JC Economics Private & Merit Goods Essay Model Answers
Do you know that, for all the types of market failure, divergences between private and social benefits / costs are commonly tested in essay exam Paper 2 (Syllabus 9757) ? For this topic of Market Failure, note that merit goods and positive externality have overlaps, although they are not identical. Similarly for demerit good and negative externality. Also realise that Cambridge likes to test this distinction for H2 Econs assessment and tests. (equally true for H1 Econs pupils).
Here is a sample question modified from GCE A-Level past year qn.
Question
(a) Explain why the markets for both public goods and for goods where externalities are present fail to work optimally. [10]
(b) In Singapore, entry to The National Gallery and many museums are free of charge. In contrast, ticket entry to national museums and art galleries in Japan is very expensive. Examine the economic rationales for these two different approaches. [15]
Source: National Gallery of S’pore
JC Economics Essay – Negative Externality & Public Goods
The essay response for private and merit goods is in part (B).
Suggested Answer:
Introduction
Government intervention advocated as the above markets (for public goods and for goods where externalities are present) fail Market failure occurs whenever the price mechanism fails to allocate resources efficiently and equitably. Therefore, the government needs to take actions and provide a non-market mechanism to allocate scarce resources to bring about improved outcomes.
- Efficiency: Efficiency in resource allocation can only be achieved if there is allocative and productive efficiency at the society level. Allocative efficiency is the situation where limited resources are allocated to the production of the goods most wanted by the consumers. This is achieved when all goods and services are set at prices equal to their marginal costs of production (P-MC) Productive efficiency occurs when the products are produced with the least possible scarce resources. This is achieved when production of all the goods and services are achieved at the lowest unit costs possible.
- Equity: Equity has to do with “fairness”. Fairness in the allocation of resources occurs when income & wealth are evenly distributed.
Assuming a perfect market, the price mechanism alone will be able to allocate resources efficiently such that the right amount of the right good is produced using the least cost, thereby maximizing society’s welfare. However, in the case of public goods and goods with externalities, the price mechanism will not be able to allocate efficiently, hence government intervention is necessary to improve outcome.
Public Goods
Goods that exhibit characteristics of non-excludability and non-rivalry in consumption. The feature of non-excludability of public good means those non-paying consumers can benefit without having to pay for it. E.g. once the traffic light is set up, everyone is free to use. It is almost impossible to exclude anyone from using it. The feature of non-rivalry means that the consumption of the good by one user will not diminish the benefits available to other users. The usage of traffic lights by one pedestrian will not affect the usage of the traffic lights by other users. Public goods tend to be provided by the govt if left to the market as no firms will undertake the production.
Non-excludability: leads to the free-rider problem, hence no dd will be expressed by consumers → impossible to determine mkt price; Non-rivalry: The opp. cost of admitting one more user is 0, or MSC =0 ➜ socially optimal price = 0 where MSB = MSC =0 ➜ socially optimal mkt price = 0. With 0 market price, the good will not be provided by the private sector at all as firms are profit motivated.
Free market without government intervention, will not allocate resources for the provision of public goods which are essential for the economic welfare of the society as no private firms will be willing to supply these goods at zero price. Thus, the government has to intervene to undertake the provision due to such missing markets
Externalities
Occurs when a decision causes costs or benefits to third party and in which they are not compensated for. The existence of externality results in an inefficient allocation of resources. Products are over-produced or over-consumed where there are external cost and under-produced or under-consumed where there are external benefit. Examples of goods that exhibit negative externalities in consumption include cigarettes and alcohol. The negative externalities of smoking: Passive smokers have a 25% to 30% higher risk of developing lung cancer compared to people who are not exposed to cigarette smoke at all.
Smoking doesn’t only pollute the air. Much of the waste collected each day from our cities and streets is made up of cigarette butts, cigarette boxes and plastic wrappers. Accidents with lighted cigarettes and matches have caused fires at homes, offices and public places. Lives are often lost and property destroyed as a result All these are the marginal external cost (MEC) which is actually the distance of E1B. The existence of MEC causes a divergence between MSB and MPB, i.e. it causes the MSB to be lower than MPB.
The Marginal Private Benefit (MPB) of the smoker is represented by D1, this would include the satisfaction the smoker derive from smoking, however this marginal benefit do not take into consideration the negative externalities that comes along with smoking as the individual is not concerned with the negative externalities. Thus the market equilibrium quantity of cigarettes consumed would be at Q1 where MPB = MPC.
Without intervention by the government, external costs/benefits will not be factored into the consumers/firms’ decision and overproduction/underproduction results. The society will produce and consume up to MPB-MPC at Q2. However, socially optimal output occurs where MSB-MSC at output Q2. The market fails as at the last unit produced and consumed Q2 the MSC exceeds the MSB of production. That is, the value the society placed on the last unit of the good is lower than the opportunity cost to society of producing it. All units between Q1 and Q2 should not have been produced from society’s point of view as for each the social benefit (MSB) enjoyed is smaller than cost of production (MSC). The market outcome is less than the socially efficient level. These create deadweight loss to society as resources are not allocated efficiently. Government intervention through taxes/subsidies is likely to improve the resource allocation and thus improve the society’s welfare.
Conclusion:
While government intervention in the 2 scenarios above is justifiable on the premise that society welfare can be enhanced, in reality, government intervention ma not necessarily lead to optimal resource allocation i.e. economically efficient outcome. Effectiveness of the government depends on the govt’s ability to rightly estimate the extent of the externalities or the demand for the public good.
Comment by JC Econs Tutor:
1. Is the answer to the above question complete? What else may be missing?
JC Economics Essay – Merit Goods & Private Goods
Differences in the approach by the SG and Japanese government in their treatment of the museum and art galleries stems from the difference in their perception of the type of good they are to the country. While heavy intervention is observed in the SG, the free market seems to have a free reign in the Japanese museums and art galleries. The SG government might have considered the museums and art galleries a merit good thereby intervention is necessary to ensure sufficient resources are allocated to the production and consumption of the good as opposed to the Japanese who sees it as a private good.
On one hand, the SG government views museum as Merit Goods is a good which the government deems to be inherently desirable for the society. If left to the market, it will be underproduced and consumed due to information failure as well as the huge positive externalities that is generated.
Contextualizing the definition to Museums
Information failure: Generates benefits in consumption more than the individuals realise Social benefits of consumption to the community as a whole exceed private benefits and the government judges that market will under provide.
Private benefit undervalued
Consumers under-estimate private benefits they derive from Museum visits Increases the visitor’s awareness on these subjects. For example, a visit to a history museum allows the visitor to better appreciate the present by due to lack of imperfect information understanding the past. External benefit in consumption ignored: Consumers ignore the external benefits generated when they visit museums and art galleries Creates a well-educated and cultured society; improvement/advancement of the well-being of its society; Preservation of national heritage; Generates interests and thus tourism; safekeeping of national artefacts
As a result of the information failure and positive externalities, museum and art galleries visits will be under-consumed if left to the free market and society welfare cannot be maximised.
(Illustrate with diagram on info failure.)
Government intervention in the markets through direct provision and/ or subsidies to encourage consumption towards socially optimal level.
Direct Provision: The SG government might choose to setup/operate some of the museums and art galleries using its government revenue to meet the shortfall. That will allow the museums to admit visitors without charges. In this way, consumption will increase as consumers will visit the museum (at zero price) more frequently and those who would otherwise not be able to afford the visit will now do so since it is free of charge. Subsidies: Alternatively, the SG government may have chosen to partially subsidise a privately run museum and/or art galleries so as to lower the MPC and the consumption of these merit goods will rise, thereby increase society’s welfare.
On the other hand, the Japanese government views museum as private good. Firstly, if museums are left to market mechanism, there will be a market for it. This is because museums display the twin characteristics of a private good, namely, that of rivalry and excludability. Rivalry means consumption by one person reduces the quantity available for others. A museum is non-rival until it becomes congested. One more visitor to the museum with plenty of space does not reduce anyone’s consumption. But once the museums congested, one extra visitor lowers the quality of the product available to everyone else. Excludability means anyone who does not pay for the good or service is excluded from enjoying its benefits. For example, if you don’t pay for the admission ticket you would not allow into museums.
Hence firms are willing to undertake operation of museum and art galleries as market demand will be expressed and profit maximizing price can be determined.
Causes of the high price largely due to
i) The market power that each of these operators possess. Market power of museum operators / art galleries a result of high start up cost and maintenance, or limited competition due to the uniqueness of the product, or possibly high demand relative to supply. Hence Museum tends to operate in an oligopolistic market structure because of high barriers to entry such as the high set-up cost, ownership/accessibility to artifacts and distribution rights to operas, the private firms maximise profit at MC=MR where P>MC. Without state intervention, the admissions ticket will also be priced more steeply as a result.
i). High cost of production. The maintenance cost of museums tend to be high due to the delicateness of the exhibits. On the other hand, the production cost of operas tend to be high due to the economic rent the opera artistes command. Therefore, in order to cover cost so as to continue production, the tickets will have to be priced steeply to generate the necessary revenue. In addition, the scope of economies of scale is rather low, therefore need to charge a higher price to cover the high average costs (AC).
Conclusion:
The differences in SG and Japanese’s approach to the markets lies in the different perceptions they have of the good. In addition, such differences may be further affirmed by the workings of the free market. The Japanese may have been able to find other methods to ensure continued production of the museums despite limited government intervention (e.g. collaboration with tour groups, schools, relying on good will) while in SG there might have been near closure of these museums without government intervention. The different approach could also be a choice of due to national needs (other economic goals/priorities) and resource availability (government budget).
JC Econs Tuition Teacher’s Comments:
Other reasons for SG intervention:
1. The private sector may not operate museums as long as the private cost is higher than private benefit, although the operation of such museums generates substantial external benefits to the society. However, if it is in the hands of the govt, the govt will continue to operate them even though it is suffering losses. This is because govt. decisions are made on the basis of social costs and benefits. The govt will operate the museum as long as the social benefit exceeds the social cost even though AR is less AC. The losses arising from the operation of the museums will be financed out of tax revenue. Alternatively, the govt. may allow the private sector to operate the museums and grant them a subsidy equal to the losses per unit so that the firm can cover its average cost.
2. The private sector may not be able operate a museum because of the high initial set up cost. Only a govt via its tax revenue can finance such a huge investment. Hence, the govt. may set up the museums and let the day-to-day running of the museums be handled by the private sector. SG may not need to intervene so much – subsidies and not direct provision.
3. What other possible rationales can you come up with? The above is not the only possible answer.
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Links: Essay #28 | Essay #30