29/06/2015

2015 JC2 H1 Economics

Term 3 Week 1 Revision Lecture

2010 GCE A Level H1

Examination

Topic: Microeconomics - Market Failure

Essay Q3

24 June 2015

2010 GCE A Level H1 Examination Essay Q3

1(a) Explain, using examples, what is meant by:
(i)
a public good,
(ii) a demerit good.
[10]
(b) It is generally recognized that unlimited use of
motor vehicles by private citizens generates a level of
negative externalities that is unacceptable.
Discuss the view that a policy of indirect taxation is
the best that is available to tackle this problem in an
economy such as Singapore.
[15]

1(a) Explain, using examples, what is meant by:

(i)
a public good,
(ii)
a demerit good.
[10]
Command Word
Explain One sided, demonstration of knowledge
(Elaborate on the characteristics: definitions, different
phrasing, examples )
Introduction
Both public and demerit good are sources of market failure (Define
market failure)
Key characteristics of public good Zero production by market
complete market failure
Key characteristics of demerit good over production partial
market failure.

In part (a), virtually all answers gave relevant examples, and were
able to identify non-rivalry and non-excludability as characteristics
linked to public goods, although some showed less than accurate
understanding of what these actually mean, or, further, imply.
In the case of demerit goods, Examiners accepted answers that
defined them in terms of products that generate negative
externalities, as well as ones that are thought to be harmful to
those who choose to consume them, and most answers did
indeed include one or other of these aspects in many cases
both.
There was greater variation in the extent to which answers
explained why public goods would not be produced in a pure
market economy, or why demerit goods would be over-produced.

Explain, using examples, what is meant by:

(i) a public good,
Definition

Public goods are non-rivalry and non-excludable

in consumption

Characteristic 1

Non-rivalry in consumption: Consumption of the goods by one does

not diminish the amount available to others
Eg. Street lights an addi0onal person using the streetlight will not
make the light becomes dimmer for the next user
Once the good has been provided, there is no additional cost for
providing it for another user MC =0
Since efficiency in resource allocation calls for P=MC. Since MC=0,
P=0. Hence, there will be zero production if left to the market.

Characteristics 2 Non-excludable in consumption: once provided, it is not possible to

exclude non-payers from consuming the good.
Eg. Once street lights are provided, lit up the entire street all get
to enjoy the brightly lit street no way to prevent non-payers from
the enjoying the light
Hence, non- payers could also get to enjoy the good.
Problem of free ridership & Demand is concealed no revenue
no production
If left to market
forces,
therewilling
will betozero
production
of the public
No
producers
produce
Produc0on
= zerogood!

29/06/2015

Explain, using examples, what is meant by:

(ii) a demerit good.
Definit Demerit goods are deemed by govt to be socially undesirable
& intrinsically bad
ion
Charact
eristic 1

An economic good Rivalry and excludability in consumption

Rivalry consump0on by one user will reduce the amount le> for the next
user. Eg, cigarettes, alcohol one less cigarette after having smoked one
Excludable possible to exclude non-payers from consuming the good. Eg

Charact
eristic 2

Information failure Consumers have imperfect information about the

harmful effects of consuming the good
Ie. Smokers are not aware of the degree of harm to themselves as well as to
others when they smoke
Perceived private cost is lower than the actual cost overconsump0on

Charact
eristic 3

Has negative externality (Briefly explain 5 steps)

MEC: Non-smokers suffer from health problems due to 2nd hand smoke and
have to include medical bills
Overconsumption and DWL occurs

What makes a WOW conclusion?

Summary:
1. Public goods complete market failure (zero
production)
2. demerit goods partial market failure (overprodtn/consumption)
Loss of welfare to the society
1. [Link to part B] Such goods require the
government to intervene to correct the market
failure and bring production and consumption to
the socially optimum level.

If left to market forces, there will be overproduction/consumption of a demerit good.

(b) It is generally recognized that unlimited use of

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

In part (b) almost all answers responded well to the instruction

discuss. The approach usually taken and it was a very
sensible one was (i) to explain the nature of the negative
externalities associated with the use of motor vehicles, and to
(ii)show how an indirect tax could be used to reduce the level of
consumption to that corresponding to the social optimum; then
to (iii)consider possible weaknesses in this policy, and (iv) plausible
alternative(s); and (v)finally to make some sort of judgement as to
whether indirect taxation should be regarded as the best option.
In addition, most also set their answer firmly within a Singapore
context. Inevitably, the weaker answers did not do all these
things as well as the better ones; the most common weaknesses
related to failure to identify or explain appropriate negative
externalities, or to explain what the social optimum involves, or
to consider appropriate reasons why indirect taxation might be
regarded as a less than perfect method, or to consider the
best option aspect. However, to repeat, many answers were of
very impressive quality indeed.
3

(b) It is generally recognized that unlimited use of

motor vehicles by private citizens generates a level of
negative externalities that is unacceptable.

(b) It is generally recognized that unlimited use of

motor vehicles by private citizens generates a level of
negative externalities that is unacceptable.

Discuss the view that a policy of indirect taxation is the

best that is available to tackle this problem in an
economy such as Singapore.
[15]

Discuss the view that a policy of indirect taxation is the

best that is available to tackle this problem in an economy
such as Singapore.
[15]

Context
Consump
tion of
private
vehicles
-ve ext
(?)

Command
Word
Discuss
Two
sided
(Explain +
evaluate)

Trigger

End Pt

Indirect tax policy ERP

Best method Criteria for
best:
Address root cause
Take into account
Conditions /
Characteristics of
Singapore

Attain social
optimum
level of
consumption
of private
motor
vehicles
no DWL

Introduction
Direction:
Many measures have been implemented by the Singapore government
to mitigate this problem.
Whether a policy of indirect taxation is the best depends on whether it
addresses the root cause of the problem and whether it is sustainable

Consider at least 2 or 3
policies

29/06/2015

P1: The market fails when there is unlimited use of motor

vehicles as there will be high levels of negative externalities.
excessive exhaust fumes harmful to the health
of 3 parties such as residents and pedestrians who may
suffer from respiratory problems and therefore incur
medical costs.
Heavy traffic causes serious traffic congestion
workers/students late for work/school, delays in
delivery of raw materials/finished goods
Reduces productivity of firms
fall in output/profits
As explained in a) this represents over consumption of a good
which in this case is over use of road space in the city (or
Over-consumption of cars). Cause: motorists incur pte costs
such as petrol, parking charges but did not have to pay for the
external costs road space/driving is under-priced

P2: Indirect taxation makes motorists bear the full costs of

using roads and therefore reduces car usage
Mkt equil: MPB=MPC Oqm, OPm
Excessive road usage by QmQs
deadweight loss = area ABC
When Govt imposes an indirect tax
(Ie. ERP = MEC)
Forces motorists to internalise
external cost (MEC)
Raises the cost of using road space or
(consuming private vehicles)
Each time motorists uses the road, a
certain amount is deducted from the
electronic device as the vehicles passes
through electronic gantry.
MPC curve shifts up to MPC + tax
Price of driving rises fr Pm to Ps
Reduce level of consumption
Traffic flow is reduced from 0Qm to
the socially optimal level of 0Qs.

Cost, benefit
A

Ps
Pm

tax

MSC = MPC + tax

C

MPC

MPB=MSB
0

Qs Qm

Quantity

L: This addresses the

root cause of market
failure that arises from
excessive usage due to
price being too low

P1(a): H/r, the effectiveness of indirect taxation depends on

how consumers respond, i.e. PED for private vehicle usage

P1(b) : H/r, the effectiveness of indirect taxation also

depends on amount of info on MEC that govt has

Hwr, in Singapore, motorists may

place a high premium on the
convenience that they can get from
driving their own cars as compared
to travelling on public transport (not
good subsitutes) PED < 1 as shown
in MPB
When px rises, < than proportionate
fall in Qdd to Qm as consumers may
not be responsive to price rise
Overconsumption still exists

Difficult to assign monetary value to MEC and hence arrive at the

socially optimal amt of indirect tax

Cost, benefit

MSC = MPC + tax

MPC

tax

MPB=MSB
MPB
QsQm Qm
Quantity

But, govt can use revenue collected from ERP to improve public
transport system.
In the LR, public transport can become a beJer subs0tute PED of
private vehicle consump0on > 1 indirect tax policy more eec0ve

Overview evaluation and synthesis of

Policy 1
ERP an appropriate policy to reduce car
usage low traffic congestion for many years.
Other countries/cities tried to adopt this
system: London and soon Jakarta

Overestimate MEC
Underestimate MEC
Over-tax
Under-tax
Under-consumption of private
Over-consumption of private
vehicle
vehicle consumption still exists
Affects business operations via
higher transport cost reduce
FDIs
Govt failure arises
But, this is not a very serious problem. ERP is very flexible. Rates
can be adjusted based on traffic conditions. Can be extended to
outside the CBD area

P3: Traffic congestion can be reduced through reducing car

ownership such as direct controls like COE
Mechanics of COE (Certificate of Entitlement):
The number of COEs determines the number of cars on the
roads. Government limits the number of cars that can be
bought or sold to the socially desired level.
Potential car owners can buy or sell the permit in artificially
created market. They can bid for a permit that allows them to
own a car in Singapore.
The government can gradually reduce the number of COEs in the
future to control the no of cars.
SS of COEs price of COEs discourage car ownership.
L: Hence, fewer cars on the roads reduces traffic congestion.

29/06/2015

P2 (a): However, there are also limitations to the effectiveness

of the COE policy
Current car owners are not
affected by the fall in the
number of COEs issued.
As a result, traffic congestion
may not be reduced if car
usage does not fall.
High COE encourages high
usage!

Extent of effectiveness depends

on:
Extent of rise in premiums
Whether income increases
How good a substitute
public transport is

Overview evaluation and synthesis of Policy 2:

A powerful tool to control car ownership and therefore
traffic congestion. But problem of equity. High COE makes
owning a car an impossible dream for the average worker.

P3(a) : However, there are some problems faced

P3: Need for policies to change taste and preference for

driving own cars such as more efficient public transport
system.
1. Make public transport even more attractive to driving cars.
Shorten waiting time by increasing number of buses/ trains
Making information on waiting time more readily available for
consumers through investment in the latest technology, e.g. IRIS,
SMS , GPRS (General Package Radio Service) and WAP (Web Access
Protocol).
Subsidies for public transport to keep travelling by public transport
affordable.
Reduce demand for cars less traffic congestion

2. Other long term solutions: tackle the supply side of the problem
Build more roads and expressways, widen existing roads to ease
traffic flow, underground tunnels, etc.
Improve the existing infrastructure through building a more efficient
public transport system. E.g.: The Circle Line in the Mass Rapid
Transit system.

What makes a WOW conclusion?

Personal opinion/judgement:

1. Difficult to balance between providing quality public transport

and keeping costs low and hence, affordable for users.
2. Burden of subsidies eventually falls on taxpayers.
3. Physical limits to road improvement due to small geographical size
of Singapore.
Overview evaluation and synthesis of Policy 3:
However, it would be appropriate to spend money on improving
this alternative mode of transport to make the demand for private
vehicles more price elastic. In this way, potential car owners may
find it attractive to use public transport instead.

As far as dealing with road congestion is concerned, the Singapore

government has implemented a package of policies that seek to
reduce traffic congestion by addressing car ownership, car usage
,quality of public transport and improving road networks tackling
both from the demand and supply side of the problem
Based on the analysis of the cause of mkt failure arising from
motorists which is the under pricing of road space, the indirect tax
is indeed the best policy as it is the only policy that makes the
polluter pays for the negative externalities generated. And it is this
extra costs that the motorists have to bear that discourage him
from using roads indiscriminately.
Price is used as a rationing device for the limited road space
It is fair as those who contributes more to traffic congestion pays
more
ERP also sustainable high initial set up costs but subsequently
low cost of maintenance. In addition, earns revenue for govt
People can still own cars unlike COE or public transport