote benefits despite already having
equity (another microeconomic goal of the the ability to afford on their own.
government) as low-income households Hence the rich are still much
enjoy greater levels of subsidies than better off than the poor. Yet this
higher income households. This is seen as is still better in terms of equity
a levelling up of low-income groups. than completely leaving it to free
o E.g. helps children in low income market where the poor
groups to receive education to completely has no access??
increase social mobility (these
children can get better jobs and
enjoy higher wages than their
parents in future)

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Subsidies Legislation Direct Provision and Providing for Public Education

E.g. Means-tested hospitalisation subsidy in E.g. Compulsory education and vaccination. free E.g. public social campaigns,
SG, subsidised education in SG, SkillsFuture Australia is punishing parents who do not E.g. free entrance to museums and moral suasion
Criterion / Policy (subsidies for skills training) vaccinate their children by cutting their welfare galleries in SG & London, free
*Should be equivalent to MEB to enable benefits morning off-peak MRT travel,
consumers/producers to internalise third education in European countries
party benefits to be fully effective* (Sweden), NHS provides healthcare
for free in UK
Time Lag • May take time for effects to be seen as • Can work very fast as consumers do not • May work faster than subsidies • Takes the longest time as
PED is less than one in the short run have a choice but to comply by the because of the extremely high habits and mind-sets are
Refers to how o Consumers need time to adjust Qd in legislation imposed / deadline given by the level of provision given but still hard to change.
long it takes for the SR government. (eg: laws on the use of PMDs). subjected to consumers’ choice • However, the only true long
the policy to take and willingness to consume in term solution to imperfect
effect. (i.e. there the SR. information.
is a need to
consider short-
run vs long-run
effects of
policies)

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3.3 Public Goods

3.3.1 Characteristics of Pure Public Goods and Why Free Markets

Fails in the Provision of Public Goods

Definition:

Pure public goods are goods that are non-excludable and non-rivalry in
consumption.

• Non-excludability

Non-excludability in consumption means no one can be excluded from

consuming the good once it is produced, even if they do not pay. For
example, even if a child does not pay for defence, we cannot exclude the
child from the safety provided by the SAF or the police. As a result, no one
will be willing to pay for the good and the price of the good will be zero.

Non-excludability leads to the free-rider problem. Since there is no

feasible way of excluding non-payers from enjoying the benefits of the good
(non-excludability), consumers can consume a public good without paying
for it (in effect acting as a free rider). Consumers would not be willing to pay
for the good and hence, there is no effective demand.

Therefore, in a free market, private firms will not provide public good as the
firms are unable to derive the effective demand for it since no consumers
will reveal their willingness and ability to pay for the public good.

• Non-rivalry in consumption

Non-rivalry in consumption means that consumption of the good by one

more person will not leave less for others to consume. For example,
the addition of one more resident in the country does not reduce the
provision of protection offered by the defence force to others. As a result,
the marginal cost of providing the good to an additional person is
zero.

To maximise society’s welfare, it should be provided free to as many

users as possible (i.e. none should be excluded), to fulfil the condition of
allocative efficiency (P=MC) and to maximise society’s welfare through
having as many consumers as possible enjoy the utility of consuming the
good or service. However, producer has no incentive to produce at zero
price.

As the private firm is unable to effectively charge a price for the product
(non-excludability in consumption feature) and the price should be zero
from the society’s point of view (non-rivalry in consumption feature), no
private firm will provide the public good. This results in total market failure
in the context of public goods.

Examples of public goods include national defence, street lighting,

lighthouses, flood coontrol schemes etc.

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Firefighting Auction: Save the Highest Bidder!

What happens when firefighting services are made

excludable? Watch this video to find out!

Non-rivalry in
Non-excludability
consumption

Free-rider Undesirability to
problem charge a price

No effective
demand Non-provision

Complete market
failure

Self-Assessment 9

1. If a good/service is free, this means it is non-excludable. True or

false?

2. If there are unlimited units of a good, this means that the good is non-
rivalrous in consumption. True or false?

3. If a good is non-rivalrous in consumption, this means that it doesn’t

cost the firm anything to produce it. True or false?

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3.3.2 Government Intervention

In such a situation, the government intervenes in the market through the direct
provision of the public goods. There is no other solution as the entire market
is missing.

The government can either produce the public goods on their own (such as
defence) or pay private firms to produce them (such as paying firms to build
street lights).The finance for public goods comes from tax revenue.

Limitations of the Direct Provision of Public Goods

• The government may over-produce a public good due to a government

being unable to determine the optimal level of output. This can be
caused by imperfect information on the part of the government, resulting
in inefficiency to still exist.

• The government may not be able to produce those goods as efficiently

as private firms resulting in waste of resources. This is because being
an effective state-run monopoly, combined with no profit maximisation
pressure from shareholders, results in the perfect conditions for creating
X-inefficiency (this is further explored under the topic of Firms and
Decisions).i.e. State-owned firms have the little incentive to cut cost and
might produce in a wasteful manner.

• High government expenditure is needed to finance public goods. This is

not only a drain on government resources but may require higher tax
rates, such as higher income taxes and tax on goods and services to
finance public goods. High income tax rates are known to discourage
effort and investment in the country.

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4. Government Failure
Government failure may occur where government intervention results
in greater market inefficiencies that would otherwise occur without
government intervention. Some economists believe that even with good
intentions, governments seldom get their policy application correct, and may
create inefficiencies when they intervene in markets. Government intervention
to correct market failures might introduce further inefficiencies due to high
administrative cost, information gaps and time lags resulting from red tape
and bureaucracies. There could also be unintended and undesirable
consequences. This is because governments have their limitations.

It is essential to understand how governments make decisions in real-world

contexts. Non-economic considerations, such as public and political
acceptability, have to be taken into account when governments make policy
decisions.

Causes of Government Failure

Governments may create inefficiencies in their intervention in markets due to

the following factors:

1) High cost
In many countries, the government generates a high administrative cost.
There could also be implementation and monitoring costs, as explored earlier.
Imposing a ban on smoking in public places, for example, requires funds to
inform the public of the ban and to hire staff to monitor the ban. As a pseudo
monopoly, the government is inefficient (see Section 3.1.2b under “Direct
Provision”) and generates high waste (due to lack of profit-maximising motive).
This creates a large burden on the economy.

2) Information gaps
The government may not be in the best position to establish what consumer
preferences are and aggregating these preferences based on the number of
people that are willing and able to pay for particular goods and services. This
might cause the government to over or under estimate the amount to produce
and cause a wastage of resources.

3) Time lags
The government may suffer from recognition lag (identifying and determining
the problem), decision lag (deciding on the type of policies to use in order to
resolve the problem), implementation lag (implementing the policies). As a
result of these time lags, policies implemented may be overdue, or worsen an
existing problem

4) The power of self-interest

Politicians and civil servants may pursue self-interest (e.g. personal fame,
higher salary) rather than operating on behalf of citizens or seeking efficiency
leading to a misallocation of resources (for example, instead of allocating
resources to build roads, funds may be channelled into expanding the existing
headquarters of the ministry).

5) Regulatory capture
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This is when the industries under the control of a government regulatory body
is able to move policy options in their favour. Some economists argue that
regulators can prevent the ability of the market to operate freely. This may
lead to poor service, fewer choices and sometimes high prices charged by the
public enterprise. We might find examples of this in agriculture,
telecommunications and the other utilities and also in environmental
protection.

6) Short-termism
Governments have to be accountable to the public. However, this may result
in governments considering short term relief to particular problems but does
little to address long term problems. A decision to provide unemployment
benefits for welfare reasons might add to the problems of higher
unemployment in the country in the longer term.

7) Disincentive effects
Government policies may result in disincentive for businesses if it results in
higher business cost. A policy to reduce income inequality, for example, may
result in higher unemployment as business leave the economy due to the
higher tax rates.

8) Electoral pressures
Governments may conduct additional spending or tax reductions ahead of an
election without the projects being subjected to a full and proper cost-benefit
analysis.

Indonesian govt rapped over lack of action on haze

JAKARTA — As forest fires rage in Indonesia, the republic’s environmental

groups have launched a stinging rebuke against the Indonesian
government for its lack of seriousness in tackling the fires, which have led
to haze blanketing the region. Five non-governmental organisations, which
included prominent environmental watchdog Indonesian Forum for the
Environment (Walhi), the Indonesian Legal Aid Institute and the
Commission for Missing Persons and Victims of Violence (Kontras),
claimed that the government had committed a serious “breach of human
rights” for failing to control fires in Sumatra and Kalimantan. Singapore’s
The Straits Times quoted Kontras coordinator Yati Andriani as saying that
the NGOs had received reports that several pregnant women in remote
Hanjak Maju village in central Kalimantan’s Pulang Pisau regency faced
difficulties when they tried to evacuate to safer ground.

“So many basic rights have been breached — rights to have access to clean
air, health, mobility without restraint and education. This is not just about
the haze blocking visibility,” she was quoted as saying. Walhi head Khalisah
Khalid lamented the lack of action taken against individuals or companies
responsible for the forest fires.

Ten companies found guilty of the fires between 2012 and 2015 had yet to
be penalised, she was quoted as saying by Bernama. Walhi executive
director in Jambi, Rudiansyah, was quoted as saying that the authorities
acted selectively on those responsible for the forest fires. “More than
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11,000ha of forest land in Jambi are on fire and no action has been taken
against anyone.”

Indonesian President Joko ‘Jokowi” Widodo, as quoted by the Antara news

agency, expressed regret over efforts by district authorities in handling
forest fires, which had caused severe haze in Kalimantan, Riau and Jambi.
“We have increased the number of teams of firefighters. But if there is no
support from district authorities, it will be difficult to resolve the issue. “We
have everything, but (the resources are) not used properly. If they are used
properly, I am convinced that the problem can be tackled.”

According to the Antara report, the people were angry that Riau governor
Syamsuar and Pekanbaru mayor Firdaus were abroad even as the haze
situation was worsening.

“Indonesia can handle the problem. The central government is working

hand in hand with local administrations, as well as businesses, to put out
the fires.” He said at least 9,072 personnel from the agency and security
forces had been deployed to fire-affected regions of Riau, Jambi, south
Sumatra, west Kalimantan, central Kalimantan and south Kalimantan.
Forty-four water-bombing helicopters had also been mobilised.

Adapted from Today Online,18th September 2019

5. Decision Making Process

In this topic, we saw how free markets can produce undesirable outcomes on
the basis of efficiency or equity. Hence there is a need for governments to
intervene in markets where efficiency or equity is not achieved.

The government has to decide (i) which markets to intervene in; and (ii) the type
and extent of intervention to embark on. In making this decision, the government
considers its constraints, the necessary information that it has, the costs and
benefits of each potential choice, and the perspectives of consumers and
producers in making a decision. The process is explained below:

Firstly, the government of a country has to decide on which markets to intervene

in, and the extent of its intervention in each market. For example, the issue of
positive externalities exist in the markets for healthcare, education, transport
and housing. As a result, the presence of externalities require government
intervention. There are benefits and costs associated with intervening in each
of these markets. Choosing to intervene in one market may mean forgoing
intervention in the next-best alternative sector or for a group of economic
agents.

After the government has chosen the market to intervene, the government will
weigh the associated costs and benefits on the forms of intervention to address
the market failure. As there are many ways that resources can be committed,
this will allow the government to determine how to go about correcting the
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market failure and to choose the best and most appropriate course of action
to undertake. For example, in the market for healthcare services, market failure
results from the existence of monopoly power, positive externalities and
asymmetric information. As the form of intervention for these issues may not be
the same, a decision must therefore be made on which of these issues to focus
on and the policy measure(s) to implement.
.

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Market Failure (H1 Economics/ 8823)

As an illustration, we assume that the government has decided to intervene in the market of healthcare, and is deciding whether to subsidise the lower
income group.

Costs Benefits Constraints Information Required Perspectives

• Monetary cost of • Greater equity • Available • How much to • Perspective of the lower income
providing the government subsidize? groups in terms of spending
Stage 1: subsidies • Increase consumption funding habits
Making a to socially efficient (budget) • What is the • Perspective of the healthcare
decision • Opportunity cost of level income ceiling to sector in terms of the ability of
providing the subsidies set? the sector to cope with the
expected increase in demand
(spare capacity).

Intended consequence:
Stage 2: • Increasing the degree of healthcare usage by the lower-income group.
Outcomes
of making Unintended consequence:
a • Over- or under-subsidizing due to lack of/inaccurate information collected by the government
decision • Fraudulent claims by consumers or medical practitioners
• Lower than expected take up rate by the lower-income group due to the lack of awareness of the subsidy scheme.

Internal changes:
Stage 3: • Finding alternative ways to help low-income families other than providing subsidies.
Revisiting • Any unintended consequences arising from the first round of decision-making that necessitates another round of decision-making (e.g.
a lower-income groups not being sufficiently aware of subsidy scheme)
decision
made External changes:
• Increasing pharmaceutical costs that make subsidizing lower-income families very expensive for the government.

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6. Conclusion

We have seen how the free market can lead to inefficiency and inequity, and
therefore the market fails. Government can use various policies to intervene
in the market to correct this market failure, with each policy having its own
strengths and weaknesses. These interventions may also create
inefficiencies.

In Singapore, the government uses a myriad of policies to correct market

failure. These are in the form of market-based policies and, command and
control policies.

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Glossary of Key Terms

Ban A ban is an outright restriction of output.

Demerit Goods Demerit goods or services are deemed by the government

(or society) to be undesirable and over-consumed.

Direct Provision Direct provision refer to the provision of goods and services
by the government free or at a price close to zero. The
government could provide these goods directly, or they could
pay private firms to do so.

Equity Equity is where distribution is considered to be fair or just.

Gini coefficient A number that ranges from 0 to 1 and that measures income
distribution in a country. The higher it is, the greater is the
inequality.

Government failure Government failure may occur where government

intervention results in greater market inefficiencies that would
otherwise occur without government intervention.

Imperfect Information Consumers and producers may not have enough information
to make informed choices. This could be due to the imperfect
information about the extent of actual private benefits/costs.

Market Failure Market failure occurs when the free market fails to bring
about an efficient allocation of resources. It can also occur
due to inequitable distribution of income.

Merit Goods Merit goods or services are deemed by the government (or
society) to be desirable and under-consumed.

Negative Externality Negative externalities are costs of production or

consumption of a product that is borne by third parties who
are neither the buyer nor the seller of the good for which no
compensation is made.

Non-excludability Non-excludability in consumption means no one can be

excluded from consuming the good once it is produced, even
if they do not pay.

Non-rivalry Non-rivalry in consumption means that consumption of the

good by one more person will not leave less for others to
consume.

Positive Externality Positive externalities are the benefits of production or

consumption of a product that are enjoyed by third parties
who are neither the consumer nor the producer of the good,
for which no payment is made.

Public Goods Pure public goods are goods that are non-excludable and
non-rivalry in consumption.

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Annex A

Carbon tax VS cap-and-trade3: which is better?

The Guardian, 28 Jan 2013

Economists argue that, if the market is left to operate freely, greenhouse gas emissions will
be excessive, since there is insufficient incentive for firms and households to reduce
emissions. As such, they recommend applying the polluter pays principle and placing a price
on carbon dioxide and other greenhouse gases. This can be implemented either through a
carbon tax (known as a price instrument) or a cap-and-trade scheme (a so-called quantity
instrument).

A carbon tax imposes a tax on each unit of greenhouse gas emissions and gives firms (and
households, depending on the scope) an incentive to reduce pollution whenever doing so
would cost less than paying the tax. As such, the quantity of pollution reduced depends on the
chosen level of the tax. The tax is set by assessing the cost or damage associated with each
unit of pollution and the costs associated with controlling that pollution. Getting the tax level
right is key: too low and firms and households are likely to opt for paying the tax and continuing
to pollute, over and above what is optimal for society. Too high and the costs will rise higher
than necessary to reduce emissions, impacting on profits, jobs and end consumers.

By contrast, a cap-and-trade system sets a maximum level of pollution, a cap, and distributes
emissions permits among firms that produce emissions. Companies must have a permit to
cover each unit of pollution they produce, and they can obtain these permits either through an
initial allocation or auction, or through trading with other firms. Since some firms inevitably find
it easier or cheaper to reduce pollution than others, trading takes place. Whilst the maximum
pollution quantity is set in advance, the trading price of permits fluctuates, becoming more
expensive when demand is high relative to supply (for example when the economy is growing)
and cheaper when demand is lower (for example in a recession). A price on pollution is
therefore created as a result of setting a ceiling on the overall quantity of emissions.

In certain idealized circumstances, carbon taxes and cap-and-trade have exactly the same
outcomes, since they are both ways to price carbon. However, in reality they differ in many
ways.

One difference is the way the two policies distribute the cost of reducing pollution. With cap-
and-trade, it has often been the case that permits are given out for free initially (known as
"grandfathering"). This means cheaper compliance for industry in the early stages of the
scheme, because they only pay for any extra permits bought from other firms – not for the
initial tranche of permits given to them to cover most of their emissions under 'business as
usual'. This approach is obviously popular with industry and explains why grandfathering has
been used, since it helps get firms to accept controls on emissions in the first place. By
contrast, with a tax there is an immediate cost for businesses to pay on every unit of
greenhouse gas produced, so there is a bigger initial hit to the balance sheet. But while
grandfathering is better for near-term business profitability, it is not necessarily the best
outcome for society. Indeed, it deprives the government of valuable revenues, which it could
raise in auctioning the permits initially, and which could be used to reduce other taxes.

The mechanisms also differ in how they perform under uncertainty about the costs and
benefits of reducing emissions. Under a tax, the price of emitting a unit of pollution is set, but
the total quantity of emissions is not. Therefore a tax ensures everyone knows the price being

3
Also known as marketable pollution permits.
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Market Failure (H1 Economics/ 8823)

paid (at least for the immediate future) for each unit of carbon dioxide emitted, but uncertainty
remains about the actual quantity of emissions. Conversely, cap-and-trade provides certainty
about the quantity of emissions (it cannot exceed the cap), but uncertainty about the cost of
achieving these reductions. Which is preferred depends on how sensitive the level of
environmental damage is to changes in emissions, compared with how sensitive the cost of
reducing pollution is to the same changes. If the level of environmental damage is more
sensitive, then it is important to be sure what the quantity of emissions is, which points to cap-
and-trade. Conversely if the cost of reducing pollution is more highly sensitive to changes in
emissions, it is better to be sure about the cost of cutting emissions, pointing to a tax.

What this means for climate change policy is debated. In the short term, most economists
agree that uncertainty alone argues for a tax. Climate change depends on the stock of
greenhouse gases in the atmosphere, and in each year the increase in that stock due to new
emissions is small, so the environment is probably not that sensitive to the uncertainty about
the level of emissions brought about by choosing a tax, at least over a year or two. On the
other side of the ledger, the cost of reducing pollution is highly sensitive to changes in
emissions, since it can be expensive to businesses to change their production methods
abruptly. In the long term, however, it is less clear whether a tax is preferable, because big
changes in the stock of greenhouse gases in the atmosphere may cause substantial
environmental damage.

Some economists recommend a hybrid model that may offer the best of both worlds. This
tends to comprise of a cap on emissions (to regulate the quantity of pollution), but with
adjustment mechanisms such as a carbon price floor or ceiling, to keep the price of a permit
within acceptable bounds. Hybrid schemes have their own problems, however, such as
greater complexity and more intervention by the regulator in the permit market.

Whichever of these policies is favoured to place a price on carbon, they represent just one of
a number of policies needed to cut greenhouse gas emissions.

Summarize the article by filling in the following table:

PROS CONS

CARBON TAX

CAP-AND-TRADE

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Market Failure (H1 Economics/ 8823)

Annex B – Public-Private Partnership

One example of joint provision is the Public-Private Partnership (PPP). PPP is where long-
term partnering relationships between the public and private sector4 are forged in order to
deliver services. It is an approach that the Singapore Government has adopted to increase
private sector involvement in the delivery of public services.

Under the PPP, the government engages in a partnership with private firms to deliver goods
and services. It can happen through working with non-profit organizations or VWO. It can
happen through a contractual agreement to design, finance and operate. For example, the
Singapore Sports Hub is a PPP between Sports Singapore (a public agency) and a private
consortium. The Sports Hub consortium has a 25-year contract with the Sports Singapore to
design, build, finance and operate the Sports Hub. This is an example of the Design-Finance-
Build-Operate (DFBO) model of PPP. Sports Hub integrates sports and recreational
infrastructure and facilities, which can be considered merit goods.

4
“Private sector” in this context refers to the part of the economy not controlled by the government. It can be “for-profit”, or “not-
for-profit” in nature.
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Market Failure (H1 Economics/ 8823)

FOOD FOR THOUGHT – Selected Past Year A Level Essay Questions Related to This
Topic:

(Please note that with the new H1 8823 syllabus, essays are no longer a part of the
assessment mode. However, the following questions are still useful to you in terms of
reinforcing content, as well as in developing writing skills to answer higher-order thinking
questions in case studies)

(2017, H1)
Two possible reasons markets fail are externalities and public goods.

a) Using examples from Singapore, explain why a free market would fail to operate efficiently
when the provision of a good by a private producer generates positive externalities. [10]

b) Discuss the view that the provision of government subsidies would be the best policy to
correct market failure caused by public goods. [15]

(2013, H1)
‘Market failures always exist, so reliance on the price mechanism alone is inevitably an
unsatisfactory way of allocating scarce economic resources.

a) Explain how the price mechanism allocates scarce resources in a free market.
[10]
b) Explain and evaluate one method that a government might use to bring about a more
efficient allocation of resources when, for some reason, there is market failure.
[15]

(2012, H1)
a) Explain why the existence of demerit goods represents market failure. [10]
b) Discuss the view that the best way for governments to respond to the existence of
demerit goods is to regulate their production directly. [15]

(2010, H2)

5. Explain why government intervention is advocated in the markets both for public goods
and for goods where externalities are present. [12]

6. In the UK, entry to national museums and art galleries is free of charge and tickets to
see the opera are heavily subsidised. In contrast, in Japan, entry to national museums
and art galleries comes at a high price and a ticket to see opera is among the most
expensive in the world.

Assess the economic case for these two different approaches. [13]

(2010, H1)
a) Explain, using examples, what is meant by
(i) A public good,
(ii) A demerit good. [10]

b) It is generally recognised that unlimited use of motor vehicles by private citizens

generates a level of negative externalities that is unacceptable. Discuss the view that
policy of indirect taxation is the best that is available to tackle this problem in an
economy such as Singapore. [15]

© Catholic Junior College Economics Department 2020 3