JC Economics Essay PED & Imperfect Information for Demerit Goods Model Answers
Oftentimes, Cambridge examiners and JC teachers set relatively tough essay questions by mixing concepts across topics. An example is this: Price Elasticity of Demand and Market Failure! Price Elasticity of Demand (YED) relates to effects of changes in quantity demanded, whereas Market Structures highlights the reasons for under- or over- provision of goods and services in a market. The following essay question illustrates the combined analysis of both concepts.
Question (Modified from past year Cambridge – UCLES – SEAB exam question)
There is a growing change in taste and preference towards sugary drinks among local consumers. The Singapore health authorities is planning to impose a tax on sugary drinks in response to the growing concern over diabetes and obesity.
(a) Explain the likely impact of both changes on the total expenditure of S’pore consumers. 
(b) Discuss whether a policy of indirect taxes on soft drinks is appropriate in addressing the obesity problem?
Consumer Expenditure & Price Elasticity of Demand
Identify the two changes mentioned in the preamble: Growing change in T&P towards soft drinks (increase in demand) and imposing an indirect tax on soft drinks (decrease in supply) Define indirect tax on soft drinks: Tax imposed on expenditure on goods and services. This tax is levied on producers and paid by the producers to the government. Define total expenditure by consumers: Equilibrium Price paid by consumers x Equilibrium Qty consumed by consumers
Likely impact Determined by the extent of changes in demand and supply in the market for soft drinks and PED relative to PES
Growing change in T&P towards soft drinks
T&P affects consumer’s desire to consume goods and services. A growing change in T&P towards soft drinks in the SG may be due to intense advertising efforts by soft drink producers, which is designed to cause shifts in T&P by S’pore youths towards soft drinks. In particular, these efforts seek to influence popular culture and encourage soft drinks consumption. This change in T&P towards soft drinks will cause the demand for soft drinks to increase, since at each price level, the quantity that the consumers are willing to purchase has increased, thereby shifting the demand curve to the right, shown by DDO to DD1 in Diag. 1. Indirect tax on soft drinks imposed by S’pore government
Indirect tax imposed on producers will cause the cost of soft drinks production to increase. For firms to produce the same quantity of soft drinks after the imposition of the tax, they must receive a price to recoup the tax being levied. This tax leads to an increase in the minimum price at which producers are willing and able to produce a certain quantity of soft drinks, ceteris paribus. As such, this tax will cause the supply of soft drinks to decrease. The quantity that producers are willing and able to offer for sale at each given price decreases, hence shifting the supply curve to the left, shown by SSO to SS1 in Diag. 1.
(Sketch it on your own, as an exercise.)
The effect on total expenditure as a result of the indirect tax is dependent on the price elasticity of demand (PED) for soft drinks. For the case of demand for soft drinks being price inelastic due to the habit forming effect of drinking soft drinks, the increase in price will bring about a less than proportionate decrease in quantity demanded, leading to a rise in total expenditure, since the fall in total expenditure due to a fall in quantity demanded is less than the rise in total expenditure due to a rise in price.
*Candidates may also argue a case of PED < 1
Extent of shift of demand and supply curves (combined effect on equilibrium price and quantity) *Candidates should justify the extent of shift using either cases with plausible economic reasoning.
Case 1: increase in demand > decrease in supply and IPED| is <1 and IPES) is >1 Reason: Possible intensive advertising of soft drinks in the SG hence large increase in T&P towards soft drinks especially among youths.
Equilibrium price of soft drinks: increases Equilibrium quantity of soft drinks: increases
Total expenditure: increases
Price adjustment process:
At the original price PO, there is a shortage (Qd > 0s) such that there is an upward pressure on price as consumers bid up product prices. As price begins to rise in response to the shortage, consumers and producers re-make decisions. The rising price is a signal to consumers to reduce their quantity demanded while incentivizing producers to increase their quantity supplied. With the movement up along DD1 and SS1, a new equilibrium is reached where Qd equals Qs and the shortage is eliminated The equilibrium price of soft drinks increases to P1 and the equilibrium quantity of soft drinks decreases to Q1.
Impact on Q and TE: Since the increase in demand is greater than the decrease in supply and demand is relatively more price inelastic than supply, then total expenditure for consumers will increase as POQ0 < P1Q1. This is because the rise in expenditure due to the increase in price is greater than the fall in expenditure due to the fall in quantity consumed.
Due to the tax on soft drinks, consumer expenditure will increase assuming an increase in demand greater than a fall in supply.
L1: Serious conceptual errors and/or lack of economic framework.
L2; Superficial attempt to link demand and supply concepts to preamble No link drawn to impact on total expenditure of consumers Sound use of economic framework
L3; Answer is not adequately developed in terms of impact on total expenditure for consumers. No application of extent of shifts or PED/PES Competent use of economic framework with detailed discussion of combined shifts of dd/ss curves (including extent of shifts justified) as well as application of PED/PES
JC Econs Examiner’s Comments:
1. Market failure is not required in part (a). If a candidate explains the market failure diagram in part (a) but not in part (b), part (b) will be marked as if he/she did not provide a market failure framework because marks are not transferrable between parts.
2. Better linkages between textual explanation and diagram are required; Candidates should refer to the demand and supply curves according to how they label the curves in their diagram and to also identify the areas that represent the original and new total expenditure. Candidates should avoid listing down ideas without explaining each idea or establishing linkages between ideas. Linkages between ideas can be established through the use of connective words like “because”, “leads to”, “hence and so on. Key linkages in explanation need to be present in order for candidates to move to L3:
3. Candidates to need explain how and why an increase in taste and preference will lead to an increase in demand which is reflected by shifting the demand curve to the right. For instance, an increase in taste and preference is a non-price determinant which will cause more consumers to want to buy the good, hence this increases the quantity demanded for soft drinks at every price level, shifting the demand curve to the right. Or an increase in taste and preference is a non-price determinant which will cause consumers to be more willing to pay a higher price for each and every unit of soft drinks, hence shifting the demand curve to the right.
4. Candidates need to explain how and why an indirect tax will shift the supply curve to the right. For instance, when an indirect tax is imposed on soft drinks, the costs of producing an additional unit of soft drink will increase, hence producing soft drinks will become less profitable which will cause producers to cut back on production because they have less incentive to produce as much, hence quantity supplied at every price level will fall and supply curve shifts leftwards. When explaining why price will increase, candidates need to explain the market adjustment process.
5. The rightward shift in demand curve and leftward shift in supply curve will lead to a shortage at the original price level. Consumers will signal to producers that they want more of the good by bidding up the price of the good or through their willingness to pay a higher price for the good. Producers will be incentivised by the higher price and respond by increasing quantity supplied of soft drinks. Price will increase until the shortage is eliminated.
6. candidates are advised to go straight into analysing the impact on P. Q and TE arising from simultaneous shifts in demand and supply curves, rather than analysing the impact on P, Q and TE arising from shift in demand curve and supply curve separately.
7. To enhance the quality of the scripts, candidates are advised to suggest whether the rightward shift in demand is more likely to outweigh the leftward shift in supply or vice versa and to explain why.
8. There were a few glaring conceptual errors that candidates tend to make: A tax on soft drinks is an indirect tax and not a direct tax. Tax on goods and services is an indirect tax while a tax on personal income / firm profits is a direct tax.
9. A significant number of candidates did not shift the supply curve when explaining how an indirect tax works. A few even shifted the demand curve which was clearly incorrect. o Confusion between changes in quantity traded and quantity demanded/supplied hence shifts vs movements along the demand/supply curve.
10. Quite a number of candidates illustrating upward-sloping demand curves and downward-sloping supply curves in their diagrams. Candidates are reminded to check their answers at the end of the paper to prevent such glaring errors.
11. Candidates need to be consistent in their explanation and diagrammatic illustration: When assuming a specific tax, there should be a parallel upward shift of the supply curve. When assuming an ad valorem tax, the supply curve should pivot upwards.
Indirect Taxation, Demerit Goods & Imperfect Information
There are many possible causes of obesity in SG One of the main causes is the overconsumption of sugary drinks such as soft drinks by the populace. To correct this overconsumption problem, the S’pore government has decided to implement a tax on soft drinks in an attempt to lower obesity rate in the SG.
Definition of market failure: the failure of the free market to achieve allocative efficiency, resulting in over-allocation or under-allocation of resources relative to the socially efficient level or to achieve social goals. Sources of market failure: Imperfect information and negative externality from consumption. The extent to which a tax is appropriate to address the obesity problem. the SG depends on whether it can correct the root source of market failure as well as whether there are other possible causes of obesity besides overconsumption of sugared soft drinks. Sources of Market Failure (“Candidates are only required to give detailed explanation of one of the two sources of market failure for this part of the question)
1. Imperfect Information
Consumers overestimate the private benefit of consuming soft drinks and end up overconsuming from society’s point of view (Qe-Qs) Over-consumption. of the good will result in a welfare loss to society represented by area ABC as the benefits gained in consuming Qe units of soft drinks is less than the resources used in producing Qe units of soft drinks. Government takes on a paternalistic role and judge that individuals may not act in their own best because of imperfect information on the harmful effects of overconsumption of soft drinks. Consumers may be ignorant about the long term implications on their health as a result of obesity from overconsumption of sugared soft drinks.
E.g. Parents are ignorant of the sugar content in soft drinks that their children are consuming hence may allow their children to overconsume soft drinks which lead to childhood obesity problems.
2. Negative Externality from Consumption
Costs are imposed on 3rd parties from the consumption of soft drinks by private individuals who do not take into consideration the external costs (Distance AB ) they incur when they overconsume soft drinks from society’s point of view (Qe – Qs).
The overconsumption of soft drinks generates negative externality in the form of burden on taxpayers who have to incur the cost of medical bills for obesity-related illnesses under the SG National Health Services (NHS). In this case, non-drinkers of soft drinks (3rd parties) have to incur the cost of higher taxes but they are not compensated by the drinkers of soft drinks.
If left to free market forces, Qe is consumed where MPB = MPC. On the other hand, the socially optimal level of consumption of soft drinks is Qs where MSB = MSC. A deadweight loss of ABC is generated in the overconsumption of soft drinks if left to free market forces.
Thesis: A tax on soft drinks is appropriate to address the obesity problem in the SG. *Negative externality from consumption explanation
The levying of a specific tax equivalent to the monetary value of the marginal external cost (Distance CD, sketch diagram yourself) imposed on society will allow soft drink consumers to internalize the external costs. When a specific tax of CD which is equal to MEC at Qs is imposed on the seller of soft drinks, it leads to an equal increase in the marginal private costs of production, resulting in a decrease in supply. This will cause a rise in the market price of soft drinks from PO to P1 and a reduction in the final quantity traded and consumed in the market to the optimal level of Qs, where MSB = MSC. The deadweight loss (ABC) is eliminated and the overconsumption of soft drinks is corrected as shown in Diag. 4.
Imperfect information explanation
The imposition of an indirect tax (Distance CE shown in Diag. 5) on producers of soft drinks will cause the supply of soft drinks to decrease hence increasing the equilibrium price of soft drinks from PO to P1 as mentioned in part (a) of the essay. This will cause the quantity demanded for soft drinks to decrease from Qe to Qs which is the socially optimal level from society’s point of view, hence eliminating the deadweight loss to society as shown in Diag. 5 since the overconsumption issue has been addressed.
Antithesis: A tax on soft drinks is not appropriate to address the obesity problem in SG
Limitations of taxation policy to correct market failure such as difficulty to accurately value the external cost due to imperfect information as well as the effectiveness of the tax to lower consumption levels of soft drinks depends on the PED. As seen in part (a), given the increase in T&P towards soft drinks in the SG, the quantity of soft drinks may not necessarily decrease despite the imposition of the tax as it depends on the extent of increase in demand from changes in T&P relative to the decrease in supply as a result of the indirect tax. The PED of soft drinks in the SG market also matters to determine whether a tax can address the overconsumption in SG problem in SG.
Use of indirect tax to correct the overconsumption problem due to imperfect information cannot cannot address the root cause of this source market failure as consumers are still ignorant of the harmful effects of overconsumption of soft drinks on their health. There are other possible causes of obesity apart from the overconsumption of sugared soft drinks which means that a tax on soft drinks is no longer appropriate should these other causes be the predominant reasons for obesity in the SG. Overconsumption of junk food (e.g. fast food), lack of exercise, stress, genetics.
Other government policies besides a tax on soft drinks can be used by the SG government to address the obesity problem in the country. Education / healthy lifestyle education campaigns to correct imperfect information
Limitation: Takes a long time to see effect on soft drinks consumption. Effectiveness depends on how receptive the S’pore public is to such campaigns. Direct provision of free health checkups to identify children and teenagers who are at risk of becoming obese so that they can embark on healthy lifestyle habits starting young. Limitation: Burden on government budget.
Government regulations should also be in place regarding advertisements of junk food and sugared soft drinks on children television channels and around school zones. Limitation: Difficult to enforce in reality unless regular patrolling by authorities is conducted. Sports and games subsidies to encourage active lifestyles among Britons similar to the ActiveSG credits given to Singaporeans by the government. Limitation: Burden on government budget.
*Candidates are not required to provide in depth economic analysis of how the other policies work to correct the sources of market failure.
Long run economic implications of obesity to the SG can come in the form of heavier burden on taxpayers from health spending, lower productivity of workforce because of health-related issues arising from obesity and lower non-material standard of living from lower life expectancy etc.
Marking Scheme for H2 Econs Essay:
L1: Glaring conceptual errors Did not address the question, superficial analysis with no/inappropriate theoretical framework No anti-thesis,
L2: Appropriate theoretical framework used: externality/imperfect info diagram Incomplete underdeveloped analysis in explaining the impact of taxation to correct either sources of market failure, OR Balanced answer but no mention of sources of market failure max; No contextualization of limitations of taxation specifically to the issues regarding obesity in antithesis max. 9 Balanced answer with broad scope of coverage.
L3; Analysis of strategies are contextualized and relevant to SG Well elaborated analysis of how a tax on soft drinks can correct the overconsumption issue with appropriate theoretical framework Clarity of thought and coherent argument Answer has sufficient breadth and depth with at least one other cause of obesity
E1: At least one other policy to address obesity issue Pros and cons of policy addressed
E2: Judgment substantiated with analysis Economic impact on larger society [macroeconomic impacts etc, policy tradeoffs (Micro vs Macro aims)]
Remarks by JC Econs Teacher:
1. Candidates often start off their essays about soft drinks being a demerit good but failed to explain and justify why it is so. Candidates should take note that not every good that generate negative externality is a demerit good. Instead, it is the government taking on a paternalistic role and perceives that consumers over-consume such goods due to imperfect information or pursuit of self-interest in the case of negative externalities hence classifying these goods to be demerit goods.
2. Candidates should be aware that the two sources of market failure, externalities and imperfect information, are different. Externality is linked to third party effects argument and the main reason why externalities are ignored is due to pursuit of self-interest. Imperfect information, on the other hand, is linked to the personal well-being argument. Candidates can choose either framework but if candidates provide both externality and imperfect information models, they must explain how and why a tax can reduce overconsumption arising from both negative externalities in consumption as well as from imperfect information.
3. There are many different approaches to the externality framework which can cause confusion to the marker when candidates do not explain what the curves in their framework refer to. Hence, candidates are advised to explain clearly and explicitly what the curves in their framework refer to and why they choose to split a certain set of curves and not the other curves in the given context. They are advised to use the framework in the school’s lecture notes.
5. The externality framework the sch lecture notes is an extension of the market demand and market supply framework. The market demand reflects the MPB of consuming soft drinks while market supply reflects the MPC of producing soft drinks. Negative externalities are generated from the consumption of soft drinks because by consuming soft drinks and becoming obese, consumers tend to suffer from heart related diseases. Hence they have to seek treatment more frequently and incur medical costs which can impose a strain on public healthcare expenditure and the SG tax payers because the SG government has to channel more funds to subsidising public healthcare services and these funds could have been used for other projects like education or infrastructure or reducing income inequality. Hence, the society’s benefit is lower than the consumers’ benefit from consuming soft drinks but the consumers do not care about the negative MEB generated from consumption because of the pursuit of self-interest.
A consumption externality will cause a divergence between the MPB curve and the MSB curve and since the marginal external benefit from consuming soft drinks are negative, MSB will be less than MPB. Assuming no production externalities, MPC of production (or supply curve) is equal to MSC. In the above framework where the MPC curve in the diagram reflects the MPC of production (supply curve), to avoid confusing the marker, it is better to use the term negative MEB rather than MEC.
6. Candidates need to explain clearly what these third party effects are. A significant number of candidates argued that consumption of soft drinks will lead to obesity which will lead to health related problems and a loss in productivity. There was no further elaboration as to how and why third parties will be affected by the consumer’s poor health and loss in productivity. The consumer’s poor health and loss in productivity could lead to the consumer being absent more frequently from work and hence, receiving lower bonuses and performance ratings, which are examples of negative impact of obesity on the consumer himself or herself, not third party effects. Candidates need to point out that the consumer’s poor health may result in him or her seeking treatment at public hospitals which are heavily subsidised and as a result, this imposes a heavy burden on the government and taxpayers (third parties). Loss in productivity of the consumers at work can result in lower profits for the firms and in turn the employers (third parties).
7. A few candidates argued that education can reduce overconsumption arising from externalities because it creates awareness about the externalities but if the reason for neglecting the externalities is due to pursuit of self-interests, consumers can be more aware but they still don’t care. In order for education to be effective in this case is for education to be able to change the mind set and value system of consumers so that consumers will have greater empathy and civics consciousness and be more sensitive about how his actions will affect others and seek to change his behaviour to minimise the negative impact on others.
8. Candidates need to be aware of the difference between distorting and displacing the price mechanism. Indirect tax distorts the price mechanism but does not displace the price mechanism. For imperfect information, candidates are also advised to use the framework given by the Institution’s set of lecture notes to avoid confusing the marker. Again the framework given by the Institution’s set of lecture notes is based on the demand and supply framework whereby the demand curve reflects the MPB from consuming the good while the supply curve reflects the MPC of producing the good. Hence when there is imperfect information regarding the MPB from consuming the good which results in the consumers overvaluing the benefits from consuming the good, demand under imperfect information is higher than demand under perfect information or the perceived MPB is higher than actual MPB.
9. Candidates need to provide an explanation rather than a list of pros and cons of the tax policy. For instance, why is it an advantage that an indirect does not displace but distorts the price mechanism? Why is it difficult for the government to measure the negative MEC generated from consuming soft drinks? Why is it a disadvantage that the demand for soft drinks is price inelastic? Why is it a disadvantage that the government has to implement a very high tax when demand is price inelastic?
10. A number of candidates focused too much on other policies, like education or legislation, and neglected providing or developing the analysis on the tax policy within the market failure framework. Other policies are credited under evaluation and evaluation is worth maximum 4 marks. To score maximum evaluation marks of 4 marks, candidates need to consider the context of SG and broader implications for the SG economy (For instance, candidates can consider the extent of impact on the SG soft drink industry and the Singapore economy. Candidates can also consider if there are any trade-offs between government objectives and consider the priorities of the government.) To score evaluation 3 or 4 marks, the evaluation must not be listed but must be explained and supported by economic analysis.