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. 

Explain, with relevant examples, the situations when prices determined by the intersection of demand and supply do not correctly reflect the costs and benefits, and how these situations lead to market failure in the free market.

The topic addressed in this economics paper is market failure in competitive markets. Prices do not always accurately reflect the costs and benefits of the market, thus leading to market failure in the case of positive and negative externalities, merit and demerit goods. This essay aims to identify the circumstances when prices do not correctly reflect the costs and benefits of the market and explain how markets fail as a result.

Firstly, negative externalities are defined as the adverse spillover effects on third parties arising from the production or consumption of a good. Third parties refer to people who are not directly involved in the transaction of a good. An example of negative externalities would be evident in the case of production, where plants may discharge industrial waste into the environment and therefore cause health and environmental risks to nearby residents. In addition, in the case of consumption, the existence of alcoholics may pose as a threat to the peace and security of law abiding people and society at large. Therefore, negative externalities result in the marginal social costs exceeding the marginal private costs in society, causing deadweight loss.

[Insert diagram for negative externality in production]

Without government intervention, the private equilibrium occurs where MPB = MPC, but the social equilibrium occurs where MSB = MSC. Between Qs and Qp, since MSC > MSB, the triangle pointing towards Qs represents the negative welfare generated and therefore the good is over-produced in the case of negative externalities, leading to market failure. 

Positive externalities, on the other hand, refer to the benefits enjoyed by third parties from the production and consumption of the good. In the case of production, for example, receiving a complete education up till or beyond the tertiary level will not only benefit the student himself but also the society collectively as a whole due to his contribution to the society through application of his knowledge. Likewise, in the case of consumption, for example, vaccination not only reduces the risk of contracting a disease in the vaccinated person, but also reduces the risk of diseases for third parties coming into contact with him. Thus there are greater marginal social benefits than costs but the good may be under-consumed by the society.

[Insert diagram on positive externality in production]

When there is no government intervention, the private equilibrium is where MPB = MPC. The social equilibrium however is at MSB = MSC. Between Qp and Qs, as MSB > MSC, the loss in potential welfare of the society is represented by the triangle pointing towards Qs. Therefore the good is under-produced in the case of positive externalities, leading to market failure.

Furthermore, merit goods refer to goods 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. For example, a student may decide to leave school early to work as he perceive the short term benefits of working to be greater than the long term benefits of receiving a complete education, therefore unknowingly undermining the marginal private benefits he has brought to himself.

[Insert diagram on merit good]

For merit good, the private outcome is Qp where MPB = MPC, whereas the social outcome is Qs where MSC = MSB. Between Qp and Qs, since MSB > MSC, there is a loss in potential welfare represented by the triangle pointing towards Qs, and the good is under-consumed, thereby leading to market failure. 

Demerit goods are goods that the state believes will be over-consumed if left to the free market forces because some individuals are unable to factor in the dull private costs of consumption. For example, goods like alcohol and cigarettes may result in severe health and financial problems when excessively consumed and since there are people that still consume them thinking that the marginal private costs do not exceed the marginal private benefits, when it is in reality, thus results in market failure. 

[Insert diagram on demerit good]

For demerit good, the private outcome is when MPC = MPB at Qp, while the social outcome is at Qs when MSC = MSB. Between Qp and Qs, since MSC > MSB, this results in a deadweight loss represented by the triangle pointing towards Qs, where the good is over-consumed in the case of demerit goods. 

In conclusion, prices do not always accurately reflect their costs and benefits of the market. As seen in the cases of merit goods and positive externalities, the goods are under-consumed by the society although the marginal social benefits outweigh the marginal social costs, and in the case of negative externalities and demerit goods, the marginal social costs outweigh the marginal social benefits and the goods are over-consumed. Therefore, the deadweight loss – the loss in potential welfare of the society due to the over-consumption and under-consumption of goods leads to market failure.

JC Economics Essays - H1, H2, H3 sample essays - tutor's comments: Market failure and the operation of the free market under conditions of perfect competition are important economics topics for both Economics at A levels and introductory undergraduate economics courses, and as such this might be a useful topic to prepare for examinations. It might be a good idea to get a firm understanding of how markets operate and how market failure distorts the workings of the price mechanism as it allocates resources. In this section on comments on the above economics paper, instead of providing general feedback or pointing out what went well and went not so well with it, I will ask questions instead: using Bloom's taxonomy as an intellectual framework to address this economics essay, has the student identified the topic properly, defined and explained key terms, drawn the right diagrams, explained the economic theory with real world examples, explained the diagrams drawn, and come to a reasoned, fair, nuanced conclusion? What has the essay writer done well, and what has the essay writer got to improve on and make better? Are there economics materials that you would have added, and why are these additional concepts, ideas, and arguments important and relevant? Think through these issues. I should give a hint for an important enduring understanding: structure is important to good essay writing, and this economics paper is well structured and well laid out. Always remember to improve on your writing skills, and craft well-thought-out, clear economics essays. Special thanks to S S and A G once again for their useful, relevant, and interesting contributions. Thanks for reading and cheers. 

Explain, with relevant examples, the economic circumstances when prices do not accurately or correctly reflect actual benefits and costs, and explain how free markets fail as a result. [10]

The general theme of this economics essay is on market failure. The circumstances when prices do not correctly reflect costs and benefits include the presence of externalities, both positive and negative, merit and demerit goods, as well as imperfect pricing information. Therefore, this essay aims to explain how the above mentioned circumstances will lead to market failure.

What are externalities? Externalities refer to the spillover effects on third parties arising from the production or consumption of a good. They can then be sub-divided into positive externalities, referring to benefits imposed on third parties, and negative externalities, referring to adverse effects imposed on third parties.

Prices are usually set at the intersection point of the market demand and supply curves. However, in the case of positive externalities, prices do not reflect the actual costs and benefits since the market demand and supply curves fail to take into account the marginal external benefits brought about by the consumption and production of the good.

[Insert diagrams on positive externalities from consumption and production]

Marginal external benefits (MEB) is defined as the additional benefit enjoyed by third parties from the production or consumption of a good. For positive externalities in consumption, assuming no externalities on the production side, positive externalities results in MSB exceeding MPB by the amount equal to MEB. Without government intervention, the private equilibrium is at Qp, where MPB = MPC. However, the socially optimum equilibrium is at Qs where MSB = MSC. Since Qp < Qs, the good is under-consumed, resulting in allocative inefficiency and hence the market fails. An example would be the consumption of vaccination, where the risk of disease is reduced for both the vaccinated person and third parties he comes into contact with.

Similarly, for positive externalities in production, assuming no externalities on the consumption side, there is a divergence between MPC and MSC due to MEB. The private equilibrium is at Qp where MPC = MPB, while the socially optimal equilibrium is at Qs, where MSC = MSB. Since Qp < Qs, the good is under-produced, resulting in allocative inefficiency and hence market failure. An example would be the production of honey which bees would pollinate the nearby fruit orchards.

In the case of negative externalities, prices do not reflect the actual costs and benefits as the market demand and supply curves do not take into account the marginal external costs bought by the consumption or production of the good.

[Insert diagrams on negative externalities from consumption and production]

Marginal external costs (MEC) id defined as the additional costs imposed on third parties from the production or consumption of a good. For negative externalities from consumption, assuming no externalities on the production side, there exist a divergence between MSB and MPB due to MEC. This results in the over-consumption of the good as seen from how the private outcome Qp exceeds the socially optimal outcome of Qs. The outcome is allocative inefficient and thus the market fails. An example would be smoking, where third parties incur costs such as the inhalation and breathing in of second hand smoke.

For negative externalities from production, assuming no externalities from consumption, there exist a divergence between MPC and MSC due to MEC. This results in the over-production of the good, seen from how Qp exceeds Qs, resulting in allocative inefficiency and hence the failure of the market. An example would be the disposal of industrial waste into rivers, causing water pollution which poisons the catches of fishermen whom are third parties.

Next, prices also do not reflect the actual costs and benefits in the case of merit and demerit goods. Merit goods refer to goods 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. 

[Insert diagram on merit good]

For merit good, between Qp and Qs, MSB > MSC, thus the triangle pointing towards Qs represents the area of deadweight loss arising from allocative inefficiency, since the good is under-consumed. Hence the price will not be accurate in reflecting the benefits instead it is at MPB. An example would be the consumption of education where a person may leave school early because he is too young to understand education can improve his future. 

On the other hand, demerit goods are goods which the government believes will be over-consumed if left to the free market because some individuals are unable to factor in the full private costs of consumption.

[Insert diagram on demerit good]

For demerit good, between Qs and Qp, MSC > MSB and Qp > Qs, thus the triangle pointing towards Qs represents the area of deadweight loss arising from the over-consumption of the good, resulting in allocative inefficiency and thus market failure. Hence the price of the good will not be accurate in reflecting the costs since the demand of the good is at MPB, while it should have been at MSB. Examples of demerit goods include alcohol, where excessive consumption results in serious health and financial problems.

Lastly, where there is information asymmetry with regards to pricing, prices will not reflect the actual costs of production as sellers will be able to charge prices that are higher than marginal costs. This is due to the fact that buyers find difficulty acquiring pricing information from different sellers, thus gives seller pricing power and enable them to charge prices that are higher than marginal costs. Therefore, deadweight loss is generated and market failure occurs.

In conclusion, there are various instances where prices do not reflect the actual costs and benefits and in most of the cases, the resulting market failure arises due to the presence of allocative inefficiency.

JC Economics Essays - H1, H2, H3 economics essays - tutor's comments: This economics essay paper is very well done, by directly addressing the question requirements, and providing clear, simple to understand, direct examples that target the requirements of the economics exam question. Always remember to answer your economics exam question as it stands, and not as you imagine it to be. The student also has a very sound understanding of economic theory, and knows how to properly structure the memorised economics material and essay answer to make this paper a model essay. This model paper was done under timed conditions, which makes it even more remarkable. Thanks to S for editing work done, and thanks to A G and S H for their kind and invaluable contributions. Usual question applies - how can you apply this to your essay writing, and how could you write a better economics paper? Always seek to improve and better your standards. 

"Education is a Merit Good; The Government Should Pay for Education." Discuss. [25] (Rephrased Economics Question)

“Since education is a merit good, the government should pay for the people’s education up to, and including, tertiary education, such that education is free”. Discuss.  [25]

A merit good can be defined as a good that society deems desirable, or a good that has positive externalities to society. Education is definitely a merit good given that it is desirable to society, and certainly it seems to confer positive externalities to society as educated people are generally more cultured, logical, and reasonable, and are thus less likely to contribute to crime and social disorder. This paper discusses the issue that, since education is a merit good, the government should pay for education up to and including tertiary (university) education. While it is true that education is indeed a merit good and the first part of the statement is definitely true, it does not follow that the government should do more than merely subsidise education. In fact, governments should only provide or pay for public goods which are not produced by the free market, and since education is not a public good it should not be provided free.

Education as merit good – and the government should subsidise merit goods

It can be argued that a good that has positive externalities to society can be considered a merit good. An externality is a third party spill-over effect, or an effect that affects third parties not involved in the production and consumption of the good in question, and can be negative or positive. Positive externalities are positive third party spill-over effects. As people do not consider the positive externalities to society, but rather consider private benefits and private costs, they under-consume merit goods. The government can subsidise merit goods in order to boost their consumption, which is good for society.

Alternatively, a merit good can be thought of in terms of imperfect information – people do not have perfect information about the nature of the good, and thus they misjudge its merits and demerits. Hence, this leads also to the under-consumption of merit goods. The government by providing education at low cost (or even providing education free) can be seen as trying to mitigate this informational failure.

According to the diagram below, there is a divergence caused by the externality between the marginal social benefit (MSB) and the marginal private benefit (MPB), assuming that marginal social cost equals marginal private cost (MSC = MPC). Hence, clearly the government should directly subsidise merit goods, which would shift the MPB to the MSB. In this case, a subsidy here is a government payment directly to the consumer of education, which would shift the demand curve to the right. The famous economist Milton Friedman once suggested that an education voucher could be given to students, which would have the effect of shifting the MPB to the right to eliminate the externality. If, on the other hand, an indirect subsidy was given, meaning a subsidy was given to the producer of education, then the MSC curve would shift to the right.

Economics diagram - what diagram should be drawn here?

The Government Should Not Pay Entirely for Merit Goods

On the other hand, the government should not pay entirely for merit goods. Governments should pay for public goods which are non-rivalrous and non-excludable because public goods cannot be produced by the free market without government intervention, whereas merit goods can be produced by the free market. Non-rivalry is the condition that consumption of a good by one person does not reduce the amount of that same good for another person. Non-excludable is the condition that a consumer cannot be excluded from consuming a good. These two conditions lead to the situation where a free market does not produce public goods because of the free-rider problem and because the allocative efficient outcome leads to marginal cost being zero (MC = 0).

There are also other major issues on having free education, other than the fact that education is not a public good. First, there is the issue of opportunity cost. Opportunity cost is the cost of the next best alternative forgone. The problem is that if resources are devoted to making education free, then there are alternative uses for those resources that are forgone, such as national defence, healthcare, and infrastructural investments. Hence, subsidising education would make more economic sense rather than providing it entirely free. Second, the government is not the only possible provider of education – private agencies or public-private-partnerships (PPP) can also provide education. For instance, in many countries around the world, there are private agencies that provide education for profit.

Conclusions

In conclusion, while the government could possibly provide merit goods, such as education, for free in order to solve the market failure of positive externalities not being taken into account by individuals, and to overcome the informational failures associated with merit goods because people misperceive their benefits, there are other issues that need to be seriously considered like opportunity cost and alternative financing methods such as private provision with some government intervention and public-private-partnerships. However, in my opinion, the most important reason why governments should not provide merit goods is that they are not public goods which are not provided by the free market, and as such market-based policies should be used to encourage a higher consumption of education rather than direct government provision of education.

JC Economics Essays – Tutor's Commentary: This Economics paper was written under examination conditions by one of my former economics students, GSW. Putting yourself into your Economics tutor’s shoes, how would your Economics tutor make this essay even better? Hint: Any good Economics tutor would suggest using properly-labelled diagrams, with the curves moving to demonstrate a point, to make a good economics argument. Having said that, this economics site does not feature diagrams - so what else can be improved on, other than the usual "draw a diagram"? In fact, this economics essay is rather well written, and an excellent example of how a hardworking student from a humble background can learn and improve in his studies! This is a economics good paper. Yet, there are other approaches. How would YOU approach this question? Would you go for a more direct approach, or a more indirect approach, compared to this Economics answer? While I would not have answered this Economics question in this particular way, this approach is still workable and can be utilised to get a good grade in Economics examinations. Thank you for reading, and cheers. 

Evaluate the policies used by the Singapore government to correct imperfect information and the lack of mobility of the FOP? [15]

Evaluate the policies used by the Singapore government to correct these causes (imperfect information and lack of mobility of the factors of production/ resources) of market failure. [15]

Tutor's Quick Note: This is a continuation, part (b), of the previous question on this economics site.

There are many policies that the Singapore government can implement to correct market failure due to imperfect information and due to immobility of resources. This paper evaluates the Singapore government’s policies in correcting imperfect information and lack of resource mobility, and the evaluation here is whether these policies solve the underlying cause, causing the market failure, directly.

First, we examine subsidies for merit goods like subsidized healthcare, to compensate for consumers’ undervaluation of them and suppliers’ underproduction of them. Secondly, we also examine state intervention in the form of taxes to solve negative externalities. These two examinations address positive and negative externalities which are unknown or unconsidered by private consumers and producers and thus cause market failure.

Insert Economics diagram. Think: which diagram is relevant here? How would you explain it?

The economic answer is clear: increasing subsidies solves the problem of positive externalities being unacknowledged, while increasing taxes solves negative externalities. For instance, there are portions of the budget set aside for subsidized healthcare for senior citizens. Provision of food stamps and rations for low-income families, a wide umbrella of social services to provide free counseling for problem cases such as troubled teenagers, marital and family problems, and other services which private markets tend to fail in. These subsidies cost money, and perhaps that might be a problem, due to opportunity cost, which is the cost of the next best alternatives foregone. Yet, it is still possible to argue that using a cost benefit analysis the costs of the subsidies are worth it.

Furthermore, smoking, which is a demerit good, which has negative externalities, is heavily taxed in Singapore. These show that the Singapore government has done the right thing by removing distortions caused by people not taking externalities into account. The underlying causes indeed were taken into account.

Secondly, there can be the direct provision of information, for instance, with respect to smoking as well as insurance and unit trusts. The public often over-value demerit goods like cigarettes and tobacco, causing market failure as consumers overestimate the marginal benefits of it. The government thus runs a full series of anti-smoking campaigns trying to educate consumers such that they make informed decisions and are fully aware of health consequences in purchasing cigarettes. This does not fully correct market failure but mitigates it. Regarding cost-benefit analysis, this is viable due to the low costs of mass media campaigns but sustainable benefits of consumer knowledge. In Singapore, there is the Financial Advisers Act, under which independent advisory firms act as intermediaries between agents (insurance companies) and principals (consumers), acting to inform and educate consumers fully about insurance products from all insurance firms and providing proper product recommendation. This policy can correct market failure in the long run as many consumers are reliant on private insurance providers. However, it has its sustainable benefits as independent advisory advisers earn their remuneration from the portfolio growth of their clients, thus aligning their interests. Lack of information thus necessitates more information. Therefore, possibly the underlying causes were taken into account.

In Singapore, the most immobile form of capital is labour, which the government has targeted constantly. Capital flows are all flexible in Singapore, as from the beginning we have had a focus on external MNCs and foreign direct investment. We focus here on labour. Has the government done a good job here?

The government can solve the problem of immobility of factors of production: first, job matching and training schemes to link up supply and demand forces in the labour market. Colleges have job centers to facilitate the process in which graduates get their credentials matched to suitable jobs. Similar job matching centers under the National Trades Union Centre (NTUC) are widely available, all measures to improve structural rigidities, to reduce time-lags in factors of employment is responding to market demands. Perhaps the only criticism might be in terms of costs of training and opportunity costs. The underlying economic causes were taken into account. Increasing information and increasing training solve frictional unemployment and structural unemployment and hence reduce immobility of labour greatly.

Regarding trade union pressures, all agents representing workers’ benefits come under the NTUC, which tries to incorporate employee and firm interests, aligning them to national interests. Politicking at workplaces and lobbying are actively stopped by the Singapore government. This is a measure that only works for Singapore, in which political power is centralized and the state can intervene. Singapore’s uniqueness works in its favour here.

However, for other countries with many federal states, lobbying and union pressure is still abundant, which proactively try to manipulate prices and market systems for their own interests. Hence it might be only possible for Singapore to use the internationally famous tripartite method of solving immobility of labour.

In conclusion, Singapore has many heavy duty weapons in its arsenal for reducing imperfect information and immobility of labour. However, any policy used must be checked for its effectiveness in solving the underlying problems that cause the market failure.

JC ECONOMICS ESSAYS Tutor's Comments: This was written by a former Economics student of mine (from MJC) under examination conditions. I would not have approached this economics question this way; however this quite skilfully written economics paper is very good and very clear. Do, however, ask yourself a few questions. How would you have written it, to address the question? How would you have improved on it? There are many other ways to approach this question that would have also adequately addressed its specialised requirements. Do remember to think of how you can learn from this Economics essay. Thank you for reading and cheers. 

(b) “The government should produce all public goods and all merit goods”. Is this statement accurate from an economist’s point of view? (15)

(b) “The government should produce all public goods and all merit goods”. Is this statement accurate from an economist’s point of view? [15]

Note: please read the economics tutor's comments at the back after reading this economics essay. 

The efficient allocation of resources is the use of a country’s limited resources in such a manner that maximises the total welfare of the people. A pure market economy will not be able to do this for three main reasons: the emergence of imperfect market structures, externalities and the lack of public goods. Therefore, government intervention is needed to deal with these market failures. In this paper, we shall look at the main features of the market economy, and then look at its limitations.

Firstly, in a market economy, there is private ownership of resources and finished goods. Individuals and firms can thus transfer ownership to any other party that they wish. Secondly, the allocation of resources is determined by a unique system known as the price mechanism of the market. The forces of demand representing consumers and the forces of supply that represent producers interact to determine the price of goods – thus leading to “the invisible hand” allocating resources to the best possible uses. The price mechanism is the channel by which consumers signal to producers of the goods they want and the respective quantity that they want.

The market mechanism is also very efficient because decision making is completely decentralised. Producers respond at the local market level immediately to consumer preferences. As freedom of choice and profit motive is allowed, producers will use scarce resources as efficiently to produce. Intense competition also forces producers to produce at the lowest cost and thus forces producers to produce at the lowest cost and thus forces them to innovate and invent new products in order to satisfy the wants of consumers. In the long run, it is the consumer who benefits in the form of new, better and cheaper products.

However, the market economy is not without its drawbacks and the most serious one is its inability to deal with externalities. Externalities are benefits (positive externality) and costs (negative externality) that fall on society due to economic activities which the price mechanism is unable to account for.

In the case of public goods, no producers would want to produce goods like street lighting or radio broadcasts because these are non-exclusive between payers and non-payers. And they are also inexhaustible. Thus, in a market economy, they would not be produced although the consumers would generally benefit from these goods. Thus, to maximise welfare, government should supply the good at zero market price. The government may either produce these goods itself or contract the production of these goods to the private sector. The government would hence, finance the production of these goods from tax revenue.

Even in the case of market goods, the market will not produce a quantity at the socially optimum level- private companies would only produce education for those who can pay although it is to society’s benefit in the long run to provide all children with education Thus, the government would intervene in the case of merit goods by providing subsidies.

Subsidies are transfers from the government to individuals and firms. In the case of merit goods, a subsidy can be provided directly to producers or consumers. Legislation, which is enacting laws and regulations to ensure optimum consumption of a good, can also, be implemented by the government. Thus, the fear of being penalised increases the demand for the goods, leading to greater consumption. The government may also provide the shortfall of merit goods or may contract private firms to supply the shortfall. The government can also educate the public through mass media and carry out campaigns to teach the citizens the importance of consuming the merit good. Thus, in the case of merit goods, the government would have to intervene as it has large revenue from taxes that is able to finance the provision of merit goods unlike private enterprises which do not have such a large capital base.

In the case of a negative externality, private consumers and businesses would generate the social costs of pollution, congestion and environment degradation in the process of seeking their own interest. As the market fails to place a market value on these costs, they get away with paying for them. Thus, the government also has to intervene in this case due to the negative externality generated that affects the third party. Thus, the government would have to impose taxes such that producers would be motivated to produce using greener technologies in order to reduce their probability of them having to pay taxes that add on t their production costs. The government may also introduce legislation in order to reduce emissions and negative externalities in production.

Figure 1: Marginal Social Costs, Benefits and Marginal Private Benefits, costs

Indeed for the efficient allocation of resources, form all points of view, production of any good should be where the MSC=MSB. As show in Figure 1, output 0Q0, is the ideal level of production from society’s point of view. However, the market will only consider MPC which is only part of MSC. Marginal Private Benefit is only part of MSB. Therefore, goods are either under produced or overproduced. Hence, government intervention is required to correct these market imperfections in order to achieve the socially optimum level of output.

The market mechanism may also undermine consumer’s welfare. As producers are profit motivated-they only produce for the rich-people who can afford to pay. Thus, food, housing, medical services and even ordinary goods will not be adequately produced and provided for the poor.

Another disadvantage is the market economy does not guarantee against the concentration of economic power in the hands of a few. This is called a monopoly or an oligopoly. One company would then be able to exploit consumers.

Finally, the market economy, as seen in history, causes a wide gap or disparity between groups of people in the country. Massive wealth is held by a few and this small group gets richer because one needs wealth to generate more wealth. Thus, the market economy may fail to maximise society’s welfare.

For the above reasons, it is best that some form of government supervision of economic activities may be present. A good example of this is Singapore. This country has prospered due to the spirit of free enterprise-private ownership and profit. However, the government has set up a number of authorities to ensure that resources are efficiently allocated while market forces prevail. The Urban Redevelopment Authority (URA) looks into the use of limited land space. The Land Transport Authority (LTA) supervises private and public transportation. The Port of Singapore Authority (PSA) looks into ports and shipping. In this way, Singapore benefits from the market system: without its bad effects.

JC ECONOMICS ESSAYS - Economics Tutor's Note: This is a very interesting approach. I think this Economics essay is interesting, well thought-out and reflective. In fact, it is rather good. However, it is not the standard way to deal with "A" level exam questions. In terms of an A level answer, this would not be the proper way to answer the economics question. The standard view should be something like:

Essay Introduction - Define public goods and merit goods, perhaps arguing that merit goods are underconsumed and underproduced because of either imperfect information or the presence of positive externalities. Introduce the main arguments. 

Essay Thesis - Yes, on the one hand, the government should produce public goods and merit goods (Diagram +egs + why)

Essay Anti-thesis - No, on the other hand, the government shouldn’t produce public goods and merit goods (Diagram + egs + why)

It can legislate, it can use free market, it can use the Coase theorem (perhaps tradeable permits or other methods), it can subsidise private producers. (Include limitations of the government also; government failure - thus it shouldn't, since it could be even worse.)

Essay Synthesis, for an evaluative conclusion that weighs the arguments and their merits - Govt produces public goods, govt taxes/subsidises. Demerit/merit goods should not be directly provided. Clever, pithy, evaluative opinion-based statement justified with Economics reasoning, concepts, and theories at the end.

Having said that, think of how you could approach this essay question and think about the answers that you would give. This student answered the question in a divergent way, but there are lots that we can learn from it. Perhaps, this economics essay could be even better if the student had focused on answering the question directly or in a more clear or obvious manner. Thanks for reading and cheers. 

(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.