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Market Failure and government Intervention
This theme examines the nature of market failure, its causes and possible policy remedies. Candidates should be able to understand why markets may not allocate resources efficiently and the methods of dealing with market failure, together with an evaluation of their effectiveness.
Candidates should be able to:
2.1 Market Failure
Meaning of market failure and efficiency
Why markets may not work efficiently
Positive & negative externalities
Public & merit goods
Inequalities in the distribution of income & wealth
Analyse why market dominance, imperfect information and immobility of factors of production can lead to inefficiency
Understand that externalities exist when there is a divergence between private and social costs/benefits
Illustrate positive & negative externalities in both production and consumption using simple demand and supply diagrams
An understanding of what is meant by deadweight loss is necessary when discussing market failure
Government Intervention in the Market
Rationale for government intervention
Methods by which government intervene in markets and the impact on market outcomes
Understand what is meant by a cost-benefit approach in the context of externalities
Explain why governments intervene in the markets to correct market failures
Examine the various methods by which governments intervene in markets
Discuss how governments may create inefficiencies when they intervene in markets due to factors such as political objectives, administrative costs and lack of information
Short Q&A on Market failure
2 Characteristics of a private good
Explain why clothing is a private good
Clothing is excludable in terms of people being excluded from possible consumption if they cannot afford the good
Clothing is arrival good because consumption by one person does diminish the amount that another person can consume (or it diminishes the satisfaction gained)
Caution: Do not confuse the concept of rivalry and excludability
Three Forms of market failure are:
Government intervention at internalizing any negative externality
Regulation (eg via fines)
Introduction of tradeable permits
Enforcing property rights
Diagram to show the imposition of a tax
Explanation of how permits would be successfully introduced
What size the tax should be
The problems of correctly measuring external costs (to set the correct tax)
The ineffectiveness of taxing products which have inelastic demand
The need for international rather than national taxes to be set as otherwise polluters simply move production to other countries
The problems of enforcing and monitoring regulations (and the resulting opportunity cost issues)
Government intervention at internalizing any positive externality
To encourage consumption through:
Introduction of subsidies
Use of legislation
The difficulties of establishing exactly what size the subsidy should be
The cost to the government (& associated opportunity cost issues)
The ineffectiveness of subsidy if products have inelastic demand
Need to consider the reason for under/over provision of the goods.
In the case of merit goods:
Analyze the fact that consumers fail to see how beneficial these products are for them and therefore under consume because they only consider the lower private benefits rather than the total social benefit.
In the case of demerit goods:
Consumers fail to see how harmful these products are and therefore over-consume
Need to explain the problem of market failure in terms of factors of production not being responsive to price signals. For example, whilst demand switches away from manufacturing goods, production cannot switch to services due to the immobile nature of capital. When factors of production no longer respond to price signals then market failure arises.
Common example is the application to labour market immobility:
If workers have ‘specific’ skills in manufacturing and are unable to acquire the skills required to undertake the jobs now on offer, then they will suffer from structural unemployment due to occupational immobility.
Likewise, if workers are unable to move to other areas of the country where there are job vacancies then they will suffer from regional unemployment due to geographical immobility (This is may not be applicable to Singapore as we are a small country & the whole city state is well connected with efficient road or MRT system). This represents market failure because resources (in this case labour) are not being used to their full potential.
Government policies to solve problems caused by factor immobility:
Training and re-training
The provision of more information on job vacancies
The availability of more affordable housing for workers
Evaluation of government policies:
The above policies are expensive and are more long-term in nature
Hence, government intervention may not correct market failure in the short term
Training & re-training policies may fail to address market failure if they fail to provide workers with the skills necessary to undertake new jobs.
Reference: EDEXEL Q&A
Granted that government should only subsidize basic healthcare, but if a Class C patient wants better facilities such as air-conditioning or any better “hotel facilities” of hospital care and is willing to pay for them without subsidy, he should be catered to. Comment.
It is not justified to allow a Class C subsidized patient to enjoy “hotel facilities” even though he is willing to pay for them. This is because it is not possible to compartmentalize subsidies. The argument for health subsidy is based on the premise that it has a higher priority claim for equity reason, in terms of need and value than other needs eg for air-conditioning. Had the patient not been subsidized for his healthcare, he would presumably be using his money to pay for his health care first. So it is the health subsidy which enables him to save money to pay for the non-critical needs. In a sense therefore we are subsidizing his air-conditioning in the hospital even though it is quite clear we will not have subsidized his air-conditioning at home.
This does not fulfill the objective of the medical subsidy which is only suppose to
focus on subsidizing basic & essential healthcare services to those who cannot afford them.
From Fig 1 & 2, we see that assuming the cost of supplying the medical treatment is the same for both wards, the subsidy amounting to the difference between the price of Class A ward (P
) and the price of Class C ward (P
) is ‘saved’ by the patient, by virtue of the fact that he is staying in Class C ward will enable him to use the money to pay for the air-conditioning.
Fig 1: Market for Class A wards
Fig 2: Market for Class C wards
Qty of Class C Wards
Qty of Class A Wards
(no frills allowed)
There is another angle to this issue. Since there are very substantial differentials in subsidies between classes of wards and since the medical treatment standard cannot vary between classes, there is a possibility of someone seeking very sophisticated or costly treatment shifting to a lower class of ward. Hence if the non-medical amenities in the Class C wards are just as comfortable as the Class A wards, the incentive for such a shift is even greater. This would defeat the attempt to have a graduated subsidy system whereby those who can afford should be subsidized less. The more basic the lower class wards are, the more effective they are as a deterrent against such shifts and therefore
act as a substitute for a means test
for ward admissions.
is an examination of the personal and financial circumstances of an individual to assess his or her eligibility for benefits under a country’s system of social security benefits.)
The principle of price discrimination is used here. From Fig 1 and 2, we can see that a segmentation of the two markets can be made if we do not allow the addition of ‘frills’ in Class C wards. This will ensure that Class C wards will be demanded only by patients who are poor and need the subsidy and prevent patients with the ability to pay to benefit from the Class C Wards. The latter group of patients will not opt for the “no frills” Class C wards because they feel that they cannot live without air-conditioning which they are used to at home.
An additional note on the concept of public goods is useful here. A public good has to satisfy two conditions – non-excludability (ie no consumer can be easily excluded from consumption, with broadcast signals often being used as an example); and non-rivalry in consumption (ie my consumption of it does not affect your consumption). Very few goods can satisfy these strict criteria.
Since healthcare is both rivalry & excludable, it cannot be categorized as a public good. Instead, it is a merit good because if left to the free market allocation, insufficient amount will be produced or consumed. Hence, there is a need for government to subsidize basic healthcare. In order to ensure that such subsidies benefit those who need it most, means testing is implemented.
Healthcare in Singapore is financed by a combination of taxes, employee medical benefits, compulsory savings in the form of Medisave, insurance and out-of-pocket payment. When healthcare subsidies benefit the poor most, it fulfills both the efficiency and equity aims of government policy.
In order to minimize abuse, the financing philosophy of Singapore’s healthcare delivery system is based on individual responsibility and community support. Patients are expected to co-pay part of their medical expenses and to pay more when they demand a higher level of service. At the same time, government subsidies help to keep basic healthcare affordable. To help Singaporeans to pay for their medical expenses, the government has put in place a financing framework, which consists of Medisave, Medishield, Eldershield and Medifund.
Suggested guiding questions:
How does a merit good differ from a public good ?
Can the free market provide merit goods ?
Why is there a need for government intervention in the case of healthcare ?
What is means testing ?
Should patients staying in Class C wards be allowed to opt for better facilities, which are available in Class A and B wards, if they are willing to pay for the facilities in full ? Assume the role of the Minister of Health of Singapore and justify your views.
Since education is a basic need, the government should pay for education or highly subsidize it up to and including tertiary education. Comment
Most governments today subsidize education up to the tertiary level. The case for subsidy up to the secondary level is quite strong. Education provides literacy, a lingua franca, and a pre-requisite to absorb higher level skills. A government subsidy can be viewed as a collective investment decision by the society paid for by taxes from the current generation for the training of the next. But the case for government subsidies varies with each level of education.
Primary school education is the most basic. It is now widely regarded that literacy is so crucial to society and its functions that it should be available to all. Some countries, including Singapore has even made it legally compulsory. Since this level of education must be provided for all and the syllabi are basic and standardized, it is best provided for by the state and subsidized from general taxation. No issue of equity of tax burden is at stake as it is provided from general taxation. The free market cannot provide universal education at primary levels adequately when the main beneficiary is the population at large and the economic pay-off to the market is rather diffuse and uncertain. A free market solution will not be able to allocate resources efficiently in the provision of education at the primary level.
(Note: Primary education was made compulsory in Singapore in Jan 2003 with the intention to give every Singaporean child the same head start in life and be taught the foundational knowledge and skills that will enable him to further his education and training later on.)
For secondary education, the case for complete government subsidy is weaker as not everyone proceeds on to this level. However, with increasing sophistication in the economy, the value of a universal or very high proportion of the population possessing secondary education is increasingly being recognized. Societies with high secondary literacy rates tend to have higher productivity rates and higher competitiveness as the general higher educational attainment makes the population more receptive to complex skills training in a knowledge-based economy. In an agrarian society, it may be better off for the worker in the fields as soon as possible or have vocational training instead of a general academic education. In an IT age, a worker with secondary education will be more easily trainable (assuming a given amount of intelligence in the individual) than a primary school graduate. Given the
to the economy of literacy and in Singapore’s case, the near universal attainment of secondary education, it is justifiable and efficient for the government to subsidize secondary education. This is all the more so given that the human resource is our most valuable factor of production. Further, a ready supply of educated workers is an asset in attracting investment which may otherwise go elsewhere.
Using economic analysis, we term primary and secondary education as a merit good. The consumption of education will generate external benefits to the society. Hence, left to the market forces, there will be an under-production as well as under-consumption of education. Government intervention is required to ensure that a socially optimum level of production and consumption is achieved at
(refer to fig 1).
Price of Education MSB MPC=MSC
Positive Externalities = amt of subsidy
Fig 1: Market for Education
Quantity of Education
As we reach
however, the case further weakens. In some advanced countries, private universities do exist and this shows that the market, or at least a non-government body (usually a so-called non-profit trust) can respond to the need for tertiary education. By the time, the student has a full successful secondary education and has the capacity to undertake a university education, he would have been sufficiently informed to make a decision on his future career. His ability would be known and the value of any further education can be reasonably ascertained. It will be feasible for a
or a bank to issue a
to finance the student’s education just as companies can take a view to borrow to invest in any plan or equipment. The economic value of the subject of study and the 3 – 5 years’ horizon are sufficiently certain for the market to assess and finance. The advantage of such a system is the
minimization of waste
as only the course of highest economic relevance will be financed most readily.
The disadvantage is that certain courses not seen to be of immediate value may be underdeveloped. The Arts and the Basic or Pure Sciences subjects may be undervalued as their payoff is less certain.
A purely free market approach also favours those with greater creditworthiness, financial assets, collateral backing or financing, say from parents, which may not be correlated with the talent of the individual students. Thus a system of government bursaries or government guaranteed
loans for poorer but brighter students has to supplement this if society’s talent is to be more fully exploited.
Another argument is that, it is in a sense “fairer” for those selected few who want a higher education to pay for it themselves than to use general taxation paid for by everyone to finance the education of a selected few. However, this argument is mitigated by the fact that the total tax burden is always highly skewed in the Pareto sense of a small number bearing the heavier part of the tax burden unless the country has no taxes other than a flat general consumption tax. Thus with a
meritocratic admission system
, one may argue that it is fair for part of the wealth of the society in general to be used for the education of these
smaller group of talent
for the betterment of that society in the next generation; a form of income redistribution from one generation to another.
The case for subsidizing tertiary education is finely balanced so that no country has left tertiary education to the free market exclusively.
Where private universities and colleges exist, they
rather than replace government ones.
Bursaries, scholarships, state grants etc have always been part of the scene. So the convention judgement is that
tertiary education should be mainly subsidized.
As we move further up into more
specialized vocational training
eg those provided by employers, the case for a government subsidy becomes practically non-existent. The situation is the reverse of that of basic education. Just as the free market will have difficulty assessing the worth of primary and secondary education, government will find it difficult to put a value to the worth of specific company training programmes.
Economic discipline is better exercised in the free market and the
created by subsidies from the government the
If the government tries to give a general subsidy of all specific training i.e. one open to every company to apply for, then the outcome is similar to a general tax break for the industry and an inefficient one at that because the subsidy cannot be spent on other things which may be of more value to the company.
The only case for subsidized specific training is when there is
or when the government wants to develop new areas of skills in a specific field. This could either be in emergent skills where the market has yet to recognize or to make up for past deficiencies in the education system or to develop skills in sectors where we are already behind others and have to catch up. However, in the nature of such things, these subsidies must be selective and targeted rather than broadly applied.
Suggested guiding questions:
How does a merit good differ from a public good ?
Can free market provide merit goods ?
Why is there a need for government intervention in the case of education ?
Should education be uniformly subsidized at all levels (primary, secondary and tertiary) ? Justify your answer.
Education at the primary and secondary levels is basic and should be highly subsidized. However, tertiary education is not basic and should not be highly subsidized. Do you agree ?
The government should not increase the upfront cost of car ownership but raise car operating costs and road pricing to better manage traffic and vehicle usage. Comment.
The statement is probably true.
The total cost of owning and operating a car in Singapore comprises the vehicle purchase costs, finance charges on vehicle loan(s), gasoline and motor oil expenses, car insurance expenses, maintenance and repair expenses, road tax and other fees. The quantity demanded for cars is inversely related to the total cost of owning and operating it.
The supply of cars in Singapore is determined by Vehicle Quota System (VQS) which was implemented in May 1990 (refer to Fig 1). This system controls the growth of the vehicle population at a sustainable rate. Certificate of Entitlement (COEs) must be obtained through a process of competitive bidding before a vehicle can be registered. The vehicle quotas are revised annually, considering de-registration patterns and sustainable growth rates relative to road space constraint.
Fig 1: Market for Cars in Singapore
a car P
Quantity of Cars
The government can either increase the upfront cost of car ownership or raise the car operating costs to reduce the quantity demanded for cars. Referring to Fig 1, when the car operating costs increase, the supply curve shift left, showing that less quantity of cars will be supplied at each price level. This is further reflected in the higher price of car ownership ( an increase from P
). Although there is a need to strike a balance between car ownership and car operating cost, it is generally believed that the latter (ie car operating cost) is a more effective tool to manage traffic and vehicle usage. The basis of the argument here is that it is the usage of cars and not the ownership that contributes to road congestion.
The upfront cost of car ownership in Singapore comprises the down-payment for the car (ie the price of the car, inclusive of the COE price and interest charges, minus the loan amount), insurance fee and road tax.
Raising the upfront cost of car ownership
will reduce the growth of the vehicle population, but it
may not be effective in managing traffic and vehicle usage
. In fact, it is generally believed that having a
high ownership cost distorts usage pattern
encouraging car owners to drive frequently, since the car has been paid for.
The cost of operating a car in Singapore comprises the cost of gasoline and motor oil, maintenance and repair expenses, car park charges as well as Electronic Road Pricing (ERP) charges. Wile the costs of gasoline and motor oil as well as the wear and tear costs are determined by market forces, the
ERP system is put in place by the government to moderate and spread out vehicle usage for a more optimal and congestion-free road network
. It is believed that the
ERP is a more efficient
and precise instrument
in controlling congestion
and by moderating
(rather than ownership), a higher overall vehicle population can be supported.
However, the up-front cost of car-ownership should not be decreased excessively as higher car population implies that any mistake in road pricing (in terms of amount charge and time of operations) due to a miscalculation of demand will probably lead to more severe traffic congestions. The demand for parking space will also increase, leading to the need to build more massive carparks or charge higher carpark fees, hence increasing the cost of operating a car.
Relying on either one of the policy tools will not be good. The Authority will
need to strike a balance
between control of car ownership and car usage tools to ensure that traffic and vehicle usage in Singapore can continue to be managed efficiently and effectively in the long run.
Suggested guiding questions:
If you were to purchase a car, what are your monetary considerations ?
What are the factors affecting the upfront costs of car ownership ?
What are the factors affecting car operating or usage costs ?
Why is there a need for the government to better manage traffic and vehicle usage ?
Increasing the upfront cost of car ownership
Raising car operating cost and
Road pricing help in the management of traffic and vehicle usage ?
In your opinion, which one of the above is most effective in managing traffic and vehicle usage ? Justify your views,
ECONOMICS IN PUBLIC POLICIES
Control of Car population
Given Singapore’s small size, it is important to manage vehicle ownership and usage. The demand for car ownership needs to be balanced with the number of vehicles using the roads. If these two competing demands are not managed properly, it could lead to serious traffic congestion on the roads. The two principal demand management tools for road traffic management are the Vehicle Quota System (VQS) and Electronic Road Pricing (ERP).
VQS was implemented in May 1990 to control the growth of the vehicle population at a sustainable rate. Under this system, the Land Transport Authority (LTA), which is a statutory board under the Ministry of Transport, determines the number of new vehicles allowed for registration while the market determines the price of owning a vehicle. In determining the number of cars allowed for registration, LTA takes into account the prevailing traffic conditions and the number of vehicles taken off the roads permanently. The quota allocated to each vehicle category is in proportion to that category’s share of the total vehicle population and revised annually, looking at de-registration patterns and sustainable growth rates. The vehicle quota for a given year is administered through the monthly release of Certificates of Entitlement (COEs).
COEs must be obtained through a process of competitive bidding before a vehicle can be registered.
“Pay-as-you-bid” for COE will collect less money for the government. Comment
The objective to government intervention is to control car population and not to derive revenue. The government can only set the price or the quantity of COEs. Given that the government set quotas on the number of cars via COEs, it necessarily implies that the prices of the COEs will be based on the demand for cars.
Under the current “common pricing” or “minimum successful bid” system whereby the COE price is determined by the lowest successful bid price, the “pay-as-you-bid” system, which charges each bidder price according to what he bids, should lead to an increase in government revenue.
Under the “minimum successful bid” system, the quota premium is based on the minimum successful bid submitted. Hence except for the marginal bidder, the other successful bidders would gain
as they are paying an actual price lower than their
reserve price ie the maximum amount that they would have been prepared to pay.
This can be illustrated using Fig 1.
Fig 1: Market for COEs
Quantity of COEs
SS (Fixed Supply – Quota)
Price of COEs
The “pay-as-you-bid” system will increase the government’s revenue. Here, the government would be able to charge a separate price to each consumer that reflected the maximum amount that the consumer was prepared to pay, hence appropriating all consumer surplus in the form of government revenue. This is illustrated in Fig 2.
Fig 2: Market for COEs
Quantity of COEs
SS (Fixed Supply – Quota)
Price of COEs
This answer can be explained by a simple numerical example. Under the current system, suppose a consumer is willing to pay $30,000 for his COE to buy a car, if the lowest successful bid is $20,000, he will ‘save’ $10,000 or enjoy a consumer surplus of $10,000. On the other hand, under the “pay-as-you-bid” system, he will pay his bid of $30,000 if successful and will have no ‘savings’ or consumer surplus at all.
Under the “pay-as-you-bid” system, in the event that consumers have a very accurate prediction of the likely COE prices, then the government may not be able to obtain a significant increase in revenue if the final COE prices are close to what most consumers bid.
One additional factor that we should consider in a real-life situation is that gaming behavior will have an impact on the outcomes. While auction theory tends to assume that bidders know their own reservation price and their valuation of the product being bid for
ie the maximum amount that they would have been prepared to pay
, in reality, this does not hold true. Bidders may be swayed by others’ bidding to increase their bids. The design of the rules of auction becomes significant, eg whether the bids are sealed or whether bidding information is available to bidders in real-time.
Currently the “common pricing” or “minimum successful bid” system is used instead of the “pay-as-you-bid” system due to implementation and equity issues. It was predicted that the “pay-as-you-bid” system would not work as consumers are entitled to bid for COEs indefinitely and repeatedly at any point in time. This will result in people trying their luck and bidding at a price much lower than the actual value that they placed on the COE at the start and gradually increasing it if their bid is not successful. The short term effect is that prices will be set below the equilibrium and the common clearing price might only be reached in the long run. However, it was noted that this problem arose because of the closed bidding system and would have been resolved when the open bidding system was adopted in April 2002.
Open Bidding System
COEs must be obtained through a process of competitive bidding before a vehicle can be registered. Open Bidding of COEs was introduced in April 2002, after a trial in the second quarter of 2001. The online COE Open Bidding System was developed to provide a greater degree of transparency. It provides bidders with better access to information during the bidding process to make more informed decisions.
COE OPEN BIDDING (‘MINIMUM SUCCESSFUL BID SYSTEM)
January 2005 2nd Open Bidding Exercise has ended on 19/01/2005 16:00 hrs
Results for JANUARY 2005 2nd Open Bidding Exercise
Quota Premium (QP)($)
Prevailing Quota Premium (PQP)($)
Car (1600cc & below) & Taxi
Car (Above 1600cc)
Goods Vehicle & Bus
PQP: Prevailing Quota Premium (for existing vehicles). It is a moving average of QP over the last 3 months.
Results for JANUARY 2005 2nd Open Bidding Exercise
Car (1600cc & below) & Taxi
Car (Above 1600cc)
Goods Vehicle & Bus
Received: Total Bids Received
Unused: Unused Quota carried forward
Some questions for you to think through:
Congestion caused by motorists driving their cars during peak hours has often been cited as an example of a negative externality in Singapore. Explain.
What are the various public policy tools used in managing car ownership and/or usage in Singapore ?
Do COEs control car ownership or usage ?
Are COEs more effective in reducing road congestion as compared to other policy measures ? Do measures complement each other ? Explain your reasons.
How do motorists bid for COEs ?
What is the difference between a closed and an open bidding system ?
How does an alternative bidding system, like “pay-as-you-bid” differ from the current “common pricing” or “minimum successful bid” system ?
Which system is likely to be more effective in controlling car ownership ?
Which system is likely to collect more revenue for the government ?
Should the amount of government revenue collected be a consideration when issuing COEs to control car population ?
Which system would you prefer as a future motorist ? support your answer.
Which system would you implement if you were the Transport Minister ? Give your reasons.
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