JC Econs Essay: Microeconomic Policies To Address Congestion In Singapore
Congestion is, without a doubt, the most severe forms of Negative Externality in Consumption. For the context of Singapore markets, this is the most obvious market failure in Singapore, and you are highly advised to thoroughly prepare for the context of traffic jams due to excessive driving. Our physical land being so tiny, it is quite a feat that we do not see the type of massive and unthinkable traffic jams in other major cities.
However, the S’pore government has to be ready to adjust current policies, so as to accommodate more cars on the road, especially when they think of the plan to have a population size of 10 million people in SG.
Question
(a) Using examples, explain what is meant by “externality” and show how it leads to market failure. [10]
(b) ” While Singaporeans aim to meet as much of their aspirations as possible, such as the love to own cars. we also recognise costs are inflicted on other road users every time motorists drive.” Examine the policy measures undertaken by the Singapore government to address the market failure in the statement.
JC Econs Essay – Positive & Negative Externalities in Production or Consumption
Suggested Answer: Part (a)
Explain the term externality and how negative and positive externalities both result in market failure.
An externality is a cost or benefit that affects someone not directly involved in the production or consumption of a good, and which occurs without compensation. They are sometimes referred to as spillover effects, third party effects, external effects or neighbourhood effects. Whenever other people are affected beneficially, the externalities are called external benefits / positive externalities.
Whenever, other people are affected adversely, the externalities are called external costs / negative externalities.
TYPE OF EXTERNALITIES:
i) Positive Externalities in Consumption
Received in consumption process
EXTERNAL BENEFITS: Value of houses rise from the scenic beauty of neighbours’ gardens (benefits)
ii) Positive Externalities in Production
Generated in consumption process
EXTERNAL BENEFITS: A farmer benefiting from a drainage system which a neighbouring farmer has installed (or lower or -ve cost)
iii) Negative Externalities in Production
Generated in consumption process:
EXTERNAL COSTS: Acid rain pollution from a power supply station which harms a commercially-run farm
iii) Negative Externalities in Consumption
Generated in consumption process
EXTERNAL COSTS: Noisy music at a private party disturbing neighbouring houses (or lower or -ve benefit)
Explain the term negative externality
Define negative externality and explain an example of negative externality arising from either production or consumption of a good. In the example, identity both the first and third party as well as the externality.
External Cost or Negative Externality refers to the costs of production or consumption borne by people other than the producers or consumers. An example of external cost in production would be the release of industrial waste into rivers which decreases the catch of commercial fishermen. Another example of an activity that generates external costs in production is the pollution of air from smoke emitted by factories.
An example of an activity that generates external costs (MEC) in consumption is the smoke from cigarettes-smoker(1st party). It imposes health hazard on non-smokers (3rd party)
Explain how negative externality results in market failure
Use a diagram to explain how the socially optimal output Q, would be less than the private optimal output Q, and identify the deadweight loss due to over- consumption/over production.
Explain the significance of arriving at Q, and Qp.
Explain also the divergence between MPC and MSC due to the MEC.
Negative Externality
A negative externality will cause a divergence of private cost and social cost or private benefit and social benefit. There can be external cost from production. For example, when a firm dumps its production waste into a river or pollutes the air, they only care about their own costs incurred (MPC). However, the community will have to bear additional costs.
With the presence of external cost in production, the marginal social cost (MSC) will be greater than the marginal private cost, so MSC = MPC + External Cost (MEC).
There can also be external cost from consumption. For example, when people use their cars, other people suffer from their exhaust, the added congestion and the noise. With the presence of external cost in consumption, the marginal social benefit will be lesser than the marginal private benefit. MSB MPB- External Cost.
Diagram 1 illustrates how a good with a negative externality in production, eg when a factory emits pollutants into the air and this action causes people living nearby to suffer from air pollution. If the factory is left to make its decision on how much to produce, it will be at MPC = MPB.
(Sketch the diagram yourself based on the explanation below. Alternatively, refer to the diagram analysis in this externality essay)
In the diagram (to be sketched by you), D= MPB = MSB because there is no externality in consumption. The factory’s market supply curve also reflects his MPC, therefore S MPC. Due to the negative externality in production, MSC is higher than MPC The market equilibrium is at E where MPC MPB.
This will give an equilibrium quantity 0Qe. At this output, MSC MPC because External Cost (CE in diagram) is not taken into account by the producers. More Importantly, MSB is less than MSC. Society values an extra unit of the good less than what it would cost society to produce it.
Therefore, the price mechanism over-allocates resources to the production of the good. The good is “under-priced” resulting in greater quantity of the good being demanded and produced. Area ECD represents the welfare/deadweight loss to society as a result of this over-allocation of resources. The socially efficient level should be where MSC MSB, le. at output 0Qs. Therefore, the existence of a negative externality will lead to market failure because of allocative inefficiency of the price mechanism.
Explain the term positive externality
A positive externality will cause a divergence private benefit and social benefit or private cost and social cost.
Use an example of positive externality arising from either production or consumption of a good. In the example, identify both the first and the third party as well as the externality.
Explain how positive externality results in market failure Using a diagram show the socially optimal output Q, would be more than the private optimal output Q, and identify the deadweight loss due to under-consumption / under production. Explain the significance of arriving at Q, and Qp. Also explain the divergence between MPB and MSB due to the MEB.
Positive Externality
There can be external benefits from production. For example, research and development benefits not only the firm which finances but also other firms who have access to the results of the research. Therefore from the standpoint of society, MSC MPC because of the external benefit. (MSC = MPC -EB) There can also be external benefits from consumption.
For example, the increased knowledge and skill from education. The individual who not only benefit the pay for them but may increase the productivity of the economy and so raise other people’s Incomes. From the standpoint of society as a whole, MSB> MPB because of the external benefit. (MSB = MPB + EB)
Consider another good with a positive externality in consumption, eg: COVID-19 vaccination shots. If an individual makes a decision to be vaccinated against a disease, he will receive a private benefit of not being infected by the disease. He will not consider the possible benefits of not infecting others as a result of his vaccination ie his decision is based on his own private benefit and cost only.
In the diagram (sketched by you as an exercise), S = MPC = MSC because there is no externality in production. The individual’s market demand curve also reflects his MPB, so D = MPB. Due to the positive externality in consumption, MSB is higher than MPS because of the External Benefit. His decision is where D = S, ie whereby MPB = MPC. This will give rise to the market equilibrium, which is at E. with resultant market equilibrium quantity 0Qe. He does not consider the external benefit (AE in the diagram) in his action At market equilibrium output 0Qs, MSB is greater than MSC, that is society values an extra unit of the good more than what it would cost society to produce it. The society efficient level should be where MGC MSB, le at output 0Qs.
Therefore, the price mechanism under-allocates resources to the production of the good since OQe < OQs. Area EAB represents the welfare/deadweight loss to society as a result of this under-allocation of resources Therefore, the market falls to allocate resources efficiently because it does not take into about the external benefit in consumption.
Mark Scheme:
L3: For a very good and clear explanation of externalities both positive and negative, as well as an analytical discussion, with the use of appropriate diagrams, to show how market failure can arise when externalities (both positive and negative) are ignored.
L2: For a rather clear but not fully developed explanation of externalities, both positive and negative, with some remarks on how it causes market failure.
L1: For an answer which has some basic and imperfect knowledge of positive and negative externalities and market failure, OR only gives either +VE or -VE but not both types of EXT.
JC Econs Essay – Microeconomic Policies to Address Congestion in SG
Part B Essay Answer
Students are expected to explain the market failure in the given statement, the possible ways of addressing the negative externality arising from the use of cars, and conduct an evaluation of these measures. Measures include taxation, regulation, road pricing, increase the cost of car usage, Improvements in other modes of transport.
Explain the market failure in the given statement
Externality arising from the use/consumption of cars leads to market failure, so just back to the corresponding market failure in part (a). Make reference to part (a) to show diagrammatically the market failure.
Explain the externalities that arise from the use of cars (e.g. pollution, road congestion).
Explain the possible ways of addressing the negative externality from car use. Explain clearly how each of the measures works as well as evaluate these measures – i.e. their limitations, constraints and conditions for their effective functioning:
(i) (Indirect) Taxation
Impose tax by the amount of the MEC on car consumption (e.g. higher import duties on new cars – additional registration fees (ARF) Use a diagram to show that micro economic policy of taxation raises the MPC such that it coincides with the MSC. Consumer wanting to maximize their net private benefit would now consume quantity Q, (where MPC = MSB)
Limitation: Forces consumers to internalise the externalities they cause.
Difficult to quantify the actual value of MEC and to impose tax equal to the MEC. Over-taxation would lead to an output below Q, and hence lead to market failure.(Imperfect Information)
(ii) Regulation
Impose quota on the amount of cars that can be bought. Quotas should set at Q₂. The is what the Certificate of Entitlement (COE) scheme does.
Limitation: Prevents overconsumption (i.e. congestion) of cars on the roads In the case of COE cars owners need to purchase COE in order to buy a car – thus it raises the consumer’s MPC, as well as providing the government with revenue. Due to the inability to measure the externalities accurately it is difficult to obtain the socially optimum output.
Both ARF and COE control car ownership but congestion is caused by usage rather than ownership of cars.
(iii) Electronic Road Pricing (ERP)
This policy acts just like a tax and charges the consumer for the use of road space. During peak periods the charges are higher. The charges should reflect the MEC of using the road so that it raises the MPC to coincide with the MSC and the optimal amount of road space consumed.
Limitation: the road pricing charge (aka ERP in S’pore) internalises the externality caused by road consumption the charges should be made variable to better optimise road usage. Traffic flows should be near maximum possible. E.g., when speed goes above the upper threshold, too few vehicles are using the roads and the road pricing charge could be reduced to allow more vehicles to use the roads, and vice versa. However, charges will be of little use if the demand for road space is price inelastic. The system is difficult and very costly to implement throughout the country.
(iv) Improvements in other modes of transport
Constant improvements in public transport (MRT and bus systems in SG) in terms of convenience, frequency and cleanliness may result in the public using more and more of these and less of cars. Affordable and reasonable pricing is also necessary for the car owners to switch to public transport. Hence, with better and cheaper substitutes available, car usage can be reduced towards the socially optimum level.
Limitation: If successful, road usage can be made more optimal as people use the other modes of transport like bus, MRT, and LRT. However, cars are not only a means of transport, but also a status symbol or Veblen good, and people may not be willing to cut down on their purchases and use of cars.
Mark Scheme:
L3: For a competent response containing a well-developed analysis of the problem and effects of congestion, and the different policy measures to tackle the problem with appropriate diagrams.
L2: For an answer that analyses the problem and effects of congestion and provides undeveloped explanation of the policy measures to tackle the problem.
L1: For an answer that shows limited analysis of the problem and effects of congestion
Allow up to 5 additional marks for Evaluation
E2: For an evaluative assessment of the various policy measures.
E1: For an unexplained assessment, or one that is not supported by analysis.
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