Economics tuition teacher: Market Failure and Government Intervention

March6, 2018
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Critically examine Singapore’s approach to tackling market failure arising from the existence of externalities. (25)

This is a relatively standard question on the evaluation of government policies used to tackle externalities in Singapore. Since it is a 25m question, Economics tuition teacher Mr Koh would remind students to first explain how externalities result in market failure. In evaluating the measures to tackle market failure, aside from discussing the usual pros and cons associated with each measures (e.g. imperfect information in tax decisions), students should assess how the nature of market failure may be changing, and discuss new measures that could be undertaken.

Market failure occurs when an unregulated market fails to allocate resources efficiently and equitably, resulting in social welfare not being maximised. In Singapore, one major source of market failure arises from the existence of positive and negative externalities in production or consumption activities. While the government has undertaken a range of effective policies to tackle market failure due to the existence of such externalities, the nature of the problem is constantly changing. Hence, revisions to existing policies may need to be considered along the way.

In the case of negative externalities, market failure occurs as spillover costs affecting third-parties are not accounted for by the price mechanism, leading to the loss of allocative efficiency. For example, the consumption of cigarettes generates negative externalities, which are defined as spillover costs that third parties incur, without compensation. Specifically, smoking results in spillover costs in the form of second-hand smoke, which affects the health of passive smokers, who are not compensated for the higher healthcare bill which they have to incur.

Fig.1: Over-consumption of cigarettes

In the diagram above, marginal private costs (MPC) represent the private cost of smoking, which refers to the cost of cigarettes and other private health costs e.g. lung damage. Marginal social cost (MSC) is greater than MPC as marginal external costs (MEC) are greater than zero, due to the existence of negative externalities from the consumption of cigarettes (described above). Marginal social benefits (MSB) are equal to marginal private benefits (MPB), which refer to the satisfaction that the individual derives from smoking, due to the assumption that there are no positive externalities from smoking. Given that consumers and producers are motivated by self-interest and only consider private costs and benefits, the equilibrium in the market above is given by the intersection of MPB and MPC, i.e. Qe. However, the socially efficient level of output is defined by the intersection of MSB and MSC, i.e. Qse.

At Qe, MSC is greater than MSB, which means that the total cost to society from the consumption of an additional unit of alcohol is greater than the total benefits that society enjoys. Hence, there is over-consumption of smoking, which leads to a deadweight loss shown by the shaded area. As a result, allocative inefficiency occurs and social welfare is not maximised.

To tackle the problem of negative externalities like in the case above, the government has imposed taxes, e.g. in the form of tobacco taxation. As shown in Fig.2, imposing a tax equal to the size of MEC would increase the cost of smoking and shift MPC to MPCt. This results in the equilibrium output coinciding with the socially-efficient output, hence effectively internalising the externality. An added advantage of a taxation policy is that it generates tax revenue for the government, which can be used to fund other public campaigns against smoking.

Fig.2: Internalisation of externality with tax

Notwithstanding that the tax internalises the externality without overly disrupting the interaction of market demand and supply, due to imperfect information on the size of MEC, the government may over-tax or under-tax. This results in the deadweight loss not being eliminated, due to over/under-consumption of cigarettes. Furthermore, given that demand for cigarettes is price-inelastic due to consumer addiction, a tax may not significantly reduce the quantity of cigarettes consumed.

To increase the price-elasticity of demand for cigarettes, the government has promoted the use of substitutes in the form of nicotine replacement products, such as nicotine gums and nicotine patches. This measure complements the use of taxation to encourage more consumers to lower their craving for cigarettes. Furthermore, moral suasive efforts are also in place, e.g. public campaigns against smoking, and printing of gory images on cigarette packs to warn against the harmful effects of smoking. Such efforts are directed towards changing the consumers’ mentality towards smoking, in order to achieve results which are more sustainable in the long run. For example, some consumers may be persuaded to kick the habit of smoking entirely, instead of reducing the number of sticks they smoke per day.

However, as it takes time to change the consumer mindset and the results of moral suasion are not enforceable, the government has also complemented its approach with the use of legislation, such as a prohibition on the sale of cigarettes to consumers under the age of 18. In addition, smoking in enclosed areas such as restaurants is banned. Notwithstanding that imposing a ban also results in a deadweight loss (Area A) as shown in Fig.3, the government has deemed this necessary in view of the larger MEC associated with smoking in enclosed areas, i.e. Area B which represents deadweight loss from over-consumption of cigarettes, is larger than Area A.

Fig.3: A ban on consumption of cigarettes

While the above policies have worked well so far and there is no need for a policy overhaul, the nature of the problem is also changing, which may necessitate the use of or strengthening of other policies to tackle the problem of smoking more holistically. For example, more young Singaporeans are picking up the habit of smoking in recent years. To tackle this problem, the government has been intensifying its education campaigns in schools to warn students about the harmful effects of smoking. Furthermore, with rising population density in Singapore, the effects of 2nd hand smoke tends to affect more 3rd parties. To reduce the spillover costs, the government has also widened the ban on smoking to encompass most enclosed areas, including large parts of most coffee-shops.

In the case of positive externalities, which arise due to the presence of spillover benefits on 3rd parties, who do not need to pay to enjoy these benefits, the government has similarly adopted a range of policies to tackle the problem. For example, market failure may occur due to the under-consumption of healthcare. The spillover benefits not accounted for by the price mechanism include a healthier and more productive workforce, which leads economic growth for Singapore, benefitting almost all segments of the population, including non-recipients of healthcare.

Fig.4: Under-consumption of healthcare

In Fig.4 above, marginal private benefit (MPB) refers to the better health status that a consumer of healthcare can enjoy. Marginal social benefit (MSB) is greater than MPB as marginal external benefit (MEB) is greater than zero, due to the existence of positive externalities from consumption of healthcare (as described above). Marginal social cost (MSB) is equal to marginal private cost (MPC), which refer to the private cost of consuming healthcare (e.g. medical fees). This is due to the assumption that there are no negative externalities from healthcare consumption.

The equilibrium in the market above is given by the intersection of MPB and MPC, i.e. Qe. However, the socially efficient level of output is defined by the intersection of MSB and MSC, i.e. Qse. . At Qe, the addition to social benefits from the consumption of an additional unit of healthcare is higher than the cost to society of providing that extra unit of healthcare. This leads to under-consumption of healthcare, generating a deadweight loss as shown by the shaded area.

To tackle market failure in the healthcare market, the Singapore government has provided subsidies e.g. drug subsidies in polyclinics to lower the cost of healthcare. As shown in Fig.5, granting a subsidy equal to the size of MEB would lower the cost of consuming healthcare and shift MPC to MPCs. This results in the equilibrium output coinciding with the socially-efficient output, hence effectively internalising the externality.

Similar to the case of smoking, imperfect information on the part of the government in estimating MEB may lead to over or under-subsidisation, resulting in deadweight loss not being eliminated. In addition, taxpayers may have to face the additional strain of financing the subsidy. Hence, over-consumption of healthcare arising from over-subsidisation would represent a waste of resources, and an opportunity cost for the economy. This is because the tax revenue could be better deployed elsewhere in the economy.

In addition to the use of subsidies, the government has also undertaken measures such as moral suasion e.g. health campaigns to encourage Singaporeans to go for regular health check-ups. Given that moral suasion works better in the longer term by changing consumer mindset, these campaigns are also complemented with the use of legislation which is more effective in tackling immediate problems. For example, compulsory vaccination programmes are in place to ensure new-borns are adequately protected against infectious diseases. While the use of legislation may be blunt, it is enforceable and hence, effective in ensuring that Singaporeans adopt the minimum healthcare standards.

However, the nature of the market failure in healthcare has changed over the years. Hence, while existing policies do not have to change, new policies may need to be implemented. For example, with an ageing population, the demand for healthcare services and facilities to cater to the aged has increased. Traditional measures such as Medisave, compulsory vaccination and moral suasive efforts may be unable to address this gap effectively. As a result, the government has taken on a more involved role, e.g. direct involvement in construction of nursing homes and providing free health checks for the aged. Also, with a rising population density in Singapore, the risk of spread of infectious diseases is higher. To address this issue, the government has adopted a combination of short-term and long-term policies. For example, in the short run, the government had imposed quarantine orders where patients down with infectious diseases were temporarily segregated from the rest of the population. In the long run, the government had also taken pains to educate the citizens about good health habits e.g. staying at home or wearing a mask if unwell.

In conclusion, the Singapore government has undertaken a range of policies to tackle the problem of market failure arising from the presence of externalities comprehensively. While there is no need to change the existing policies; given the changing nature of the problem of positive and negative externalities in Singapore, new policies or the strengthening of existing policies may need to be undertaken.

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