JC Economics Essay Series #78 – Market Efficiency & Subsidies

JC Economics Essay Market Efficiency & Subsidies Model Answers 

In a laissez faire system, the invisible hand of the free market will, based on the self interest of buyers and producer in a market, lead a market outcome, and that outcome will inevitably benefit society as a whole. In reality, such concern of their own interest may lead to less than desirable market equilibrium.

Here is a common sample of a typical question on this section of efficiency that is common in the Prelim exams and also Cambridge A-Levels.


(a) Explain how the invisible hand works in the allocation of resources.
(b) Evaluate the view that a government such as that of Singapore should entry to museums and tickets to watch arts performances.


JC Economics Essay – Invisible Hand & Allocative Efficiency Concept

(a) Suggested Answer
Define invisible hand: price mechanism ⇒ plays an allocative function as it allocates resources to the production of different types of goods.

It as rationing mechanism synchronizing decisions by buyers and sellers. As resources are scarce relative to the insatiable demands of human wants, economies are concerned with basic questions of allocation:
i. What and how much to produce?
ii. How to produce?
iii. For whom to produce?


i. What and how much to produce?
Insufficient resources to produce enough goods and services to satisfy human wants ⇒ economy must make a choice on the types of goods and services that it wants to make available to the country.

→ For example, an economy has to decide on the different quantities of consumer goods and capital goods. determined jointly by firms and consumers through the signalling role of prices and the profit motive. price of a good reflects the value placed on it by consumers.

Consumers indicate their tastes and preferences to firms by the price they are willing to pay for the goods. Producers would only produce goods which consumers demand because they want to maximize profits. The higher the price of a good, the more the producers will supply that good  ⇒ In this way, the price acts as a signal telling the producers what to produce and how much of the good to produce. Thus determines the allocation of resources among various goods.


ii. How to produce?
What method of production should the scarce resources be used to produce the desired combination of goods and services as efficiently as possible. ⇒ For example, a manufactured good can either be produced by capital intensive methods (where there is little use of labour and greater use of machines) or labour intensive methods (where greater use is made of labour). o involves the organization of production.

Main aim: to achieve the least cost combination guided by relative factor prices.


iii. For whom to produce?
This problem concerns the distribution of a country’s national income. → resources are scarce, no society can satisfy all the wants of its people. → finished goods/services have to be distributed to households, firms and the government.

How the limited supply of final goods/services produced is allocated among the members of society? price acts as a rationing mechanism in a market economy and distributes the output only to people who are able and willing to pay for the good. This in turn depends on the purchasing power and the value that people place on the good.

Brief explanation of demand and supply analysis with the help of a diagram Determination of price and quantity by the interaction of demand and supply Any market disequilibrium market adjustment until equilibrium price and quantity achieved satisfaction of both buyers and sellers maximized


JC Economics Essay – Allocative Efficiency Concept

The shortcomings of the price system as a mechanism to allocate resources explains the economic rationale for government intervention in a market economy. ⇒ Eg: presence of merit goods and positive externalities in the case of museums and arts performances


Thesis: Govt should subsidise

Explanation of the type of market failure for museums and arts performances → positive externality & merit goods

Positive externalities occurs when third parties in the society benefit from the consumption of a commodity or service by private individuals


For museums and arts performances there exist external benefits such as more cultured and refined society, inculcate ability to appreciate arts, encouraged local artists showcase their work, boost to tourism and hospitality industry. Divergence between MSB and MPB (MSB>MPB) Left to the free market, underconsumption as individuals (producers and consumers) disregard the external benefits. Therefore, they will choose to equate their marginal private costs and marginal private benefits, ignoring the marginal external benefit generated. This is shown by point E₂ on Figure 1.
(Sketch the diagram, as an exercise.)


Allocative efficiency is not achieved at the free-market equilibrium. Society seeks to maximise the welfare of the society and would thus prefer to consume/produce where MSB = MSC, as illustrated by point E on diagram, illustrating shaded area as deadweight losses.

Merit goods
Individuals may not act in their own best interests because of imperfect information about the benefits that can be derived from the consumption of merit good like museums and art performances. Merit goods are those goods and services that the government thinks are “beneficial” for the individual consuming them as individuals are likely to underestimate their personal benefits in consuming merit goods.

Left wholly to the private sector, merit goods will be under-consumed because individuals do not understand or appreciate the good effects (that can be seen only in the long term). (sketch) Diagram shows allocative inefficiency under an unregulated free mkt system. Market failure results. Thus, govt intervention may be necessary to reduce the allocative inefficiency.


Explanation of how subsidy works to correct the market failure A subsidy is a payment made either to a firm or to a consumer when the firm produces or when the consumer buys a good or service. Can be used to correct the problem of positive externalities and merit goods.

Subsidies to Consumers
With government intervention, a subsidy of AB per unit to consumers will shift the demand curve from MPB to MSB as consumers are ‘encouraged to increase consumption, resulting in the socially optimal level, Q2 where MSC = MSB.


Subsidies to Producers
Subsidies given to producers reduce the cost of supplying products. This is shown in Figure 3. The equilibrium without government intervention is at output Q, where MPC = MPB or D₁ = S,. In this case, marginal external benefit is added to the MPB curve to give the MSB or marginal social benefit curve.

If the government subsidises the production of arts performances, the supply curve moves to the right from S, to S2, which equals MPC minus the subsidy. The marginal cost of supplying the good is reduced by the amount of subsidy and the vertical distance GH is equal to the value of the subsidy provided. Producers will be able to sell output Q₂ at a price of P3 which is where D₁ crosses S₂. The production and consumption level would be socially optimal.
(Qn: is there a need to distinguish between subsidising buyers or sellers?)


In both cases, the under-allocation of resources would be corrected as positive externality is said to have been ‘internalised’. The net gain to society from the subsidy or the elimination of deadweight loss is shown by the triangle DBC in figure 2 and triangle GHF in figure 3. Desirable as it is flexible and market based solution. In the case of Singapore (National Arts Council) Fundings to the performing arts was provided through a comprehensive grants framework.

Under the 2-year Major Grant Scheme, ten of Singapore’s top performing arts companies received a total of $2.8 million in FY 2009. These were Singapore Dance Theatre, Tang Quartet, Singapore Lyric Opera, The Finger Players, The Necessary Stage, Drama Box, TheatreWorks, The Thea Practice, Singapore Repertory Theatre and Wild Rice.

The grants enabled these groups to create and present quality programmes, develop artistic practice and professional expertise in their fields and facilitate their artistic growth and resource development


Anti-thesis: Govt should not subsidize

Limitations of subsidy: The valuation of the external benefit generated at the social optimal output level is in practice a difficult task. An overestimation will lead to over consumption of the good. An underestimation will lead to less than social optimal consumption but at this level it is at least more than the market equilibrium level.

High government expenditure is required to provide for the subsidy required, especially when demand is price inelastic.

Strain on govt finances especially with ageing population and diversion of resources away from other areas like education, national defence, healthcare (need to examine the trade offs/opportunity costs incurred)

– Reason why govt should not subsidize
– If perceived by government to generate zero or negligible positive externality → should be left to the market mechanism


Size of MEB is debatable. 
SG Gov can, with help from firms, co-sponsor (ie. direct provision) museums and tours.

As for arts performances, bulk of gains is MPB, little MEB, so unwise to subsidise.


Need for govt intervention if there are positive external effects from entry to museums and watching arts performances.

Other than subsidies, other solutions could possibly include campaigns and direct provisions. – If positive benefits are perceived to be low or negligible, then it is best left to the price mechanism to do the allocation of resources.


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