Introduction

Define market failure and state the possible causes of market failure – of which negative externalities, imperfect information and income inequity would be explained. 

Market failure is a situation whereby the free market, in the absence of government intervention, fails to allocate resources efficiently, resulting in societal welfare not being maximised. Negative externalities are external costs incurred by 3rdparties not directly involved in the production or consumption of a good or service, of which these costs are unaccounted for in the free market. Imperfect information is a case whereby one party in the market has a larger access or has superior information in a market as compared to another and can make decisions more rationally. Income inequity refers to the extent to which income earned within a country is distributed unevenly among the population.

 

Causes of market failure – Negative Externalities, Imperfect Information and Income Inequity 

 

Figure 35a: Negative Externalities in Market for Cigarettes   

   

Figure35b: Imperfect Information in Market for Cigarettes

 

Negative externalities

Negative externalities are external costs incurred by 3rdparties not directly involved in the production or consumption of a good or service, of which these costs are unaccounted for in the free market.  

Marginal private benefits enjoyed by consumers include stress relief provided from smoking
Marginal private costs imposed on consumers includes the cost of the cigarettes and damage to their own health such as increased risk of lung cancer.
Marginal external costs exist due to negative externalities generated such as such as increased second-hand smoke causing health complications to people around such as lung related problems. The presence of external costs means that there is a divergence between marginal social costs and marginal private costs.

With reference to figure 35a, which shows the market for cigarettes,

• Free market output would be at Qm where MPC=MPB, since producers would only consider their own private costs and benefits when choosing to consume cigarettes and not the external costs

• Socially desirable level of output is at Qs where MSC=MSB.

• Since Qm>Qs, overconsumption of cigarettesoccurs and deadweight loss of area ABC is generated

• Due to allocative inefficiency, market failure exists the market for cigarettes

 

Imperfect Information 

A situation whereby one party in the market has a larger access or has superior information in a market as compared to another and can make decisions more rationally.

Imperfect information arises due to underestimation of health-related costs in cigarette consumption, such as increased risk of cancer, pneumonia and cardiovascular diseases. With reference to figure 35b, which shows the market for cigarettes

• Perceived MPC higher than actual MPC due to underestimation of costs or harmful effects of cigarettes 

• Consumption of goods occurs at Qm based on perceived MPC instead of basing consumption on actual MPC at Qs

• Overconsumption occurs, as Qm amount of goods is consumed instead of Qs 

 

Income inequity

1.     In the case of income inequity, the problem arises due to the way price mechanism functions.

2.     The free market allocates resources based on demand and supply.

3.     Effective demand is defined as demand with both the willingness to purchase backed by purchasing power. This means that the rich votes with the “dollar”.

4.     With purchasing power, the market will produce goods that the rich want to purchase, whereas necessities required by the poor may not be reflected in the market at all if they cannot afford to pay for it.

5.     Suppliers will produce goods based on what is wanted by the rich and not the poor.

6.     This leads to market failure due to underconsumption by the poor of certain goods like healthcare & education.

 

Alternative Policies in addressing Negative Externalities

Taxes vs Legislation

1.      Taxes are often used to manage market failure arising from negative externalities.

·       e.g. In Singapore, a tobacco tax of 42.7 cents per gram is imposed on cigarettes. This increases the marginal private costs and shifts the MPC to the left, reducing the consumption of smoking

2.      While taxes are easy to implement for goods like cigarettes, it may not be very effective in reducing consumption since demand for habit-forming goods is price inelastic – taxes may have to be frequently revised to account for income changes.

3.      Another policy that can be used would be legislation.

4.     In Singapore, the Smoking (Prohibition in Public Places) Act bans smoking in public places.

5.      This reduces the negative externalities since smoking is banned in such crowded areas, it reduces the chances of 3rdparties being affected by 2ndhand smoke and therefore helping to reduce the negative externalities generated.

6.      Such legislation can help to directly reduce negative externalities but it is challenging to enforce,considering the high monitoring costs to ensure that smokers comply with this rule all the time.

 

Alternative Policies in addressing Imperfect Information

Education campaigns vs Legislation

1.      Education campaigns: can be carried out in schools, through the media such as TV commercials, print advertisements on newspapers and social media

·       e.g. the government can run campaigns to educate the public on the potential negative health impacts of smoking, such as increased risk of cancer 

2.      Such a policy can be costly to implement and the problem with such policies would be that it may be hard to reach out to certain groups of people such as the elderly and the illiterate.

3.      Another policy would be through legislation 

·       e.g. An outright ban on smoking for minors – in Singapore and many other countries, the minimum legal age to smoke would be 18. Those under 18 are likely to suffer from the problem of imperfect information

·       This means that this group might be the ones who would likely overconsume.

4.     Such a policy may not be easy to enforce since minors can bypass this law, by getting friends who are older to purchase on their behalf.

 

Alternative Policies in addressing Income Inequity

Progressive income taxes vs transfer payments

1.     The percentage tax levied on personal income can be increased based on income levels.

2.     The higher the income, the higher the percentage tax levied.

·       e.g. In Singapore the first $20,000 of annual income is taxed at 0%. The next $10,000 is taxed at 2% 

·       Going further up, any income above $320,000 is taxed at 22%

3.     This will help to reduce income inequality since it reduces the after-tax income for the higher income earners.

4.     At the same time, transfer payments can be made directly to the poor based on their income levels.

5.     This can come either in the form of cash or subsidies for essential services such as education or healthcare.

·       e.g. In Singapore, we do this in the form of Workfare Income Supplement and GST Offset Vouchers. This will increase the disposable income of the poor.

 

Conclusion

It is likely that in most countries, a range of policies would be used to tackle the various market failure issues since most policies, when implemented on its own, still has limitations.

 

Comments

There are many different causes of market failure, but it is not reasonable to expect that we cover all causes and have at least 2 policies addressing each cause of market failure. As such, my approach is to choose 3 and deal with the 3 accordingly.

Also, when we discuss alternative policies, it would be best if we can decide which policy we prefer from the 2 suggested and justify why.