Written by Ryan Reagan, founding partner of HKExcel Education Limited

Market Failure Sample Essay

Explain why there is welfare loss in cigarette market (10 marks)

Market failure is said to exist when the market is unable to allocation

resources efficiently and achieve allocative efficiency. There is either over-
provision or under-provision. The market of cigarette can be considered as a
type of market failure as it is a demerit good with negative consumption
externality. Negative externalities of consumption occur when consumption
leads to negative consequence to third parties.

The consumption of cigarette does not only lower benefits individual by

worsening their health conditions, but also creates negative consequences
on third parties. Smoking will reduce the benefit by creating negative
effects on health and hence their productivity. Smokers also pollute the
environment and harm others’ health through second hand smoke. As a
result, there is a divergence the marginal social benefit and marginal
private benefit.

Refer to the diagram below showing negative consumption externalities

of smoking:

The market for cigarettes


MSB < MPB due to the negative consequences to a third party when
consuming cigarettes. Free market equilibrium quantity and price are
determined at where MPB = MPC, that is at Q1 and P1. While the social
optimal is attained when MSB = MSC at P* and Q*. In free market, Q1 < Q*
i.e. an overconsumption of cigarettes. Between Q* and Q1, MSC > MSB and
that there is a welfare loss due to over consumption which is equal to the
shaded area.

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Written by Ryan Reagan, founding partner of HKExcel Education Limited
Market Failure Sample Essay

Since there is welfare loss in cigarettes due to over consumption, many

countries such as the US imposes an indirect tax on cigarettes to reduce the
consumption of cigarettes.

Explain the private and external costs in university education (10 marks)

Market failure is said to exist when the market is unable to allocation

resources efficiently and achieve allocative efficiency. There is either over-
provision or under-provision. The market of university education can be
considered as a type of market failure as it is a merit good with positive
consumption externality. Positive externalities of consumption occur when
consumption leads to positive consequences to third parties.

University education benefits both individual and third parties. The

private benefit of university education for the individual includes better
understanding of the world, higher productivity with more knowledge and
skills developed and a higher future income. It also benefits the third party
by raising the quality of human capital. For example, hiring people with
higher education degree, firms’ productivity would increase and hence
boosting economic growth for society. Besides, with higher education level,
people has higher opportunity cost of committing crimes thus reduces crime
rates in the society. 


The positive externalities of consumption can be illustrated by a diagram

below

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Written by Ryan Reagan, founding partner of HKExcel Education Limited
Market Failure Sample Essay

MSB > MPB due to the positive consequences to a third party when pursuing
university education. Free market equilibrium quantity and price are
determined at where MPB = MPC, that is at Q1 and P1. While the social
optimal is attained when MSB = MSC at P* and Q*. In free market, Q1 < Q*
i.e. an under-consumption of university education. Between Q* and Q1, MSB
> MSC and that there is a potential welfare gain due to under-consumption
which is equal to the shaded area.

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Written by Ryan Reagan, founding partner of HKExcel Education Limited
Market Failure Sample Essay

Evaluate 3 policies that the government can deal with negative production
externalities that relate to the environment (15 marks) 


Negative production externalities occur when production leads to

negative consequences to third parties. For example, when a firm produce
pet bottles, it emits pollutants and discharges sewage that pollutes the
environment. Negative production externalities can be illustrated by the
diagram below


From the diagram, we can see a divergence between MSC and MPC due to
the pollution from factories affecting the neighborhoods or polluting the air
and rivers. MSC > MPC, indicating an external cost i.e. negative externality
of production. In free market, market equilibrium is determined at where
MPB = MPC. Therefore, the equilibrium quantity is at P1 and Q1. However,
the social optimal price and quantity is at Pe and Qe which is determined by
MSC = MSB. Since Qe < Q1, we can say that there is an over production of
pet bottles in the free market. Between Qe and Q1, MSC > MSB, thus there
is a welfare loss that equals to the area shaded in green.

Government policies like indirect taxes on output, carbon tax on

emission and tradeable permits would help reduce or even eliminate the
negative production externalities. However, each of them has its upsides
and downsides.

Using an indirect tax on output means for each extra unit of output, the
producer must pay a tax to the government. This would raise the cost of

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 Market Failure Sample Essay
Written by Ryan Reagan, founding partner of HKExcel Education Limited
production for firms, shifting up the MPC curve towards to MSC curve. The
socially optimal quantity is at Q* where MSC = MSB. Since the free market
equilibrium will be determined by MPC = MPB, market equilibrium quantity
falls from Q1 to Q2, approaching the socially optimal quantity Q*. 


The good thing about imposing indirect tax on output is that it generates tax
revenue for government that can be used as subsidies for merit goods.
Nevertheless, revenue for producers would fall which in turn leads to
unemployment. Prices is also raised above P1 to P2 as illustrated in the
diagram above, which is harmful for consumers. In reality, it is very hard to
measure the value of external costs and to set the right amount of tax that
eliminates negative externalities. With incentives to avoid paying higher
price and avoid higher cost, black market may appear. More importantly, the
effects of the tax depend on the PED. If PED is low, producers are less
responsive to changes in price. Hence, there will only be a small reduction
in Qd and large increase in price, meaning that the reduction in pollution
will be limited.
Another way is to tax on emission, which is similar to tax on output but
slightly different. A carbon tax on emission is a tax per unit of emission of
carbon, since producers must pay a tax per unit of emission, cost of
production rises. This shifts up the MPC to MPC+tax and reduce the free
market equilibrium quantity from Qm to Qopt1 which is determined by
MPC=MPB. A further consequence of this tax would be incentivizing the
producers to substitute the polluting energy to cleaner resources to reduce
emission. Hence, negative production externalities would be reduced and
shifting down the MSC to MSC2. Consequently, socially optimal quantity will

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Written by Ryan Reagan, founding partner of HKExcel Education Limited
Market Failure Sample Essay

increase to Qopt2. 


This is advantageous has it is more effective in reducing pollution since

it only increase cost associated with pollution but not overall costs, thereby
incentivize firms to use cleaner production technology. Besides, imposing a
carbon tax can make energy prices more predictable. This is because by
fixing prices of carbon emission, price of fossil fuel becomes more stable
and predictable . This helps businesses to plan ahead. However, practically,
it can be difficult to determine which pollutants are harmful and to quantify
the harm of pollutants so as to set right amount of tax. PED will affect the
effect of the tax. In particular, with a low PED, even if price of using
pollutants increase significantly, the producers will only respond by reducing
the quantity demand by a negligible fraction.

Introduction of tradable pollution permits will also achieve similar

objectives. They are licenses for a specific amount of pollution that
government allocates to polluting firms that are tradable in the open
market. The permits put a cap on the total level of pollution for all firms
and provides incentives for firms to cut pollution and sell permits so as to
reduce costs or raise revenues. Firms with higher pollution level will be
incentivized to lower pollution and reduce expenses on getting the permits.
This can be illustrated by the diagram below

When demand for pollutants increase, the demand for permits will rise,
leading to a higher price of permit. Price of permits are a part of costs for
the firms to produce, hence, this causes a disincentive effects for firms to

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 Market Failure Sample Essay
Written by Ryan Reagan, founding partner of HKExcel Education Limited
use pollutants by raising the cost of production. The tradable permits
incentivize producers to shift to cleaner technology. But there are also
downsides of using such schemes. It is costly for the government to decide
the right amount of a particular pollutant to allow since it is hard to
quantify the harm of pollutant. Besides, unfair allocation to various firms
can easily lead to political disputes and social unrests. With the permits
being tradable, the cost of pollutants will be relatively volatile compared to
using other government policies. For instance, a tradable permit for carbon
will lead to more price fluctuations for fossil fuel. Hence, the price of fossil
fuel and the cost of production becomes less predictable.

By comparing the 3 policies, carbon tax seems to be the most effective

in eliminating negative production externalities due to a number of reasons.
By comparison with indirect tax on output, the carbon tax directly
disincentivises the use of pollutants and encourages the use of cleaner
energy. Unlike tradable permits, it is less political disputable with identical
effect on all producers. Issuing tradable permits may spark off disputes due
to over-allocation and unfairness. But the government must not forget a
huge obstacle in getting accurate measurement of value of externalities.
The difficulty in measuring the value would affect the feasibility of the
policies and effectiveness on dealing with the problem of market failure.
One example is that it would be a challenge for the government to decide
on the right amount of carbon tax to bring about the socially optimal
quantity.

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Written by Ryan Reagan, founding partner of HKExcel Education Limited

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