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# Q.92 market-forces-market-failure-and-water

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• 1. Since the time of Adam Smith, there have been many staunch believers in market forces. However, there are governments which subsidise water and governments which impose a tax on it. Discuss. [25] The question on why there are governments which subsidise water and governments which impose a tax on it can be discussed with reference to the concepts of market forces, social efficiency, positive externalities, imperfect information, tax revenue and affordability. The equilibrium of a market is determined by the market forces of demand and supply. The demand for a good is the quantity of the good that consumers are able and willing to buy, known as the quantity demanded, at each price over a period of time, ceteris paribus. The supply of a good is the quantity of the good that firms are able and willing to sell, known as the quantity supplied, at each price over a period of time, ceteris paribus. An equilibrium is a state where there is no tendency to change. In the above diagram, given the demand (D) and the supply (S), the equilibrium price and the equilibrium quantity are PE and QE. If the price is above PE, such as P1, the quantity supplied (QS) will be greater than the quantity demanded (QD) and this is known as a surplus or excess supply (QS – QD). When firms cannot sell all the output that they produce, their stocks will build up. Therefore, they will lower the price to reduce their stocks. The lower price will lead to a decrease in the quantity supplied and an increase in the quantity demanded and this process will continue until the price falls to P E where the surplus is eliminated. © 2011 Economics Cafe All rights reserved. Written by: Edmund Quek
• 2. If the price is below PE, such as P2, the quantity demanded (QD) will be greater than the quantity supplied (QS) and this is known as a shortage or excess demand (QD – QS). When firms do not produce enough to sell, they can raise the price without losing sales. Therefore, they will raise the price to increase their profits. The higher price will lead to an increase in the quantity supplied and a decrease the quantity demanded and this process will continue until the price rises to PE where the shortage is eliminated. If the price is equal to PE, the quantity demanded will be equal to the quantity supplied. There will be neither surplus nor shortage and hence there will be no incentive for firms to change the price. The socially efficient output level is the output level where marginal social cost (MSC) is equal to marginal social benefit (MSB). 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. In the absence of externalities, the equilibrium of a market will lead to social efficiency, assuming no market imperfections, imperfect information, public goods and immobility of factor inputs. Firms and consumers consider only private costs and benefits. In other words, the demand curve is the MPB curve and the supply curve is the MPC curve. © 2011 Economics Cafe All rights reserved. Written by: Edmund Quek
• 3. In the above diagram, due to the absence of external benefits, the MSB is equal to the MPB, and due to the absence of external costs, the MSC is equal to the MPC. As a result, the equilibrium output level (QE) where MPB is equal to MPC is equal to the socially efficient output level (QS) where MSB is equal to MSC. Governments may subsidise water to correct the problem of underconsumption due to positive externalities and imperfect information. The consumption of water allows people to remain healthy. Therefore, it produces positive externalities such as reduced frequency of falling sick and hence reduced frequency of spreading diseases to others and this leads to a divergence between the MSB and the MPB resulting in under-consumption. Further, although people are well aware of the short-term benefits of consuming water, many do not fully realise the long-term health benefits. Therefore, the perceived MPB of water is lower than the true MPB and this leads to under-consumption. A subsidy on water will lead to a fall in the cost of production and hence a rise in the supply. When this happens, the price of water will fall which will lead to a rise in the quantity demanded and this may correct the problem of under-consumption. © 2011 Economics Cafe All rights reserved. Written by: Edmund Quek
• 4. In the above diagram, due to external benefits, the MSB is higher than the MPB. Therefore, QE is lower than QS. A subsidy on water 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. In the above diagram, the perceived MPB (MPBP) is lower than the true MPB (MPB). Therefore, QE is lower than QS. A subsidy on water leads to a fall in the MPC curve. If the new MPC curve is MPC’, QE’ will be equal to QS. Governments may subsidise water to increase the affordability. Water has a high degree of necessity as it is essential for survival. Therefore, a high price of water could lead to severe hardship. A subsidy on water will lead to a fall in the cost of production and hence a rise in the supply. When this happens, the price of water will fall which will lead to an increase in the affordability. © 2011 Economics Cafe All rights reserved. Written by: Edmund Quek
• 5. Governments may impose a tax on water to conserve the resource. Water may be a scarce resource in a country. A tax on water will lead to a rise in the cost of production and hence a fall in the supply. When this happens, the price of water will rise which will lead to a fall in the quantity demanded and this may help conserve the resource. In the above diagram, a decrease in the supply (S) from S0 to S1 leads to a rise in the price (P) from P0 to P1 and a fall in the quantity (Q) from Q0 to Q1. Governments may impose a tax on water to raise tax revenue. The price elasticity of demand for a good is a measure of the degree of responsiveness of the quantity demanded to a change in the price, ceteris paribus. The demand for water is price inelastic due to the high degree of necessity and lack of close substitutes. Therefore, a tax on water will lead to a huge rise in the price and a small decrease in the quantity demanded resulting in a large increase in tax revenue. Intuitively, when the demand for a good is price inelastic, consumers are not sensitive to a change in the price. Therefore, when the government imposes a tax on such a good, firms can pass on a large fraction of the tax to consumers in the form of a huge rise in the price without causing a large decrease in the quantity demanded. © 2011 Economics Cafe All rights reserved. Written by: Edmund Quek
• 6. In the above diagram, a tax on water leads to a decrease in the supply (S) from S0 to S1. Due to the inelastic demand, which gives rise to the steep demand curve (D0), the decrease in the quantity demanded (Q) from Q0 to Q1 is small. In the final analysis, a government is more likely to subsidise water to increase the affordability. A subsidy on water is typically given in a developing economy such as South Africa. In such an economy, many of the poor households can barely afford necessities which are essential for survival such as water. Therefore, a subsidy on water is likely to substantially reduce the hardship of the people. A government is more likely to tax water to conserve the resource. A tax on water is typically imposed in an economy with limited water supply such as Singapore. Such an economy relies heavily on import for water supply which is undesirable. A tax on water is likely to reduce wastage and hence help the economy moves towards self-sufficiency in water supply. © 2011 Economics Cafe All rights reserved. Written by: Edmund Quek