JC Economics Essay Negative Externalities & Taxation Model Answers
How many of you usually skip the essay question that is of the 25-mark, no-part type? Do you think can afford to skip of this kind of essay question appears for the topic of Market Failure, which can include any of the following of Negative Externalities (or Positive Externality), and can comprise any of the externality types, for example, healthcare, education, pollution (including air, water, land and even noise pollution), congestion, smoking, bike-sharing, e-scooter riding, etc. (Note that such diverse and even obscure context for externalities can appear for for H1 Econs exams as well).
Here is a sample Q&A submitted by one of our JC Econs students:
Question
Critically analyse the view that the Singapore government should use taxes rather than any other economic approaches when dealing with the market failure associated with negative externalities [25]
JC Economics Essay – Negative Externality
Suggested Answer:
Introduction:
1. Define market failure: Market failure occurs when the price mechanism fails to allocate resources efficiently and equitably and usually the government needs to take actions and provide a non-market mechanism to allocate scarce resources. 2. Define negative externality and state briefly that it will cause a divergence in the benefit cost curves
Costs incurred on third parties who are not directly involved in the production or consumption of a good, and which occurs without compensation. production ⇒ MSC > MPC
* Negative externality in consumption – MPB> MSB ⇒ Over-consumption/ over-production of goods ⇒ inefficiency in resource allocation ⇒ market failure
Scope 1: Explain & elaborate how market failure can result from the existence of a negative externality in consumption/production
Figure 1 illustrates the market for cigarettes. Smoking is enjoyable to the smoker but it imposes external costs on 3″ parties in the society.
(Sketch the example as according to the description that follow, as an exercise.)
Elaborate on MEC: The smoke from cigarettes imposes health hazard on non-smokers. As a result, passive smokers’ health worsens and they incur extra medical costs, without compensation. The government also incurs extra cost of financing health care cost of citizens who suffer from smoking related illnesses. o Employers will suffer a loss in revenue due to the lower productivity of workers at work.
The demand curve reflects the private benefits the individual enjoys and takes into consideration in making buying decisions so it is also the MPB curve.
The external costs of smoking are ignored by the individuals. Thus, the social benefits of consumption (what the society gains) are smaller than the private benefits of consumption and the MSB curve lies below the MPB curve for all levels of cigarette output. It follows that
MSB < MPB-MEC. Define MPC= Cost incurred by the individual smoker. E.g. Cost of cigarettes, cost of medical care. Define MSC Measures the next best alternative use of resources that are available to the whole society. Here, we assumed that there are no externalities in production. Thus, the supply curve reflects both the private and social costs. MPC = MSC.
The market equilibrium occurs at the intersection of both the demand and supply curves. And in this case, it would be the intersection of both MPC and MPB curves at output Qm. At this level of output, the individuals’ ignores the external cost incurred on 3rd parties. However, the socially optimal level of output occurs when MSB = MSC. At this point, the benefits enjoyed by the society from the last unit of good consumed are equivalent to the opportunity cost of producing the last unit of the good.
All units between Qs and Qm should not be consumed from the society’s point of view as for each unit, the social benefits enjoyed (MSB) are less than the social costs of production (MSC). The over-consumption of cigarettes resulted in welfare loss equivalent to the area of triangle, E2E1B. Thus the market fails as there is an over-consumption of cigarettes, represented by the gap QsQm, which reflects inefficiency in resources allocation as more resources are being diverted into the activity. Society’s welfare is not maximised.
Thus, government intervention is required. Government can intervene by implementing policies such as taxes to reduce the external cost generated and thus, correct market failure.
Remarks by JC Econs tutor:
1. Is smoking the best context to offer a example for the S’pore context?
2. The above example considers the MSB to be less than MPB for case of smoking. We don’t have to explain it this way. We can actually consider this as a divergence between private and social costs instead.
3. Is one market failure sufficient?
JC Economics Essay – Taxation to Tackle Negative Externality in SG
Thesis: Singapore government should use taxes when dealing with the market failure associated with negative externalities.
Define taxes: Compulsory payment made to the government by firms or individuals.
A form of market-based solution.
How it works?
The Singapore government imposes an indirect tax equivalent to the amount of MEC (E2B).
The imposition of taxes increases the firm’s cost of production. This would result in a lower profit per unit. Hence, at each possible price, fewer units will be supplied. shown in Figure 2, the fall in supply is represented by the shift in the supply curve from SS to SS1. This results in an increase in equilibrium price of cigarettes from P to P1 and a fall in equilibrium quantity from Qm to the socially optimal level, Qs.
The higher price will also reduce the amount consumed to the optimal level. (Sketch diagram below on your own as a practice.)
Advantages of using taxes:
Since it is a market-based solution, it can easily implemented to reduce consumption. Reflects the true external cost to the society as the amount of tax can be varied based on the external cost => thus, it is equitable and fair since it is based on polluters pay principle. Increase in Singapore government revenue which can help to compensate the affected parties.
Anti-Thesis: Singapore government should also use other economic policies when dealing with the market failure associated with negative externalities.
Limitations of using taxes:
1. Difficulty in determining the exact value of MEC:
a. difficult to monetize and estimate => difficult to ensure accuracy in the amount of tax imposed;
b. Over-taxing => under-allocation of resources;
c. Under-taxing => over-consumption will still exist in the economy although the market equilibrium is now closer to the socially optimal level of output
Limited effectiveness in dealing with demerit goods (Negative externality In Cn):
Goods which the government believes that consumers will over-consume if provided by the market due to the presence of negative externalities in consumption and information failure. E.g. Cigarettes
Low PED
Success of reducing the amount of cigarettes consumed is highly dependent on the PED of cigarettes. Demand of cigarettes is price inelastic due to the addictive nature of the good => the amount of taxes must be high enough to have a significant impact on reducing the quantity demanded of cigarettes. For example in Singapore, the government has increased the amount of taxes on cigarettes over
the years.
However, when taxes are excessively high, it might encourage smuggling activities.
Information Failure
While the imposition of taxes addresses the problem of negative externality in consumption, it does not address the problem of information failure. As such, there is a need for the government to complement the imposition of taxes with other policies such as education/ regulation to effectively achieve efficiency in resource allocation. This is because it will target both supply of and demand for cigarettes respectively.
Adverse impact on economic performance
Given that S’pore is highly dependent on exports for growth, when tax = MEC is imposed to correct negative externality in production => increase COP => increase Px => erode the export competitiveness of the country, especially if the tax imposed are excessively high => assuming PED for X > 1 => fall in export revenue hence AD => negative impact on growth, current a/c balance.
(Qn: Is this point a very strong point?)
Thus, there is a need for the government to complement taxes with other policies in order to correct market failure caused by negative externalities.
Government intervention could also be in the form of legislation, education and provision of information.
A. Legislation
Command and control measure; Legislations are rules and regulations for compliances.
The government could control consumption/business activities through licenses, setting standards, administrative rules and laws. Government will conduct monitoring and checking to ensure adherence. Punitive measures will be established for violators. For example, in SG, the government has banned smoking in public areas such as coffee shops, playground and HDB lifts. Any person caught smoking would be fined.
Moreover, with the new enhanced Tobacco Product Regulation, the government lowers the maximum allowable tar and nicotine yield limits. Provision of information – cigarette producers are required by law to issue health warnings about the harmful effects of smoking on their packaging.
The fear of punitive measures makes smokers and cigarette manufactures to adhere to the law. This helps to reduce consumption level to the socially optimal level and thus ensure efficiency in resource allocation.
Comparison to taxes Advantages of legislation
Legislation might be a more powerful tool in correcting market failure as it is mandatory. Moreover, it also seeks to address the information failure that exists for demerit goods. It would be more effective in reducing the consumption of cigarettes to the socially optimal level as legislation is directed to both the producers of cigarettes and individual smokers. Producers are to comply with the new standards of cigarettes, whilst consumers are now more aware of the external costs of smoking and faced greater restrictions on the places that they can smoke.
Limitations of legislation
Laws are blunt instruments as compared to taxes =>> not customized to the needs and circumstances of the individual.
To ensure adherence => requires large amount of manpower to monitor and enforce => high opportunity cost unlike taxes which are easily implemented as it is a market-based solution. The penalties for violations also need to be severe enough for the measure to be deterrent.
b. Education and provision of information
The direct provision of information by the S’pore government may help to discourage the consumption of smoking. For example, in Singapore, the government promotes public awareness on the harmful effects of demerit goods such as smoking or alcohol through campaigns and the media.
Once individuals are fully aware of the full private cost, they would demand less of the good. The demand curve would shift to the left and reflects the true private benefit of the good to the individual, and thus, the right amount of the good is consumed => addresses the problem of over consumption of demerit goods.
Comparison to taxes Advantages of education
As compared to taxes, the provision of information is targeted mainly to the consumers. The government seeks to reduce the demand for cigarettes by providing consumers with adequate and relevant information. Unlike taxes, the provision of information by the government would not have disincentive effects on the consumers.
Limitations of education
However, education and provision of information would not be effective in correcting market failure cause by negative externality especially negative externality in production. This is because there are no incentives for firms to reduce their production to the socially optimal level. Thus, it would be more effective in addressing the problem of information failure.
Moreover, the effectiveness of the policy is similar to the relevance of PED in assessing the effectiveness of taxes in reducing quantity demanded. If a good is addictive in nature, it would take more than just providing information to consumers to reduce the demand of cigarettes to the socially optimal level. However, in the case of taxes, the government could simply increase the amount of tax to achieve the intended impact.
In addition, education is a long-term and costly process to undertake with no certain outcomes. Financing public education may also require high taxes which may have disincentives effects on work, investment and thus affect economic growth.
Evaluation:
1. Which is the preferred policy?
2. Is the policy choice clear cut? Dies it depend on the context?
Conclusion
There are various ways in which the government could intervene in correcting market failure. The type of policy is dependent on the source of market failure. However, since each policy has its own limitations, it would be best to use the different policies to complement one another in ensuring a more efficient allocation of resources.
The S’pore government has been adopting a multi-pronged approach in correcting market failure associated with negative externalities. As in the case of smoking, the government has been actively increasing the amount of tax imposed over the years and have been ensuring that Singaporeans are fully informed of the external cost of smoking through mass education and campaigns.
Moreover, since SG is a small and open economy, imposing taxes alone would affect its country’s competitiveness in the international market and thus impede growth.
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