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Q.70 externalities-and-income-inequity

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  • 1. (a) Explain why externalities and income inequity are market failures. [10] (b) Discuss whether the Singapore government would worsen income inequity when correcting the market failure of externalities. [15] (a) A market failure occurs when the free market fails to achieve social efficiency or income equity. Social efficiency is achieved when marginal social cost (MSC) is equal to marginal social benefit (MSB) where MSC is the sum of marginal private cost (MPC) and marginal external cost (MEC) and MSB is the sum of marginal private benefit (MPB) and marginal external benefit (MEB). External costs and benefits, or simply externalities, are costs and benefits of consumption or production experienced by society other than the producers or the consumers. External benefits, or positive externalities, lead to a divergence between MSB and MPB resulting in under-consumption or under-production and this is a matter of concern particularly if the goods are merit goods. Merit goods are goods that society deems desirable and the government thinks people should be encouraged to consume. Examples of merit goods include education and healthcare. In the above diagram, due to external benefits, the MSB is higher than the MPB. For example, the consumption of education produces external benefits such as a more innovative labour force. Therefore, the equilibrium output level (QE) where MPB is equal to MPC is lower than the socially efficient output level (QS) where MSB is equal to MSC. The deadweight loss, which is the loss of surplus due to market failure or government intervention, is represented by the shaded area. © 2011 Economics Cafe All rights reserved. Written by: Edmund Quek
  • 2. External costs, or negative externalities, lead to a divergence between MSC and MPC resulting in over-consumption or over-production and this is a matter of concern particularly if the goods are demerit goods. Demerit goods are goods that society deems undesirable and the government thinks people should be discouraged to consume. Examples of demerit goods include tobacco and alcohol. In the above diagram, due to external costs, the MSC is higher than the MPC. For example, the consumption of tobacco produces external costs such as increased air pollution. Therefore, QE is higher than QS. The deadweight loss is represented by the shaded area. Income inequity may result in some goods and services not being allocated to the people who need them more. Effective demands are demands that are backed by the ability to pay. Ineffective demands are demands that are merely driven by the willingness to buy. The free market only responds to effective demands which means that it only distributes goods and services to the people who have the willingness and the ability to pay for them. However, the ability to pay does not reflect needs and hence individuals who need some goods and services but do not have the ability to pay for them have to go without the goods and services. This is likely to happen if the distribution of income in the economy is inequitable, with the high ability to pay of high income individuals pushing up the prices of goods and services, keeping low income individuals out of reach of some goods and services. Therefore, income inequity may lead to an undesirable allocation of goods and services to individuals in the sense that some goods and services may not be allocated to the people who need them more. This is a matter of concern particularly if the goods and services are necessities such as food, water, housing, education and healthcare. In the absence of government intervention, the free market may lead to gross income inequity. © 2011 Economics Cafe All rights reserved. Written by: Edmund Quek
  • 3. In conclusion, the government should correct the market failures that have serious social implications and these normally involve merit goods, demerit goods or public goods. © 2011 Economics Cafe All rights reserved. Written by: Edmund Quek
  • 4. (b) The question on whether the Singapore government would worsen income inequity when correcting the market failure of externalities can be discussed with reference to the goods involved and the measures used. The Singapore government corrects the market failure of externalities arising from the consumption of merit goods such as education and healthcare. For instance, to correct the market failure of healthcare, the Singapore government has increased the supply by giving a subsidy to public hospitals for the provision of subsidised healthcare and by providing healthcare directly alongside private hospitals through public hospitals that are run as private companies wholly-owned by the Singapore government. A subsidy on healthcare will lead to a fall in the cost of production and hence a rise in the supply. When this happens, the price of healthcare will fall which will lead to a rise in the quantity demanded and this may correct the problem of under-consumption. In the above diagram, a subsidy on healthcare leads to a fall in the MPC curve. If the new MPC curve is MPC’, the new equilibrium output level (QE’) will be equal to QS. The Singapore government has also increased the demand for healthcare by creating the 3M framework, by making childhood immunisation against certain diseases mandatory and by using education such as launching campaigns and incorporating the values of good health into the school curriculum to increase the awareness of the beneficial effects of good health. The Singapore government corrects the market failure of externalities arising from the consumption of demerit goods such as alcohol and tobacco. For instance, to correct the market failure of tobacco, the Singapore government has decreased the supply by imposing an excise tax on cigarettes. An excise tax on cigarettes will lead to a rise in the cost of production and hence a fall in the supply. When this happens, the price of cigarettes will rise which will lead to a fall in the quantity demanded and this may correct the problem of over-consumption. © 2011 Economics Cafe All rights reserved. Written by: Edmund Quek
  • 5. In the above diagram, an excise tax on cigarettes leads to a rise in the MPC curve. If the new MPC curve is MPC’, the new equilibrium output level (QE’) will be equal to QS. The Singapore government has also decreased the demand for tobacco by passing several regulations such as prohibiting smoking in some public places, people under 18 years of age from buying cigarettes, people under 18 years of age from smoking and firms from engaging in tobacco advertising in any form, by making it compulsory for health warnings to be displayed on cigarette packets and by using education such as launching campaigns to increase the awareness of the harmful effects of smoking and campaigns to help people understand that passive smoking is just as harmful as smoking and incorporating the values of good health into the school curriculum to increase the awareness of the beneficial effects of good health. The Singapore government may worsen income inequity when correcting the market failure of externalities. First, an excise tax on tobacco expressed as a percentage of income is higher for low income individuals than for high income individuals. Therefore, an excise tax on cigarettes in Singapore worsens income inequity. Second, subsidising healthcare puts a strain on the government budget which may compel the Singapore government to increase indirect taxes such as goods and services tax. If this happens, given that indirect taxes are regressive, income inequity in Singapore may worsen. The Singapore government may not worsen income inequity when correcting the market failure of externalities. First, a subsidy on healthcare expressed as a percentage of income is higher for low income individuals than for high income individuals. Therefore, a subsidy on healthcare in Singapore leads to an improvement in income equity. Second, the use of means-testing in public hospitals in Singapore means that low income individuals receive more subsidy than high income individuals which further improves income equity. Third, an excise tax on cigarettes in Singapore allows © 2011 Economics Cafe All rights reserved. Written by: Edmund Quek
  • 6. the government to raise tax revenue which can be used to increase transfer payments to low income individuals and enables the government to reduce goods and services tax. If this happens, income equity in Singapore may improve. Fourth, when correcting the market failure of education, the Singapore government has made education affordable to more poor families which will increase their income-earning power resulting in lower income inequity. In the final analysis, the Singapore government would unlikely worsen income inequity when correcting the market failure of externalities. Although a subsidy on healthcare will improve income equity, an excise tax on cigarettes may not worsen income inequity. An excise tax on cigarettes will lead to a rise in the price which may induce low income individuals to quit smoking. If this happens, the excise tax will affect mainly high income individuals which may improve income equity. Further, when the Singapore government corrects the market failures of education, healthcare, alcohol and tobacco, labour productivity and hence national income will rise. If this leads to lower unemployment in Singapore, which will benefit low income individuals more as they are less mobile than high income individuals, income equity may improve. © 2011 Economics Cafe All rights reserved. Written by: Edmund Quek

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