Explain with real world examples why markets might fail in the case of public goods and where information is imperfect. [10]

This paper explains, using real world examples, the market failures caused by public goods and imperfect information. Market failure refers to the situation where the free market fails to achieve the socially optimal outcome that maximises society’s welfare, and therefore fails to allocate resources efficiently. The market is said to be allocative inefficient. There are several sources of market failure, which include positive and negative externalities; the underconsumption of merit goods but overconsumption of demerit goods; the lack of production of public goods if they are left to the free market; market dominance, such as the existence of monopolies and oligopolies; the presence of imperfect and asymmetric information; and the immobility of the factors of production. Public goods and imperfect information would be the focus of this essay.

A public good refers to a good which is non-excludable and non-rival. Some common and popular examples of public goods include national defence and street lighting. "Non-excludable" means that it is impossible or impractical to prevent a person who has not paid from consuming the good. This implies that consumers would be unwilling to pay, as they are able to enjoy the benefits without paying, thus giving rise to “free riders”, resulting in firms lacking an incentive to produce the good and therefore a missing market. 

"Non-rival" means that the consumption of the good by a person does not diminish the quantity or quality of the good available to others. "Non-rival" implies that, once the good is produced, the Marginal Cost (MC) of allowing an additional person to consume the good is zero. Therefore, if the allocative efficient level of consumption is where Price (P) = MC, and MC = 0, then P = MC = 0 suggests that the good should be optimally provided for free, necessitating government provision. 

Hence, public goods are a form of market failure and government provision is required. Governments have the willingness and ability to produce public goods due to their non-profit nature, and unlike private firms, are able to raise compulsory taxes which citizens are compelled to pay, for the production of the public good. 

On the other hand, imperfect information refers to the situation where an agent lacks all relevant information with which to make a rational decision. 

Negative externalities refer to the adverse effects imposed on third parties arising from the production or consumption of a good. A demerit good is an undesirable good which the state believes will be over-consumed and over-produced if left to the workings of the free market. In the case of negative externalities and demerit goods, some consumers may be unaware or may underestimate the harm done to themselves and to others when certain goods are consumed or produced, and thus do not take into account the costs for themselves and on larger society. In other words, due to imperfect information, some individuals may be unable to factor in the full private costs of consumption – perceived Marginal Private Cost (MPC) is less than the actual MPC. This is shown in the above diagram, where the actual MPC, which is also the Marginal Social Cost (MSC), lies above the perceived MPC. The private outcome is Qp where perceived MPC = Marginal Private Benefit (MPB), whereas the social outcome is Qs where Marginal Social Benefit (MSB) = MSC. Between Qs and Qp, because MSC > MSB, the shaded area representing the negative welfare, the deadweight loss, can be eliminated if output were reduced from Qp to Qs. Since Qp > Qs, the good is overconsumed. Cigarettes are an example of a demerit good with negative externalities in consumption. Due to a possible lack of knowledge of the adverse effects arising from the consumption of cigarettes, smokers place themselves and nearby passive smokers at risk from suffering future health problems. 

THINK: What economics diagram should be drawn here, and what should the diagram show?

Positive externalities refer to the benefits enjoyed by third parties arising from the production or consumption of a good. A merit good is a desirable good which the state believes would be under-consumed or under-produced if left to the workings of the free market. In the case of positive externalities and merit goods, some consumers may be unaware or may underestimate the benefits enjoyed by themselves and to others when certain goods are consumed or produced, and thus do not take into account the benefits for themselves and on larger society. Training of workers are an example of a merit good with positive externalities in production as it generates a positive benefit for other firms when these workers work there. However, due to imperfect information, companies may be unwilling to send their own workers for upgrading, thus leading to the good being under-produced and therefore market failure.

In conclusion, the free market may experience market failure due to other sources besides public goods and imperfect information. Hence, the government could decide to intervene to establish allocative efficiency as part of their micro-economic goals.

JC Economics Essays - This A level economics essay response was contributed by Wilson YWS, and is one of the best essays that he has written. The response is clear, simple to understand, and shows that the student understands what the economics question demands. 

However, the major issue with it is that the real world examples could be better used to bring out and illustrate the various elements of the theories. 

Looking closely at this essay, how could the real world examples be better used to show that there really is market failure? Merely stating the examples or bringing them out piece-meal would not be a very constructive approach. However, overall, this essay is still a strong piece of work on balance but one that could be even better if it were improved. 

Thank you very much for reading, and cheers. 

“A monopolistic firm has market power whereas a perfectly competitive firm has no market power. Perfect competition is, therefore, clearly preferable to monopoly, say economists. Discuss this statement. [25]

Monopoly is a firm which is the only seller of a unique product which has no close substitutes. In a market of perfect competition, the level of competition is very high, and each firm is a small entity, a price taker. There are four assumptions for a monopoly to exist: there is only one seller but many buyers, high barriers to entry (both natural and artificial), a highly differentiated product such that it is difficult or impractical to copy the product, and imperfect information. There are four main assumptions for a perfectly competitive market, which are: there are many sellers and buyers, low barriers to entry, homogenous product and perfect information. This essay attempts to explain the reasons for the high market power of a monopoly, low market power for a perfectly competitive firm, and the limitations of monopoly and the choice between a monopoly and a perfectly competitive market. 

Yes, it is true that monopoly has very high barriers to entry while a perfectly competitive market has very low barriers to entry. Barriers to entry refer to the reasons which deter potential entrants from entering the market. There are two types of barriers, which are natural barriers and artificial barriers. Monopoly often has high barriers due to various reasons. Firstly, when there is very high economies of scale of the existing monopoly firm, the starting cost of potential entrants will be very high as a result, and this is often because of high fixed costs, such as massive initial capital outlay followed by declining LRAC. 

Secondly, when there is limited and small market size, localized monopoly might arguably be present because the demand from the consumers is very low due to say a small population, which cannot support more suppliers. For example, there will be only one hairdressing shop in a small town because of its small population. 

Thirdly, when there are network economies, it is very hard for potential entrants to enter the market because of existing networks among users. For instance, after Facebook, it is difficult to have any more of the same type of online social network websites because users have built up broad network on Facebook already. 

These are main natural barriers. There are also artificial barriers to entry set up by governments and the existing firms as well. For example, patents, licenses, and regulations restrict potential entrants from entering. Existing will have limit pricing and predatory pricing to deter potential entrants from entering. Firms also can control retailers and suppliers to prevent potential firms. For example, deBeers controls the diamond resources of the world and can restrict diamond production. Therefore, a monopoly has very high barriers to entry to limit the number of existing firms to a very low number, i.e. one firm. The monopoly has very significant market share hence strong market power to control the price while a perfectly competitive firm has many competitors in the market and therefore their market share is insignificant as a result of this very low market power. Hence, a perfectly competitive firm is a price taker, whereas a monopoly can set output and accept a price, or set the price and accept the resulting output. 

[Insert diagram on PC Industry and PC firm]

The perfectly competitive firm takes the price from the intersection of market demand and supply. To maximize profit, the firm will produce at MC = MR at price P. In the long run, a perfectly competitive firm will gain normal profits when LRAC = P at minimum efficient scale (MES). 

Therefore, a perfectly competitive firm is productive efficient because it always produces along LRAC curve and every firm in the industry tries to produce at MES for maximized profits and minimized costs for survival. A perfectly competitive firm is also allocative efficient because P = AC. It gains maximum social welfare. 

A perfectly competitive firm is also equitable because it gains normal profits in the long run. There are therefore good and solid reasons for the preference of a perfectly competitive firm than a monopoly. A monopoly is productive inefficient , allocative inefficient, and inequitable as explained below. 

[Insert diagram on Monopoly Firm showing Supernormal profit and Deadweight loss]

A monopoly is productive inefficient because the firm has great market power and it can be X-inefficient, which means that it does not act energetically to curb its costs, for instance costs from lobbying for government intervention. It can produce above the LRAC curve due to overpaying for workers, building ostentatious buildings, or unnecessary perks. 

A monopoly is allocative inefficient because of the deadweight loss resulting from monopoly power. At the profit maximizing point, MC = MR, and P > AC. Hence, there is a positive welfare to be achieved by promoting perfectly competitive firms.

A monopoly is not equitable to consumers because of its supernormal profits gained in the long run. 

However, a monopoly can be preferred to a perfectly competitive firm because it is dynamic efficient. It has the willingness and ability to innovate and create to do research and development (R&D) and to improve its product variety through product proliferation. This is because of its supernormal profits in the long run, leading to its ability to conduct R&D. It also aims to utilise product proliferation to fill the product gap, and thereby prevent potential entrants from finding a niche to exploit in its market that it dominates. A perfectly competitive firm is also not willing to innovate because of perfect information in its market, so other firms can easily copy from it, so a monopoly does have some strengths. 

[Insert diagram to compare PC firm and Monopoly]

A monopoly firm usually restricts output and set high price at maximized profit level, while a perfectly competitive firm has lower price and more output at the intersection point of its demand and supply. At this point in time, a perfectly competitive firm is preferred to a monopoly. However, in the long run, when a monopoly grows and exploits its economies of scale, it moves its (LR)MC curve downwards. It can then produce more output at a lower price. At this time, a monopoly is preferred to a perfectly competitive firm due to its dynamic efficiency. 

In conclusion, it is not always preferable to have a perfect competition than a monopoly. Ostensibly there are many good points that perfectly competitive firms have, such as productive efficiency and allocative efficiency, among other ideal points, whereas monopoly does appear or seem not ideal, due to its lack of productive and allocative efficiency. However, a monopoly has more dynamic efficiency than a perfectly competitive firm and has the potential to have lower prices than a perfectly competitive firm. In addition, a perfectly competitive market is ideal but does not exist in the real world. Hence, monopoly is sometimes preferable to a perfectly competitive firm. 

JC Economics Essays - H2 Economics essay on monopoly and perfect competition. Normally I would give detailed comments for essays and make some commentary or remarks on how good the essay is, or how it can be further improved by identifying particular points, arguments, or even sometimes, rarely, mistakes. Sometimes, I even ask difficult thinking questions about how the essay can be improved. However, for this particular essay done under timed examination conditions, I rather like its style and content, and so instead of giving my comments I will let you do most of the thinking: one simple question is - what can you learn from this economics essay? Thanks for reading and cheers. 

Should governments always intervene in the markets to correct problems when free markets fail to allocate resources efficiently? [15]

What is market failure? Market failure is defined as the situation where the free market fails to achieve allocative efficiency – the market fails to achieve an outcome that maximizes society’s welfare. Government intervention during market failure may in certain cases be justified, but in other cases unjustified. This essay intends to discuss if government intervention in markets that fail is justified and effective, by addressing and focusing on the economic problem of externalities, demerit goods, and the lack of provision of public goods. 

Governments can utilise various methods to address externalities and demerit goods. Externalities are third party spillover effects, and can be both positive and negative, and can come from consumption or production sides. Demerit goods are goods that either cause negative externalities, or are goods that governments deem unacceptable for their citizens, for instance smoking and gambling. In the case of negative externalities and demerit goods, when goods are over-consumed as their marginal social costs exceed the marginal social benefit, the government may adapt the use of an output tax to prevent the over-consumption of the good. 

[Insert a diagram on output tax showing how this policy cures the problem]

Imposing a tax per unit that is equal to the MEC shifts the MPC to the left. The new private equilibrium now coincides with the new social equilibrium Qs where MSB = MSC. Allocative efficiency is achieved as the output has been reduced to the social optimal level and therefore government intervention is justified.

Alternatively, the government may also impose an output quota which is defined as the limit for the quantity that the industry can legally produce, therefore effectively reducing the over-consumption of the good generating either negative externalities or demerit goods.

[Insert a diagram for output quota showing how this policy cures the problem]

The original equilibrium is determined by the intersection of MSC and MSB. When the government imposes a quota, the new equilibrium price increased while output falls. Therefore, the quota effectively increases the equilibrium price and decreases the equilibrium quantity of the good.

In the case of positive externalities and merit goods, the government may choose to adopt the policy of subsidies to effectively reduce the extent of under-consumption of the good, to raise the consumption or production of a good to bring about a more socially desirable outcome.

[Insert diagram on subsidies showing how this policy cures the problem]

Giving producers a per unit subsidy that is equal to MEB lowers their production costs and shifts the MPC to the right. The initial social equilibrium of Qs where MSB = MSC now coincides with the new private equilibrium. Allocative efficiency is now achieved as output is now raised to the socially optimal level.

Alternatively, the government may also provide for the good completely free to the society, so as to reduce the extent of under-consumption of the good that brings about positive externalities or merit goods. Also, in the case of public goods, there is a missing market and usually governments have to provide the good for society. Public goods are goods that are non rival and non excludable, which means that they cannot be "used up" when someone consumes them, such that there is less of the good for others, and which means that no one can be excluded from the consumption of the good, respectively. For instance, defence and street lighting are both public goods because they are non rival and non excludable goods. These two conditions of non-rivalry and non-excludability imply that the good has MC = 0, and also that there will be free riders, and therefore profit oriented companies simply will not produce the good as they are assumed to be profit driven. 

[Insert diagram on free provision of goods showing how this policy cures the problems (plural)]

For free provision, the social outcome where output is at Qs, is when MSB = MSC. When the output is subsidized, MSC shifts to the right, where the socially optimal output of Qs is achieved. Therefore the effective price of the good is now zero and the entire cost of the good generating positive externalities or merit goods is now absolutely borne by the government.

However, although government intervention in the market may seemingly be beneficial in helping to shift prices and output to the socially desirable outcomes, they may not always be justified, as there are limitations to it as well. In the case of demerit goods and externalities, high implementation, enforcement and mentoring costs may be incurred by the government in fulfilling its role as an interventionist and thus the total administrative costs may exceed the benefits from implementing such measures, leading to an overall decline in society’s welfare. Taxing the public may also be politically unpopular and therefore hinder governments from implementing such measures by placing political interest over economic ones. 

Moreover, in the case of merit goods and positive externalities, using subsidies to resolve the problems posed may be economically costly and full provision may lead to over-production and over-consumption beyond the socially optimal level and therefore lead to allocative inefficiency as well, therefore proving that government intervention is not justifies and not effective to a large extent. 

Hence, in the final analysis, whilst government intervention in the case, where market failure arises, may be beneficial to a limited extent in helping society to maximize its welfare, in the long term, the costs of government intervention may far exceed the short term benefits enjoyed by society as seen in the limitation of using subsidies, quotas, taxes and free provision. Therefore, markets should be rid of government intervention to a maximal extent, because it is only effective in the short run and to minimal extents and therefore is unjustified as a whole.

JC Economics Essays - H1, H2 A level Economics - tutor's comments on the essay: This economics paper is clear cut, direct, and to the point, and tries its best to answer the question. There are of course a few improvements which can be made to it - try to think about what the improvements are. However, more importantly, as this is a 15 mark examination question, it is the part (b) from another part (a) question, and therefore linked to it in a particular way. Economics exam questions on market failure at H1 and H2 levels often ask for explanation in part (a) of the question, followed by deeper analysis and more evaluative comments on the same topic in the second part of the essay. This is an important thing to note - explanation will not get the highest marks here, but analysis and deeper thinking. Perhaps you could focus on the essay's well-written conclusion, which evaluates market failure and the impact of government intervention. This makes this economics essay come to a well-reasoned, nuanced, balanced, evaluative conclusion, which greatly helps the essay get higher examination marks. Thanks for reading and cheers. Special thanks to AG, who will surely be an outstanding undergraduate candidate at Nanyang Technological University, and the other students who made this essay possible: SH, JC, NT, M, and SS. Thanks for reading and cheers. 

Should governments always intervene when free markets fail to allocate resources efficiently? [15]

It should be recognized that free markets often fail due to allocative inefficiency, and there are various ways where governments can intervene to improve the outcome of resource allocation. However, governments should not always intervene as there are instances where intervention results in a less desirable outcome. This essay thus aims to analyse the pros and cons of the various ways of government intervention, and instances of government failure.

Yes, governments should intervene to improve the efficiency of free markets. Firstly, government policies to bring down the output level to the socially optimal output level can be divided into two categories, one market-based and another of direct control. A per unit output tax of the good raises production cost, thus reducing the output to the socially optimal outcome when there are negative externalities or demerit goods.

[Insert diagram for tax]

By imposing a per unit tax equivalent to MEC, MPC shifts to the left, thus bringing the output level down to Qs, coinciding with socially optimal output level. Hence, there should be intervention as it allows allocative efficiency to be achieved. 

On the flipside, an output subsidy would lower production costs, thus raising production to an output level coincidental to the socially optimal outcome, bettering the situation where there are positive externalities or merit goods.

[Insert diagram for subsidy]

By giving an output subsidy equivalent to MEB, MPC is shifted to the right, thus bringing the output level forward to Qs, the socially optimal level. Thus, allocative efficiency is similarly achieved.

While controlling output directly is a faster and more straightforward method, some may argue for the use of emission charges in the case of negative externalities as it advocates specific actions to cut down on the externalities which seem to some as a more long term solution. For example, in the case of pollution, emission charges induce firms to directly reduce pollution by the addition of a filter or the switch to less polluting production methods. However, there are limitations to such a policy as it gives high administrative costs due to the difficulty faced in monitoring emissions as compared to output.

When market-based policies fail to work, it may be sensible for the government to intervene with direct controls. An output ban could be used to forcefully bring down the output level to the socially optimal one. 

[Insert diagram on total ban]

An output ban will be advisable in the case where MEC is so large that the socially optimal output occurs at Qs = 0. In this case, a ban will be allocatively efficient. However, it should be noted that in a case where the MEC is relatively small, government intervention is not advisable as the outcome is even more allocative inefficient. As seen in the diagram above, when the government does not intervene, the area of welfare loss is smaller than when the government chooses to impose a total ban where quantity will be brought to zero. Hence, output bans are very extreme and thus governments should only intervene with a ban if MEC is large.

Another form of direct control would be direct free provision by the government to bring the output level to one that is socially optimal.

[Insert diagram on free provision]

For free provision, the MEB is so large that the socially optimal outcome occurs at Qs. Thus output has to be subsidized to such a large extent that the price of the good effectively becomes zero.

However, just like an output ban, free provision is very extreme and should only be used when the extent of MEB is very large. 

Where MEB is relatively small, MPC needs to be shifted to the right in order for socially optimal outcome to be achieved. Therefore, if the good was to be provided for free, the good will be over-consumed, resulting in a deadweight loss, implying that the outcome is worse than before intervention. Hence government should not intervene. 

In conclusion, despite substantial pros brought about by government intervention, the government should not always intervene as there will bound to be cases of government failure when the extent of intervention required is wrongly judged as seen from the examples above. Furthermore, the extent of administrative costs of some of the methods of intervention outweighs their benefits, translating to the view that the government should not always intervene.

JC Economics Essays - H1, H2, H3 Economics Essays - tutor's comments: While there is a lot of good economics material in this generally well written essay, the main problem is that it could have addressed the examination question more directly and targeted the answer better to the economics question specifically. Having said that, there are some saving graces to this economics essay. There is great use of varied economics diagrams, a lot of explanation, solid economic reasoning, and generally good application of economic principles and ideas, concepts, and logic. These save the essay quite a lot. However, better use of essay technique and more direct answering of the question would be great and would raise the grade achieved - also, lots of economics examples should also have been used. What other ways could be used to improve this essay? Think of how you could make this economics paper even better than it already is. 

H2 Explain the difference between public goods and merit goods, using examples from the United Kingdom. [10m]

Market failure refers to a situation where the free market fails to achieve an outcome that maximises  society’s welfare. Such a society is said to be allocatively inefficient. This paper delves into detail regarding the difference between public goods and merit goods, using examples from the UK. 

A public good is defined as a good that is non-excludable and non-rival; non-excludable means that it is impossible to prevent someone who has not paid from consuming the good while non-rival means that the consumption of the good by one person does not diminish the amount or quality available to others. 

On the other hand, a merit good refers to a good in which the state believes will be under-consumed if left to the free market, because some individuals are unable to factor in the full private benefits of consumption. This means that the perceived marginal private benefit is less than the actual marginal private benefit and the good is under-consumed. 

Due to the non-excludable and non-rivalrous characteristics of public goods, consumers are unwilling to pay because they are able to enjoy the benefits as “free-riders”. Firms are unable to charge a price and so they find the good unprofitable to produce. Under a free market, production does not occur and total market failure arises. 

When this happens, the government must fully finance the production of the good in which the cost of financing such good is funded from general taxation. In the case of UK, the flood control defence is funded by the government. It is non-excludable as people in the country who did not pay for the flood control system will get to enjoy the same level of safety from floods. It is non-rivalrous too as such security against these natural hazards does not diminish even if the population increases. 

Merit goods may also exhibit positive externalities, or alternatively, due to imperfect information, may be under-consumed as a result. Thus, society’s welfare is not maximised. To correct such market failure, the government must raise consumption through subsidies. In the case of the UK, the entry to national museums and art galleries is free and tickets to the opera are subsidised as the government recognizes the under consumption of art among the people. Individuals may fail to factor in the private benefits of consuming such a good such as providing an alternative form of escapism from the hectic life of city dwellers through the appreciation of art. To raise the consumption, the UK government subsidizes the entry tickets to art galleries to point of being free so as to raise the overall welfare of the society. 

Public goods defer from merit goods as the former exhibit non-excludability and non-rivalrous characteristics. On the other hand, the latter are private goods which exhibit excludability and rivalrous characteristics. Merit goods are provided by private producers as they are able to set a price on the good. There is no “free-riders” problem in the case of merit good whereas there exists such a problem in the case of public goods. As such, a public good is provided by the government directly whereas merit goods tend to be subsidised or partially provided. The argument on merit good focuses is more on individuals undervaluing private benefits while the “free-riders” problem plays a significant role in the argument on public good. 

JC Economics Essays - Economics Tutor's Comments: This is a simple, clear cut, and well presented Economics essay that is fairly accurate, direct, and to the point. This essay addresses the question posed directly. However, the usual question applies: how could you improve upon this Economics essay to make it better, or even more accurate or precise? How could you further develop the essay's paragraphs? Special thanks to S YQ for this excellent piece of economic writing. Thanks for reading and cheers. 

(b) Evaluate the idea that a government should use tradable permits to correct the market failure resulting from the existence of a negative externality. [15]

(b) Evaluate the idea that a government, for instance Singapore’s government, should use tradable permits to correct the market failure resulting from the existence of a negative externality. [15]

Adapted from an actual Economics Examination: November 2008, H1, A-Level

This paper discusses whether a government such as that of Singapore should use a policy of tradable permits to try to correct market failure resulting from the existence of a negative externality. An externality is a third-party spill-over effect affecting the welfare of a third-party in production/consumption of a good, but he neither receives nor pays compensation for that effect. In pursuit of their self-interest, producers and consumers only consider their own private costs and benefits and not account for their third-party effects, hence creating a divergence between private and social costs and benefits. However this paper discusses only negative externalities in production. One example of a negative externality in production is pollution.

Under the assumptions of perfect competition, the Marginal Private Cost curve is the same as the Marginal Social Cost Curve and that the quantity of pollution rises with output; the demand-supply diagram of a negative externality in production reflects this situation.

Diagram.

The free market equilibrium is at Em with output Qe units, since firms equate their MPC to price (MPC=P). Since the production of the good generates negative externalities, otherwise known as Marginal External Cost (MEC), the Marginal Social Costs arising from individual’s consumption of the good (MSB) is higher than Marginal Private Cost (MPC) by amount of the MEC, creating a divergence between MSC and MPC. However, the socially desired output level is Qs units (where MSB=MSC).  From society’s point of view, there is over-consumption of the good by QsQe units, and too many resources are channelled to its production. This is a situation of allocative inefficiency. The money value of benefits from output QsQe =Area QsEsRQe, and the money value of resources from output QsQe =Area QsEsEmQe. Hence the deadweight loss in not producing output QsQe = Area EsREm, showing that there is a market failure.

To correct a negative externality in production, a government such as Singapore’s can help adopt a policy such as using tradable permits. In the case of pollution, the government can use tradable carbon permits. A tradable permit is a government set quota to limit the production of a good that is a negative externality, hence limiting the amount of production of negative externalities by firms. Based on a cap and trade principle, the firms purchase permits to pay for every unit of negative externality they generate, and the cap set by the government is the socially optimal level of production of the good associated. At the same time, firms who find it more incentivising and cheaper to internalise the externality than holding on to the permits, via means such as research and technological development, will do so. This causes the external costs to society, and hence the divergence between the MSC and MPB to fall, as these producers now internalize these externalities. At the same time, they sell their permits to other firms who do not have the ability or willpower to do so. Society as a whole hence produces less of this good, and the market produces the socially optimal output of the good generating negative externalities. Hence the market failure is successfully and fully corrected. Even though the government intervenes, this market based solution does not require excessive monitoring freeing up the government’s resources for other uses. More importantly, it allows the market to use the most efficient and efficient means to abate the amount of good produced, internalising the externalities.

However, using the tradable permits scheme has its disadvantages as well. On one hand, geographical areas which have the presence of firms that can internalise the negative externalities reduce the external costs to third parties. However, this increases or concentrates the externalities in other geographical areas where firms which do not find it cheap to internalise them but produce more via purchasing more permits. This is counter-intuitive to the aims of the policy, which is to reduce or eliminate the negative externality. Even though society as whole reduces the externality, there is merely a redistribution of the externalities between those who can and cannot afford to reduce it, which could be inequitable.

At the same time, the government can introduce an indirect (Pigouvian) tax on producers to reduce the negative externality, equal to the marginal external costs to third-parties. This is shown in the diagram below.

Diagram.

Using this tax causes the producers and consumers to internalise the costs as well, because it is a market-based solution. Such a tax allows markets to continue operating along market forces to a large extent. Although prices have been inflated by taxes, consumption and production decisions are made while firms and household pursue their own self-interest. Apart from taxes providing revenue for governments to finance social and community development projects, most importantly, society as a whole reduces the externality by internalising its costs without concentrating it or reducing it only in specific geographical areas, unlike tradable permits.

Conclusions

In conclusion, governments like the Singapore government can not only use tradable permits, but also other policies such as taxation to reduce negative externalities. This is because each of these policies has their distinct advantages and disadvantages. Despite its disadvantages, I believe that governments should employ the tradable permits scheme. In a technologically-advanced country like Singapore, a majority of firms can readily seek solutions to internalise the externality, since they have the advantage of technology and financial power. At the same time, taxes might not be so effective, especially if the demand for that good or service is price inelastic. This is because a very high tax has to be imposed before any effect on production or consumption can be achieved. This also reduces the government’s popularity, as people view the government as trying to gain from the people, what more if a high tax is imposed. Despite being effective, the government’s vote pool might be reduced, which is not what it wants –maximise votes from the people. Hence, a regime of tradable permits is more effective to implement in countries like Singapore.

JC Economics Essays: Tutor's Comments - This is the second part to an Economics answer based on an actual "A" level Economics examination, but amended to fit this post to demonstrate the answering technique and approach. This Economics essay is about tradeable permits, a very hot topic - and one major suggestion that I would give is that students should find out about Ronald Coase, and his paper on Social Cost (where he came up with what is eponymously known today as Coase Theorem or Coase's Theorem). By the way, whilst Coase might seem to have nothing to do with this paper in the eyes of some new Economics students, because they might not have taught this in schools, the inclusion of his ideas into this paper would be a very good idea because Coase's ideas fit into this whole approach of tradeable permits, with the ideas of transaction costs, trading and bargaining, and internalisation of externalities. In fact, it can be argued that tradeable permits are an application of Coase's ideas. Those are relevant Economics materials that can be included into this paper. Having said that, this is a well written answer that is to the point and analyses the diagrams (they were drawn in the actual answer); yet, my usual tutor's question applies: how would you improve this Economics answer? Thanks for reading and cheers. 

Compare and contrast the various types of economic efficiencies. [10]

Compare and contrast the various types of economic efficiencies. [10]

The fundamental economic problem is a problem of scarcity, necessitating choice. This is because human wants are potentially unlimited, but resources are limited, and hence choices have to be made, “efficiently”, between competing uses for the same resources. The scarce resources, or factors of production, are land, labour, capital, and entrepreneurship. Land refers to resources, gifts of nature, and other natural factors. Labour refers to human effort and work. Capital refers to any good that can be used to produced another good. Entrepreneurship refers to risk-taking, organisation, and business acumen, among other things. It can be said that efficiency is concerned with the optimal production and distribution of society’s scarce resources. This economics essay compares and contrasts the various main types of economic efficiencies – productive efficiency, allocative efficiency, dynamic and static efficiency, X-inefficiency, social efficiency, and Pareto efficiency.

Productive Efficiency

First, productive efficiency occurs when the maximum number of goods and services are produced with a given amount of inputs. This will occur on the production possibilities curve or production possibilities frontier (PPC or PPF), meaning that any point along the PPC will be productively efficient. On the PPC, it is impossible to produce more goods without producing fewer services. Productive efficiency will also occur at the lowest point on individual firms’ average cost curves (AC curves). This is because productive efficiency can be thought of as the method of least cost production, which means that production costs are minimised. Productive efficiency is not the same as the other types of efficiencies.

Think: how would you draw the PPC?

Allocative Efficiency

Second, allocative efficiency occurs when goods and services are distributed according to society’s preferences or when they are allocated in accordance with maximising society’s welfare. An economy could be productively efficient but produce goods that people that do not need, and this would be allocatively inefficient. In other words, allocative efficiency is a subset of productive efficiency, where productive efficiency is a necessary condition of allocative efficiency. (A necessary condition is a condition for some state of affairs that must be satisfied before the state of affairs can be obtained.) It should be noted that allocative efficiency occurs when the price of the good produced by a firm equals the marginal costs of production.

Dynamic Efficiency

Third, dynamic efficiency refers to efficiency over time, whereas static efficiency refers to efficiency at a particular point in time. The first concept has the element of time taken into consideration whereas the other does not consider time. Dynamic efficiency involves the introduction of new technology and working practices to reduce costs over time, whereas static means “at a fixed point in time”. Basically, this concept of dynamic means that there are changes over time whereas static means that time is held, as it were, frozen.

X-inefficiency

Fourth, X-inefficiency occurs when firms do not have incentives to cut costs. This is usually associated with monopolies, which usually pursue rent-seeking behaviour rather than think of how to lower costs. For instance, a monopoly which makes supernormal profits may have little incentive to get rid of surplus labour. Therefore, a monopolistic firm’s average costs may be higher than necessary.

Social Efficiency

Social efficiency occurs when externalities are taken into consideration and occurs at an output where the social cost of production (SMC) = the social benefit (SMB), or alternatively, the marginal social costs (MSC) = the marginal social benefits (MSB). This is closely related to both the concepts of allocative and Pareto efficiency, also known as Pareto optimality. Pareto efficiency or optimality is defined as a situation where it is not possible to make one party better off without making another party worse off. Hence, Pareto efficiency is socially efficient and also allocatively efficient, at society’s level.

Conclusion

In conclusion, there are many efficiency concepts in Economics and it is important to understand economic efficiency. Many of the concepts are related and can be understood in relation to each other.

JC Economics Essays – Tutor’s Commentary: This is a good introduction to the various “efficiencies” that Economics has to offer, not just at ‘A’ levels, but also at O, AS levels and introductory undergraduate Economics as well. ‘A’ level Economics can be quite esoteric, it is true, and this Economics material might seem difficult. Think positively instead: how could you make this Economics essay comprehensible and easily understood by you? Let’s do some counterfactual experiments here. Put yourself in the role of the Economic tutor, the examiner, or the lecturer, and you were marking this essay paper. If you were an Economics tutor, how would you judge this essay? What were its strengths and weaknesses, and why do you think – as a professional Economics tutor – those parts of the Economics essay were strengths or weaknesses? Thanks for reading, all the best and good luck!

Explain carefully why imperfect information and the immobility of the factors of production may lead to market failure. [10]

Explain carefully why imperfect information and the immobility of the factors of production may lead to market failure. [10]

Market failure can be defined as the failure of the free market mechanism to provide goods in a socially optimal and thus efficient manner, and is usually attributed to imperfect markets, the existence of externalities, the lack of provision of public goods, and inequity. Imperfect information and immobility of the factors of production also lead to market failure, because they directly contradict the assumptions of the free market system. The two main assumptions violated are firstly that all participants have perfect information, and secondly that the factors of production are mobile, such that they can respond to changing prices which function as a signal for producers to move resources into various areas of production. With those assumptions violated, Pareto optimality - when one person cannot be made better off without making someone else worse off - cannot be derived from perfect competition in a free market. This paper explains carefully why imperfect information and the immobility of the factors of production lead to market failure.

The free market system assumes that consumers have perfect knowledge of costs and benefits, thus the market-clearing equilibrium is able to be reached when individuals’ valuation of the good equal suppliers’ marginal cost of production; hence demand = supply. But in reality, consumers are often ignorant about the quality of the goods and durables they purchase. These are cases of imperfect information, which cause market failure as individuals are unable to fully obtain the marginal benefits of the good. As the market demand curve is derived by summing up all individual demand curves an optimal market equilibrium cannot be derived. On the supply side, firms are often ignorant of market opportunities, prices and costs, and may often make inaccurate estimations of market consumer demand or fail to respond promptly to demand changes due to errors in judgment. Thus market failure occurs.

Imperfect information is present when consumers and producers do not or are unable to consider society’s benefits and society’s costs, as reflected in the diagrams below.

Insert Economics diagrams here: HINT, draw externality diagrams. Why externality diagrams?

In the first diagram, there is an overproduction of a good distorting the market. Negative externalities, if unknown to producers, or if they merely consider their own private costs benefits and ignore society’s efficiency, also result in market failure, but this time in overproduction of a good.

In the second, there is an underproduction distorting the market. Consumers often have lower than optimal demand for desirable public goods, for example healthcare and education, as they only take into account current utilities, failing to judge the full extent of welfare and benefits the good delivers to society. This presence of unacknowledged positive negative externalities results in the underproduction of the good. Hence, the failure to acknowledge externalities is a lack of full or perfect information that distorts the market.

For private markets to function efficiently, factors such as labor and capital must be able to move freely. If factors are immobile, due to perhaps occupational rigidities and inefficient job seeking processes and bureaucratic issues, it affects the supply of these knowledge-based products. This immobility can lead to the wrong price signals and inefficient allocation of resources to these industries. For the socially optimal equilibrium to be reached, firms and labor must respond to market signals. When firms have trade unions as stakeholders, markets tend to fail as unions tend to aggressively seek minimum wage rates or protect their wage benefits or restrict entry of new labor, even in the face of declining market demand.

Hence, both imperfect information and lack of mobility of resources affect the workings of the price mechanism in the free market, and because perfect competition fails, then there is market failure, and the Pareto efficiency promised by perfect competition in the free market does not arise.

JC ECONOMICS ESSAYS - Tutor's Comments: This Economics essay is rather well written and addresses the issue of market failure well. There are many good aspects to learn about it. However, it was not written by an "A" level student but was written by a trainee teacher (trainee tutor) from education school. Perhaps, as improvement, the author should have also compared and contrasted asymmetric information with imperfect information. For more information on asymmetric information, see George Akerlof and Michael Spence (for further advanced Economics readings). 

(a) Explain why pollution and congestion caused by cars may cause market failure [10]

(a) Explain why pollution and congestion caused by cars may cause market failure. [10]

Pollution and congestion may cause market failure because they are forms of negative externalities, which distort the socially optimal workings of the free market. Externalities are third party spillover effects, and can be categorized as positive and negative. Whether positive or negative, externalities cause market failure as they distort the socially optimum output to society because of a discrepancy between the social costs and benefits and private costs and benefits. Market failure can be defined as the failure of free markets to allocate resources in a socially efficient manner. This paper discusses why negative externalities cause market failure in the context of congestion and pollution, and demonstrates there is a deadweight loss to society when drivers consider only private costs and benefits and not social costs and benefits.

A negative externality occurs when motorists fail to consider the social costs of their journeys. The individual motorist only considers his private costs and benefits, and hence only his private marginal cost matters to him. For instance, fuel costs are part of his private costs and he factors them into his calculations. However, by driving on the roads, a motorist inflicts external costs on others, namely congestion and pollution. Congestion is a third party external cost because other drivers have their speeds reduced as a result and pollution is a third party external cost because pedestrians and motorcyclists suffer from irritation and perhaps even health problems. Hence, the motorist who considers only his private costs and benefits fails to take into account the external costs that he imposes on others.

These results can be seen in the following diagram…

Insert diagram

The diagram demonstrates that the socially optimum level of car journeys should be at q2 at a price of p2, yet the private market, which does not take externalities into account, produces q1 car trips at a cheaper price of p1. This means that the negative externality results in more car trips being taken at a lower price than what is socially efficient. Since the number of car journeys is underpriced and overprovided there results a deadweight loss to society. The socially optimum level should be at p2 and q2, not p1 and q1.

Therefore, pollution and congestion caused by cars are likely to cause market failure.

In conclusion, there are many types of market failure: imperfect markets, the failure of Adam Smith’s free market to produce public goods, and above all externalities. In the case of cars, causing congestion and pollution, the market failure in question is externalities – and in particular, negative externalities, where third parties suffer negative spillover effects such as congestion and pollution when others drive.

JC ECONOMICS ESSAYS Economics Tutor's Comments: This is a very well-written Economics answer. What can you learn from the way this economics essay is written? Why is it good? How would you have addressed the question? And what other comments would you have about it? Do think about how to write a proper economics essay every time you read one. This economics essay was professionally written.

(a) What are the various sources of market failure? [10]

(a) What are the various sources of market failure? [10]

Market failure is the failure of the free market to allocate goods in an efficient manner. In a free market economy, there are many types of market failure. This economics paper focuses on three main types of market failure, namely: externalities, both positive and negative, public goods, and imperfect competition in the market. This paper argues that market failure or the inefficient allocation of resources occurs when production is not at the socially optimum level.

First, externalities are said to exist when the actions of producers or consumers affect third parties who are offered no compensation for sustaining the loss generated. Externalities can be known as external diseconomies and economies as well as third party spillover effects. They exist because the market cannot deal properly with the side effects of many economic activities. Externalities involve an interdependence on utility and production functions. An external benefit or a positive externality refers to the benefit from production or consumption experienced by people other than the producers or consumers. This occurs when an externality-generating activity raises the production or the utility of the externality-affected party. Hence, the economic activity provides incidental benefits to others for whom they are not specifically intended.

Suggested Market Failure Figure 1: External cost in production

A negative externality or external cost refers to the cost of production or consumption borne by people other than the consumers or producers. The undesirable effects on the allocation of resources by an externality can be explained by the Marginal Social Cost (MSC). The Marginal Social Cost is a sum of the Marginal Private Cost (MPC) and the Marginal External Cost (MEC). MPC is a share of marginal cost caused by an activity that is paid by the people who carry out the activity and MEC is the share borne by others. When the firm’s activities generate negative externalities, its MSC will be greater than MPC. Since, in equilibrium, the market will yield an output at which consumers marginal benefit is equal to a firm’s MPC. Thus, as shown in Figure 1, MPB is less than MPC, hence the costs that is incurred to society outweighs the benefit derived from the good. Consider the soap industry which, in a free market would discharge waste products into the air and into rivers. The owners of soap factories being profit maximisers will only consider their private costs and ignore the wider social costs of their activities. Thus, MSC is more than MPC.

Suggested Market Failure Figure 2: External benefit in consumption.

An example of an activity which generates an external benefit in consumption is vaccination. If an individual makes a decision to be inoculated against a particular disease, then he will receive the private benefit of not being infected by that particular disease. However, there are also other possible benefits to all others with whom he comes into contact as they will not contract the disease from him. The vaccination protects not only the person who is vaccinated but also the entire community that person lives in, by preventing the spread of contagious diseases. Thus, MSB is greater than MPB. The individuals consider only private benefits and costs in their consumption decisions. Hence, they will consume OQ1 units where MPB=MPC. However, the socially efficient output occurs at OQ2, where MSB=MSC. There is thus an underconsumption of Q1Q2 of the good which results in a deadweight loss equal to the area of E2BE1. Insufficient scarce resources are being devoted to the production of this product. The market has failed to allocate resources efficiently.

Secondly, one major source of market failure is the failure of the free market to provide public goods without government intervention. Economic goods can further be subdivided into public and private goods. A public good is one that has two characteristics that private goods do not. Firstly, public goods are non-exclusive. This means that a producer or seller cannot separate nonpayers from benefiting from the good, so that someone who has not paid for the good cannot be prevented from consuming it. As a result, the payer too, eventually does not want to pay, because of the so-called free rider problem. As a consequence, the market will not produce a public good. This is market failure.

Using the concept of externality for public goods, there are no private benefits or revenue for the producer at all but more benefit for the society. Examples of public goods are street lighting, defence and radio broadcasts. The second characteristic is that public goods are non-exhaustible or non-rival. This means that the use of the good by one person does not reduce the quality or the amount available to another. As a result, there is no rivalry in consumption. As a result, there is no additional opportunity cost for the second and third person to use. Assuming that the allocative efficient level is P = MC, and MC = 0, then it stands to reason that P = MC = 0, and the good should be provided free of charge if it is to be produced at the socially optimal level. 

Third, there is the existence of imperfect competition which distorts a free market economy. In a free market economy, there is nothing to prevent the emergence of oligopolies and a monopoly in various industries. An oligopolistic market can be defined as a market structure where there are a few dominant firms which are rivals to each other, each producing either homogeneous or differentiated products, while a monopoly can be defined as one dominant firm producing a highly differentiated good with no close substitutes. The more successful firm (or firms) acquires other firms or puts them out of business. When these imperfect market structures occur, there will be allocative inefficiency because they generate shortages in order to hike up prices and increase profits.

Insert Economics diagram. Either oligopoly or monopoly diagrams. 

Hence, market failure usually results from the presence of externalities, the lack of provision of public goods and the allocative inefficiencies from imperfect competition. Thus there is a role for government intervention in the market to achieve a better outcome in terms of allocation of resources.

JC Economics Essays: Tutor's Comments - This economics response is a well-written and well-crafted Economics essay, that was written under model examination conditions; good work MJ! Special thanks to MJ for her kind contribution. Excellent. NOTE: This economics essay has been edited to make the language flow better but the main points were still written under examination conditions. Thank you for reading and cheers. 

Since large firms enjoy EOS, they are therefore more efficient and should be welcomed by society. Do you agree? [25]

Since large firms enjoy EOS, they are therefore more efficient and should be welcomed by society. Do you agree? [25]

Economies of scale (EOS) refers to the cost savings derived from large scale production of the firm. EOS can be generated internally or externally. If the average costs decrease due to the increase in the scale of production of the firm itself, we say that the firm experiences internal EOS. EOS allows efficiency to be achieved. To be economically efficient a firm has to achieve productive and allocative efficiency. Productive efficiency refers to the least cost method of production. Allocative efficiency on the other hand, occurs when the right amount of the right kind of goods are being produced. This occurs when the marginal social benefit is equal to the marginal social cost, society welfare is thus maximized. On top of that, Pareto efficiency also has to be achieved. Pareto efficiency is when it is no longer possible to change the allocation of resources such that it makes at least one individual better off without making any other individual worse off.

Large firms are firms usually classified as oligopolistic or monopolistic firms. An oligopolistic market occurs where the industry is dominated by a few large firms which control a large proportion of the industry’s output. These firms have a large share of market power. Similarly, in a monopolistic market, there is market dominance because a single firm controls the whole supply of a product which has no close substitutes. As a result of the large market share, profits gained from production will allow these large firms to achieve efficiency through EOS. As long as these EOS can be filtered down to consumers in terms of lower prices and higher output, I agree that because large firms enjoy EOS, they are therefore more efficient and should be welcomed by society.

A firm enjoys internal economies of scale if its average cost of production falls as its scale of production increases. This is represented by a movement along the downward sloping portion of the Long Run Average Cost (LRAC) curve. Average cost refers to cost per unit of output. This is illustrated in the figure below.

Insert Economics diagram - thinking question: what will this economics diagram look like?

A large firm can enjoy internal economies of scale through marketing economies. This occurs when a firm gets bigger and it buys inputs such as raw materials in bulk. Suppliers of these inputs, in their eagerness to secure the firm’s orders, will often offer a discount on its purchase. This lowers the firm’s unit cost of production. A firm can also enjoy marketing economies when it enjoys the ability to spread its advertising costs. Since a bigger firm produces more output, its total advertising cost is spread over a large output, thus unit cost is reduced. Such large firms can also enjoy EOS through financial economies whereby larger firms may be able to obtain financial loans at lower interest rates due to more credit worthiness. It can also raise funds in the capital market by issuing shares to member of the public. Moreover when a firm expands, it is also able to hire professionals to specialize in different areas of work. Different departments can be set up, each led by an expert in the field. With these expertises, a firm’s output can be increased, thus lowering its unit cost of production. This may not be worthwhile or economical for a smaller firm. This is known as managerial economies of scale. As such EOS allows for large firms to be more efficient as they get to reduce costs of production, achieve a minimum efficient scale (MES) and be more productively efficient. This will eventually result in costs savings passed on to consumers in the form of lower prices for the goods and services provided.

However, in the case of a natural monopoly, society has no choice but to welcome it into the market. A natural monopoly occurs when a tremendous amount of capital is required to produce a product or service. This leads to very large economies of scale and the firm’s MES occurs at a very high level of output, such that there will only be one firm in the market. This huge capital requirement means that total fixed costs make up a very large part of the total cost. Such examples of a natural monopoly would include producers for utilities such as gas, water and telecommunications. In the case of Singapore, the telecommunication lines are monopolized by Singtel. Although a natural monopoly is allocatively inefficient in P=MC pricing, where the cost of the good is equal to the marginal cost of producing a good, it is definitely more efficient than trying to duplicate the number of firm through liberalization. This is because the new entrant will eventually collapse to form a monopoly again because the duplicity of firms would cause the new entrant to incur large losses. As such, society would still accept such natural monopolists in the industry. This can be depicted by the existence of Singtel.

However, society should not welcome such large firms because there are disadvantages of EOS when it is being reaped beyond MES. These are internal diseconomies of scale (disEOS). Internal diseconomies of scale are the cost disadvantages a firm experiences as it increases its scale of production. When a firm becomes too large, its average cost of production rises as its scale of production increases. This is represented by a movement along the upward sloping portion of the LRAC curve. Internal disEOS are largely managerial inefficiencies. This can arise from the increase in complexity in management and greater difficulty in co-ordination in a large organization. A firm grows so large that it becomes more cumbersome to manage. It becomes more bureaucratic and decision-can also making process slows down. Work efficiency can be reduced by excessive paper work which results in low productivity and higher unit cost. Management problems of co-ordination may also appear as the organisation of the firm becomes too big. It becomes increasingly more difficult for top management to co-ordinate and monitor all operations, thus inefficiency may creep in. This increases unit cost.

Insert diagram - how will this economics diagram look like? Remember now that it is about disEOS rather than EOS.

Society should also not welcome such large firms because these firms tend to be monopolies. Monopolists experiences static inefficiency, or a lack of dynamic efficiency. Static efficiency is attained when there are both productive and allocative efficiency. The monopolist is productive efficient as long as it maximises profits. However, a profit maximising monopolist produces output up to the level where P>MC. Since consumers value the last unit of the good more than it costs to produce, the good is underproduced and increasing the output can increase the welfare of the consumers. The underproduction of the good has led to the loss in welfare for the society. This can be illustrated in the diagram below.

Insert economics diagram. Apply usual thinking!

As such, under similar cost conditions, the output produced by a single monopolist is lower and the price charged higher than the perfectly competitive industry. The perfectly competitive industry will produce where demand equals to supply, at output Qpc, and charge a price Ppc. However, the monopolist would produce at Qm, and charge a price equal to Pm.

Moreover, society should not accept large firms because there will be an unequal income distribution. This is because the monopolist can earn supernormal profits even in the long run due to barriers to entry. If a monopolist makes supernormal profits, these profits will go to shareholders who may be mainly upper income earners, This may worsen the income distribution in the economy. The existence of supernormal profit suggests that producers receive greater income than is needed to induce them to undertake their operations. The lack of competition enables them to receive higher profits than is economically justified. Thus income is more unequal than it needs to be.

In conclusion, large firms who enjoy EOS are accepted in the economy but too much of it will be non-beneficial for the industry. Hence, to ensure that society benefits equally, government intervention is needed where policies such as AC-pricing and taxation of profits are carried out.

JC ECONOMICS ESSAYS: Tutor's Comments: A very good attempt! Covers the majority of the points needed to tackle this exam question. This model Economics essay was written under "A" level Economics examination conditions. Economics tutor's suggested grade: 20/25. How would you improve this essay, and how would you approach the task of crafting a well argued, nuanced, balanced, and evaluative Economics answer? Perhaps the evaluation in the conclusion could be better, more argumentative, and more justified with relevant examples. Thanks for reading and cheers. Stay here for more Economics essays and materials.