Unit 3 Market Failure - Suggested Answers

Basic Questions for Market Failure (H2)

(a) Externalities
3. Discuss the case for government subsidising R&D in the
pharmaceutical sector. [10]

Reference to CSQ Skills Package:

Command word: ‘Discuss’ [Pg 27]
Requirements: Give your verdict as to what extent a statement is true, or to what
extent you agree with them. Provide a balanced argument, well-supported by
economic theories & evidences. Come to a conclusion, basing your decision on
what you judge to be the most important and justify accordingly.

Suggested Answer:

Explain the market failure briefly:

1) Private Output: Q, where MPB=MPC

In a free market, the individual producer will produce up to the output level, Q
where MPB intersects MPC, where their private welfare is maximised. 2)
Divergence between MSB and MPB: Explain MEB in context

The presence of the marginal external benefit (MEB that arises from the
existence of the positive externality) causes the divergence between MPB
and MSB such that MSB > MPB. Research and development by
inventors into new technologies generates a positive externality in
production because it creates knowledge that other firms can also use
(when the patent expires). Successful investments in smart technology allow
firms in other sectors to also benefit from this new knowledge by
adapting it for their own use, enabling them to earn higher profits,
without compensating the firm that engaged in R&D.
 Costs / Benefits
Welfare loss

MEBMPC=MSC
C

MSB

MPB

O Q Q* Output of R
and D

3) Socially Optimal Output, Q* where MSB=MSC

Socially optimal output will be where MSB intersects MSC at Q*, where
society’s welfare is maximised.
4) Allocative inefficiency: Under-production or under-consumption At
Q, the MSB is greater than the MSC. This means that the last unit of output
adds more to society’s benefits than it will to society’s costs. Hence, the price
mechanism under-allocates resources to the production of the good, leading
to an under production by Q*Q units.
5) Deadweight loss to society
This leads to a deadweight loss to society, indicated by area ABC. The
market fails because allocative efficiency has not been achieved.

Link to need for government intervention: Hence, the Singapore

government needs to re-allocate resources to increase production levels to
increase society’s welfare.

Thesis: Case for subsidising R&D in the pharmaceutical

sector 1. How subsidies work to increase the level of R&D
Adoption of subsidies is able to encourage R&D by incentivising
pharmaceutical firms to internalise the positive externalities or R&D.
R&D in the pharmaceutical sector brings about positive externalities as
creation of new research knowledge and pharmaceutical drugs allows other
firms to benefit through creating new business opportunities from the
adaption of these new creations. This causes MSB to be greater than MPB.
Assuming that the Chinese government can accurately measure the value of
MEB, imposing a subsidy equal to MEB at the socially optimal output Q*,
where MSB=MSC, would lower producers’ marginal private costs (MPC)
of investing in R&D and incentivise the producers to internalise the
marginal external benefit
of R&D. A fall in costs of investing in R&D will signal to the firms that
investing in R&D is now more profitable, causing the MPC curve to shift
vertically downwards to MPC’ by the amount of MEB. This causes the
equilibrium level of R&D, which occurs at MPC’=MPB, to coincide with social
equilibrium level which occurs at MSB = MSC. Hence, with the subsidies,
level of R&D rises from Q to the socially optimal level Q*, causing the
welfare loss of area A to be eliminated.

Costs/benefits
MPC=MSC

Subsidy per unit = MEB

A
MPC’ = MPC + Subsidy

P
’
MSB P
MPB

Q of R&D
Q* 0
activities Q
2. Advantage of subsidies (explain 1)
a) Subsidies from the government will be effective in encouraging
R&D as it helps to cover part of the high costs of R&D.
Given that R&D involves enormous costs, some firms may not have
sufficient financial resources to invest in R&D. Banks may also not be
willing to provide loans because of the uncertain nature of R&D
projects. As such, subsidies from the government will help these firms
to cover part of the R&D costs, thereby increasing firms’ ability to
undertake R&D, increasing the level of R&D in the pharmaceutical
level.
OR
b) Subsidies from the government helps to increase firm’s
willingness to undertake R&D.
Given that the development of drugs take a long time and there is a
high risk of failure, R&D projects can be risky as the high uncertainty
of the outcome means that R&D projects may be most costly than
expected. Subsidies from the government can help to reduce firms’
fear of financial losses as the government subsidies help to reduce
firms’ cost of engaging in R&D, increasing firms’ willingness to
undertake R&D, hence increasing the level of R&D in the
pharmaceutical sector.
Anti-thesis: There are limitations to the effectiveness of subsidies in
encouraging R&D in the pharmaceutical sector. (any 1)
1. Information Failure: There is difficulty
in measuring the exact value of the MEB
in monetary terms, as externalities are
“unpriced” effects. If the external benefits
are not accurately estimated, the
government could either provide too much
subsidy or too little subsidy. Too much
subsidy given (over
correction) will cause production or
consumption of the good to be higher that
socially optimal, resulting in welfare losses
from over-production or consumption. Too
little subsidy, on the other hand, will result
in persistence of the deadweight loss,
although it is now reduced.
OR
2. Problems of financing: Subsidies
require a high level of government
expenditure; in order to finance these
subsidies, there could be unintended
consequences incurred. [Opportunity
Cost Argument (Trade off Argument)]
When the subsidy is funded with resources
from other uses, e.g. government may
have to channel part of its funds from other
uses such
as expenditure from education or
infrastructure development, there is an
opportunity cost or trade-off. If the loss in
benefits from reduced infrastructure
spending outweigh the gain in benefits
from increased healthcare spending, there
is a misallocation of resources.

Synthesis and Conclusion

In theory, subsidising firm’s R&D does help
to encourage R&D by incentivising firms
to internalise the externalities. However,
there may be limited effectiveness in
the use of subsidies to encourage R&D,
given the characteristics of the
pharmaceutical sector.
One of the key problems hindering R&D in
pharmaceutical industries is likely its weak
institutions. Protecting the inventions of
firms (e.g. via patents) are exceptionally
important in the pharmaceutical sector, as
imitations of newly developed drugs will
severely undermine the profitability of the
R&D investments, given the huge costs
and time invested in such research. As
such, policies that strengthen a country’s
legal framework and intellectual property
rights may be more effective in
encouraging R&D in the pharmaceutical
sector, especially in the long run.
Mark Scheme
L1 Shows some basic knowledge of subsidies.
One-sided answer containing either expla
subsidies work to encourage R&D or why su
ineffective.
OR
Two-sided answer that lacks economic rigou
and is largely descriptive.
L2 Well-balanced analytical answer examining
can encourage R&D in the pharmaceutical s
also the limitations of using subsidies.
E Evaluative judgment that reaches a conclus
analysis.

Considers the extent to which adoption of subsidies is able

to encourage R&D in her pharmaceutical sector.

(b) Demerit / Merit/ Public goods

1. Explain why the market for alcohol fails. [6]
Reference to CSQ Skills Package:
Command word: ‘Explain why’ [Pg 22]
Requirements: Elaborate on the reason(s) using economic analysis

Suggested Answer:
Define demerit good: Alcohol is considered as a demerit good which are
goods that the government believes consumers will consume too much if
provided by the market because of information failure (underestimation of
private costs) and negative externalities in consumption (costs on third
parties not considered).

[NOTE: For 6m, explain any one of the two sources of market failure in detail;
the other one can be a brief explanation]

Explain Negative Externalities in Consumption [in detail]

The consumption of alcohol leads to negative externalities.
[explain private efficient output] In a free market, the price mechanism will
only consider private costs and benefit, ignoring externalities. To the
individual

consumer, he will consume up to the point where MPB = MPC (private

efficiency). He does not take into account external costs generated. As such,
Q is being consumed.
[Divergence in MPC and MSC curves: Explain the externality in context]
[define negative externalities in consumption] However, consumers also do
not take into account the external costs generated in the consumption of
alcohol,
which are incurred by 3rd parties who are not the producers nor consumers of
alcohol and are not being compensated for.
[give 1 example] Employers will suffer loss of revenue/profits as affected
workers may take more sick leave resulting in reduced productivity and
man-hours at work. OR The govt also incurs additional costs as more
resources will have to be diverted to build more healthcare facilities to treat
these drinking-related diseases such as liver cancer etc. These costs occur
without compensation.
[state implications on the MPC & MSC curves & make references to diagram]
These negative externalities generated will cause a divergence between the
cost curves, where MSC is higher than MPC.

[explain socially efficient output] However, the socially optimal level of output
is at Q*, where MSC = MSB.

[explain allocative inefficiency – overproduction or overconsumption] At Q,

the MSC is greater than MSB. The last unit of output adds more to society’s
costs than to society’s benefits. Therefore, the price mechanism
over-allocates resources to the production of the good, leading to an
overconsumption of alcohol by Q*Q units.

[explain deadweight loss] Hence a welfare loss to society occurs, shown by

the shaded area. The market for alcohol fails because there is allocative
inefficiency, where the right amount of alcohol is not being consumed in the
society.

Explain Information Failure [can be brief since the question is only 6

marks]
[identify private costs- list 1 example]: Private costs include:
- drinkers’ expenditure on alcohol

- extra healthcare costs incurred due to drinking-related diseases. - loss

of income due to loss of work-days as a result of the related illnesses.

[explain why there is info. failure] Addicted drinkers tend to underestimate the
private costs as
1) they may not be informed of the full private costs associated with
excessive drinking and also
2) the symptoms of these health risks are in the future, uncertain and
difficult to estimate accurately.

[state implications on the marginal private cost curve & make references to
diagram]: The consumers perceived the marginal private cost to be at MPC
perceived which is lower than the actual marginal private cost of consuming
 alcohol as indicated by MPC actual. Assuming no externalities, MPC actual =
MSC, and MPB = MSB.

Hence, with no government intervention, consumers will only be concerned

about MPC perceived and MPB in their decision-making process and consume
alcohol at Q which is higher than the socially optimal level, Q* (where
MSC=MSB). This leads to an over-consumption of alcohol by QQ* as seen in
Figure 5(a) due to the over-allocation of resources. There is a welfare loss to
the society shown by the shaded area.

2. Analyse and evaluate the following government measures to tackle

over consumption of alcohol:
Reference to CSQ Skills Package:
Command words: ‘Analyse’ & ‘Evaluate’
Requirements: Provide a balanced argument, well-supported by economic theories
& evidences.

a) Use of legislation that individuals below the age of 18 years cannot

purchase alcohol in any licensed premises. [5]
Suggested Answer:
What it is:
Legislations are command and control measure to restrict the amount of
demerit goods consumed via prohibiting or regulating behaviour that imposes
external costs in consumption.
In this case, the government has enforced a ban on purchase/consumption of
alcohol by minors. This ban is undertaken by the government as the
deadweight loss associated with over-consumption by the minors is
considered significant by the government.

How it works:
In this case, the extent of information failure / negative externalities may be
so large that the socially optimal level of consumption Q* = 0, warranting a
ban on purchase/consumption of alcohol by minors. This will result in no
goods being produced and thus the MPC will shift to MPC’ whereby output
will always be zero. The private output will be where MPB=MPC’ at zero
output. Thus, the socially optimal output is achieved and the deadweight loss
is eliminated. Allocative efficiency is achieved.
 MPC’

Fear of punitive measures/penalties (e.g. a fine of up to $5000 for those

found guilty of selling alcohol to anyone aged under 18) will ensure that
people abide by the legislation.

Note:
The legal drinking age in Singapore is 18 years old. This means that only
those aged 18 and above will be able to buy and/or consume alcoholic
beverages in premises licensed to sell alcohol (such as restaurants and
supermarkets) in Singapore.

This is because it is illegal for licensed liquor sellers to sell alcoholic

beverages to any person below the age of 18 or allow him to consume
alcohol in their licensed premises. Sellers who do so may be guilty of an
offence under regulation 37 of the Customs (Liquors Licensing)
Regulations, and be liable on conviction to a fine not exceeding $5,000.

How well it works:

(+) Easy to enact and efficient. Legislation is easy to enact and is efficient.
It decreases quantity consumed to socially optimal and corrects the market
failure. It is a powerful tool because it is mandatory, resulting in more certain
outcomes and is therefore very effective when the extent of the market
failure is large.
(elaborate in context)
∙ In this case, the partial ban is on the consumption of alcohol by youths
under the age of 18 as the extent of market failure is deemed to be
large for this age group.
∙ This is because individuals of this age group are likely to be more prone
to information failure due to ignorance and also more susceptible to
peer pressure.

(-) Require costly monitoring and enforcement. For example, the

 government needs to ensure that consumers of alcohol are abiding by the
law by conducting

periodic checks in places where alcohol is bought/ consumed. This requires a

large amount of manpower to monitor and enforce. Also, the penalties for
violations must be severe enough to be a deterrent e.g. hefty fine.
(elaborate in context)
∙ In the case of Singapore, monitoring and enforcement may be relatively
easy and less costly considering its small size and effective law
enforcement organisations.

b) Tax alcohol consumption. [5]

Suggested Answer:
How it works:
A tax on alcohol producers will increase the unit cost of production, reducing
the market supply as a result. This will raise the market price for consumers,
which will increase the marginal private cost of consuming alcohol from MPC
to MPC’. If tax implemented is equal to the MEC at socially optimal output
Q*, the new private optimal output where MPB = MPC’ will coincide with
socially optimal output where MSB = MSC at Q*. Consumers internalise the
negative externality, and welfare for society is maximised at Q*, achieving the
allocative efficient outcome.

How well it works:

(+) Tax is a market based solution and it can be easily implemented to
reduce production and consumption. It is flexible as the amount of taxes can
be varied to reflect the external cost.
(elaborate in context)
∙ For example, tax could be higher for alcoholic beverages with higher
alcohol content.
 (-) Information failure resulting in government failure. There is difficulty in
measuring the exact value of the MEC in monetary terms, as externalities are
“unpriced” effects. If the external costs are not accurately estimated, the
government could either impose too much tax or too little tax. Too much tax
given (over-correction) will cause consumption of the good to be lower than
socially optimal, resulting in welfare losses from under-consumption. Too little
tax (under
correction), on the other hand, will result in persistence of the deadweight
loss, although it is now reduced. In the case of under taxing, tax is still
effective as it helps to bring the market closer to socially optimal level of
output.

(-) Tax is less effective when demand for the good is price
inelastic (elaborate in context)
∙ Demand for alcohol may be relatively price inelastic as it is a
habit-forming good and there is a lack of close substitute. Hence, with
a given rise in price, there will be a less than proportionate fall in the
quantity demanded of alcohol.
∙ This implies that taxes must rise sharply to reduce the level of production
and consumption to the socially optimum level.

6. Explain why government intervention is advocated for the case of

lighthouses. [6m]
 Reference to CSQ Skills Package:
Command word: ‘Explain why’ [Pg 22]
Requirements: Elaborate on the reason(s) using economic analysis

Suggested Answer:
Public goods are goods that exhibit characteristics of non-excludability and
non-rivalry in consumption. The two main purposes of a lighthouse are to
serve as a navigational aid and to warn boats of dangerous areas.
Non-excludability
∙ Meaning: it is not economically feasible to exclude those non-paying
consumers from consuming the good.
∙ Contextualise: Once it is provided, every ship that passes by the region will
be able to enjoy the benefits of receiving the light signals from the
lighthouse for navigational purposes. It is almost impossible to charge a
price for these passing ships to use the lighthouse.
∙ Implication: It leads to the free-rider problem as consumers can enjoy the
good without paying. Hence no demand will be expressed by consumers
🡪 impossible to charge a market price.

Non-rivalry
∙ Meaning: The consumption of the good by one user will not diminish the
benefits available to other users.

∙ Contextualise: The usage of the light house by one ship will not decrease
the amount of light signal that is made available for the other ships. ∙
Implication: The marginal cost of providing the lighthouse signal to one
more user is zero, therefore the efficient price to charge should be zero (P=
MC). No public good is supplied by the market since producers are profit
motivated.

Welfare loss
Free market will not allocate resources for production of public goods leading
to a missing market. The right amount of right type of public goods will not be
produced, leading to allocative inefficiency and hence market failure 🡪 welfare
loss. Thus, the government has to intervene in such missing markets.

Advanced Questions for Market Failure (H2)

1. Case Study Q1: Transport: private and public
Suggested Answers:
(e) Illustrating your answer by reference to one example [4]
mentioned in Extract 1 or Extract 2, explain how a negative
externality can create a divergence between private and social
costs.

Reference to CSQ Skills Package:

Command word: ‘Explain how’ [Pg 22]
Requirements: Elaborate on how a factor impacts an area that the question has
stated. OR Elaborate on how a concept is shown or illustrated in a particular context.

Reference: Extract 1
∙ Private cost of car usage: The private cost for private transport such as
cars will include the cost of cars, petrol and maintenance.
∙ Negative externalities in consumption: However, the use of private cars
will also generate negative externalities which is a cost imposed on third
parties such as users of public transport and pedestrians, in the form of
delays and congestion related illnesses for which they are not
compensated for by those who drive. E.g. These third parties suffer loss of
income due to delays and also incur extra health care cost due to
congestion related illnesses such as depression triggered by recurring
stress [sleep deprivation, panic attacks and recurring physical illness]
linked to traffic jams.
∙ Divergence, MSC>MPC: Such external costs result in a divergence between
private and social costs since MSC (marginal social cost) =MEC (marginal
external cost) + MPC (marginal private cost). In this case of a negative
externality, the MSC will be greater than the MPC.

OR
 Reference: Extract 2
∙ Private cost: The private cost of building roads will include the cost of
materials used for building the roads, workers’ wages, and maintenance. ∙
Negative externalities in production: However, the building of more roads
will also generate negative externalities which is a cost imposed on third
parties such as residents in the city, in the form of less greenery, less open
spaces and congestion-related illnesses for which they are not compensated
for by road developers or motorists. E.g. Residents suffers loss of income and
incur extra healthcare cost due to congestion-related illnesses such as
depression triggered by recurring stress linked to an overcrowded living
environment.
∙ Divergence, MSC > MPC: Such external costs imposed on third parties
result in a divergence between private and social costs of roads since
MSC (marginal social cost) =MEC (marginal external cost) + MPC
(marginal private cost). In this case of a negative externality, the MSC will
be greater than the MPC.

(f) Discuss the view that the problem of negative externalities [8]
caused by the unlimited use of private transport can best be
solved by imposing taxes and other charges on motorists.

Reference to CSQ Skills Package: ∙ Brief analysis

Command word: ‘Discuss’ [Pg 27] of why the
Requirements: Give your verdict as to what extent a statement is market has
true, or to what extent you agree with them. Provide a balanced failed due to
argument, well-supported by economic theories & evidences.
usage of
Come to a conclusion, basing your decision on what you judge to
be the most important and justify accordingly.

Suggested Answer:

Introduction
∙ State the aim of using taxes & other charges: Taxes and
other charges on motorists are used to reduce the usage
of private transport which cause negative externalities.
The government hopes that by intervening in the market it
will reduce private transport usage to the socially
optimum level, achieving allocative efficiency.

Development 1: Briefly explain how the market fails due

to negative externalities
∙ Negative externalities in consumption due to car usage
results in overconsumption of private transport by motorists. ∙
This causes the market usage of roads [at Q, where MPC =
MPB] to be greater than the socially ideal level [at Q*, where
 MSB = MSC], and a welfare loss or deadweight loss [area private
ABC] ensues. transport.

∙ Accurate
diagram
∙ Accurate
definition of
tax
Development 2: Use of taxes and other charges ∙ What is
∙ Examples
it: A tax is a compulsory payment to the government. As
mentioned in Extract 4, the government could implement a are relevant
usage tax for car usage. One example of a tax implemented to context
would be a tax on car usage e.g. Singapore’s Electronic ∙ Analysis of
Road Pricing (ERP). how taxes
∙ How does it work: This adds to the private cost of car work is
usage by motorists which raises the MPC. A per unit tax rigorous.
equal to the MEC at Q* can be imposed. This raises MPC
to MPC2 = MSC. The new market output will now be at
Q* (where MPC2 = MPB) as motorists now internalize the
external costs. The market failure is addressed.
∙ How well does it work?
o (+) Raises tax revenue/ Double Dividend: As the
demand for private motoring is suggested to be
price inelastic in Extract 1 as many see them as
necessities. The tax revenue raised is likely to be
large which can be used to compensate third
parties’ medical costs. Policy would be
appropriate.
o (+) Addresses the root cause: Motorists do not
internalize the external costs due to car usage.
With a tax, this addresses the root cause as
motorist must now internalize the external cost
because of a tax. Policy is therefore effective.
o (-) Imperfect knowledge of government: Success
of the policy depends on the governments’ ability to
estimate the MEC accurately. As Extract 4
suggests, this is unlikely to be the case and the
government may end up overtaxing. If the extent of
the overtaxation is large enough, it may result in a
deadweight loss that is greater than the case
 without any intervention. Policy would be
ineffective.
o (-) Ineffective to ↓usage due to PED<1: As
demand is price inelastic, a tax imposed would
raise the price
 of car usage but that would only lead to less than ∙ Alternative
proportionate fall in car usage. policies are
▪ Evaluation: However, if alternatives to private discussed.
transport are developed and made cheaper, ∙ Accurate
demand may become more price elastic and a definition of
tax may be more effective in reducing car subsidy
usage. ∙ Analysis of
how
Development 3: Alternative measures (Subsidies on
subsidies
public transport; Legislation)
work is
Alternative 1: Subsidies for public transport rigorous.
∙ What is it: A subsidy is a transfer from the government to
producers to produce a good or service. As mentioned in
Extract 5, the government subsidises public
transportation.
∙ How does it work: This reduces the unit cost of production
for public transport operators which lowers the price of
public transportation. As public transport and private
transport are alternatives, this would lead to a fall in the
demand for private transport. Motorists’ MPB would fall.
The new market output will now be closer to Q*. The
welfare loss is reduced.
∙ How well does it work:
o (+) Improves equity: By making public
transportation cheaper, this reduces inequity as
public transportation is a necessity that all,
including those of lower income, should be able to
afford. The policy is thus appropriate.
o (-) Subsidies are costly: This is a costly policy that
could incur a high opportunity cost for the
government as explained in part (dii). [Given the
low price elasticities for public transport, “with
values of –(0.4) for bus travel, -(0.3) for
underground train travel and –(0.6) for suburban
rail”, quantity demanded will only increase by less
than proportionately to the decrease in price.
Hence the government will need to incur a huge
government expenditure on these subsidies in
order to persuade sufficient volume of commuters
to switch from private to public transport. This
represents a huge opportunity cost incurred
 possibly in terms of the welfare to society from the
gpvernment spending on better healthcare and
education instead that is foregone. ]
o (-) Effectiveness depends on XED of car usage
with respect to price of public transportation:
The
 policy’s effectiveness is determined by the XED of ∙ Accurate
car usage with respect to price of public definition of
transportation. The greater the magnitude of the legislation.
XED, the closer these goods are as substitutes. ∙ Analysis of
This means that given a fall in price of public how
transportation, there would be a large fall in legislation
demand for car usage. The policy would be more works is
effective. rigorous.
▪ Evaluation: However, Extract 2 suggests that
in South-east Asian countries, private
transport
and public transport may not be close
substitutes due to strong preferences for
private transport. Thus, the policy would be
ineffective.

Alternative 2: Legislation
∙ What is it: Legislation refers to rules and regulation for
compliance. As mentioned in Extract 4, the government
can legislate emission standards for private transport to
meet. This would have to be enforced with penalties for
non
compliance.
∙ How does it work: With the need to meet certain emission
standards, the private cost of car usage may increase as
cars may have to be serviced more frequently or installed
with devices to reduce emissions. As MPC increases, the
overconsumption of private transport may reduce, which
reduces the deadweight loss. (Alternative analysis:
reduces the MEC 🡪 reduces the overconsumption 🡪
↓deadweight loss)
∙ How well does it work:
o (+) Easy to understand for compliance:
Legislation is usually designed to be easy to
understand and thus more likely for motorists to
comply. Policy is thus effective.
o (-) Low cost: This particular legislation may not be
costly as it doesn’t require active/regular
enforcement as the cars can be inspected during
their annual car inspections, of which the cost
could be borne by the motorist.
 Other alternatives that can be considered: Improving the
quality of public transportation, other forms of legislation.

Conclusion/Synthesis ∙
∙ Criterion: Does it address the root cause? In terms of Evaluatio
effectiveness based on addressing the root cause, the use n: Well
of taxes may be the best option as it forces motorist to reasoned &
internalize the external cost, addressing the problem of analytical
externalities. judgment to
∙ Criterion: Is it costly? Taxation may be the best policy as it conclude,
is appropriate in terms of its costs. Compared to using CORe
legislation which still requires some degree of
enforcement and subsidies which are highly costly,
taxation is the least costly and instead is able to raise tax
revenue for the government, which can be used to
compensate the third parties as well.
∙ Criterion: Is it effective? In terms of effectiveness,
legislation may be the most effective. Taxation faces a
problem of imperfect information as well as a price
inelastic demand for private transport which limits its
effectiveness. Subsidies for public transport are limited in
their effectiveness due to weak substitute relationship
between public and private transportation. Legislation,
however, is effective due to the need for compliance and
is able to achieve the aims.

2. Essay Question (focus on positive externalities in consumption):

The presence of positive externalities in the market for vaccinations is one of the
reasons to justify government intervention.
(a) Explain how positive externalities can result in market failure. [10] (b) Evaluate
the policies that the Singapore government should implement to address the
above market failure in the market for vaccinations. [15]

Suggested Answer:
Part (a)
Introduction Define key
Externality is a source of market failure. Market failure occurs terms, set
whenever the price mechanism fails to allocate resources direction for
efficiently. The existence of externality results in an inefficient essay
allocation of resources as the market does not produce at MSB =
MSC. In this essay, I will be explaining how positive externalities Address
generated by consumption and production activities will lead to both
market failure. consumption
& production

activities for
scope
Development Identify the
Positive externalities could be generated from the production of private costs,
research and development (R&D) activities and the consumption of private
vaccinations. benefits, and
explain
In a free market, the price mechanism will only consider private private
costs and benefits, ignoring externalities. The individual producer output level.
of R&D projects will only consider his private benefits of
undertaking research (e.g. cost savings attained from successful
development of new technologies) and the private costs of R&D
(e.g. wages of researchers). In the case of vaccinations, the
individual consumer will only consider his private benefits of
getting vaccinated (e.g. reduced chances of falling ill and hence
medical cost savings) and the private cost of vaccines.

P: Based on the marginalist principle, the producer (or consumer)

will produce (or consume) up to private output level Q, where
private welfare is maximised at MPB=MPC.
Explain
D: The presence of MEB that arises from the existence of positive externality
externality causes the divergence between MSB and MPB. The (Identify 3rd
production of R&D projects creates knowledge that other firms can parties,
also use, translating into cost savings for other firms (third parties) external
who benefit in terms of higher profits without paying for the benefit,
research costs. The firm conducting R&D does not account for occurs
this, hence the social benefit of R&D exceeds the private benefit without
(MSB>MPC). compensation
)
Likewise, an individual consumer of flu vaccine will reduce the
chances of other people around him (third parties) falling sick and Explain
they will in turn, be more productive and this translates into higher divergence
profits for the firms they are working in, without compensation. in benefit
However, the individual will not take into consideration these curves.
external benefits in his consumption decisions, hence the social
benefit of vaccines exceeds private benefit. (MSB>MPB).

Draw
appropriate
cost/benefit
diagram
drawn.
S: Society on the other hand, takes into account all costs and Explain
benefits. The socially optimal output level occurs at Q* where socially
society’s welfare is maximised at MSB = MSC. optimal
output level.
A: At Q, the MSB is greater than MSC. This means the last unit of
output adds more to society’s benefits that it will to society’s costs. Explain
More should be produced to increase society’s welfare. Hence the allocation of
price mechanism underallocates resources to the consumption and resources
production of goods and services leading to an underconsumption
and underproduction by QQ* units.

D: The total social benefit of underproducing QQ* units (area

QACQ*) is greater than the total social cost of QQ* (area QBCQ*). Explain
The difference in areas (Area ABC) is the deadweight loss to deadweight
society. Society’s welfare can be increased by increasing loss to society.
consumption and production of goods and services.

Hence, the market fails as allocative efficiency has not been

achieved at Q and resources can be reallocated to increase Link back to
society’s welfare. market
failure.

Conclusion: Link to part (b)

Hence, in the presence of positive externalities, arguments in
favour of government intervention are put forward to correct such
a market failure.

Level Descriptors Marks

 L3 Well-developed explanation of how positive externalities in 8-10
production and consumption both lead to market failure.

L2 Underdeveloped explanation of how positive externalities lead 5-7

to market failure.

L1 An answer that shows some knowledge about market failure. 1-4

Part (b)
Introduction Define key
In order to correct the inefficiency that results from the positive terms
externality in consumption of vaccines, the government can
intervene in the market in several ways to increase consumption
and production of vaccinations to the socially optimal level.
Set
In this essay, we will explain and evaluate the use of subsidies, direction
legislation and direct provision to address the market failure. for essay
Development 1: Subsidies What it is🡪
[What it is]: Indirect subsidies are payments from the government define
to the firm for the provision of goods and services. policy

[How it works]: The government can introduce a subsidy equal to How it

the MEB, cd per unit, at the socially optimal output level so works🡪
consumers will internalise the external benefit. This lowers the unit Analyse
cost of production of supplying vaccines, leading to a fall in price policy with
of vaccines. Hence, the consumers face drop in their MPC to reference
MPC’. to diagram,
link back to
how it
addresses
market
failure.

MPB

The output of vaccines thus increases from Q to the socially

optimum output, Q*, correcting the under-allocation of resources
towards vaccines production and eliminating the deadweight loss
of ABC and achieving allocative efficiency.

[How well it works]:

∙ (+) Subsidies has greater flexibility and fairness relative to other How well it
measures such as legislation as the amount of subsidy can be work🡪
varied to reflect the extent of external benefit. explain at
∙ (+) In addition, subsidies can result in positive unintended least one
consequence of reducing inequity by lowering market price of advantage,
vaccines, making it more affordable for lower income one
consumers. disadvanta
∙ (-) However, the subsidy is funded with resources from other ge of
uses, e.g. government may have to channel part of its funds policy
from other uses such as expenditure from education or
infrastructure development; there is an opportunity cost or
trade-off. If loss in benefits from reduced infrastructure
spending exceeds the gain in benefits from increased
 healthcare spending, there is a misallocation of resources.
EV: Financial constraints may be less of a concern for the
Singapore government who has accumulated budget surpluses
through its fiscal prudence.

∙ (-) It is also difficult for the government to accurately estimate the

extent of the market failure as these benefits occur in the future
and are difficult to monetize. As a result of this problem in
measurement, the government may oversubsidise by a large
amount, leading to a bigger shift in MPC curve and may lead to
an overconsumption of vaccines which is not socially optimal,
worsening market failure.
EV: This outcome is less likely to occur given the Singapore
government’s use of technology and efficient data collection
methods. Moreover, an oversubsidy by a small amount may
lead to small overconsumption of vaccines. While it is not
socially optimal, it will reduce the extent of market failure as
deadweight loss could be less than the initial amount.
Development 2: Legislation What it is🡪
[What it is]: Legislations are rules and regulations for compliance. define
The government will enforce legislation through regular checks and policy,
non-compliance will be punished with penalties such as fines. One explain the
example of a legislation that can be implemented is the compulsory need to
consumption of vaccinations. punishme
nt &
[How it works]: With reference to the above figure, the enforcemen
compulsory legislation will increase MPB of consumers as t. How it
consumption of vaccines will avoid threat of punishment. Hence, works🡪
the consumption level of vaccines will increase from Q to the Analyse
socially optimal level of Q*. Deadweight loss is eliminated and policy with
allocative efficiency is achieved. reference
to diagram,
[How well it works]: link back to
∙ (+) Command and control methods are more straightforward to addressing
devise, easier to understand, and to implement. mkt failure.
EV: Legislation are likely to be effective in Singapore with high
enough punishments. Laws are easier to monitor and enforce How well it
given Singapore’s relatively small geographical size, generally work🡪
law abiding citizens and relatively incorruptible enforcement explain at
force. least one
∙ (+) There is also greater certainty in outcome compared to market advantage,
based solutions that incentivises economic agents to change one
their behaviour but does not compel them to do so. disadvanta
∙ (-) However, regular monitoring can be costly. High costs are ge of
incurred in hiring enforcement officers to ensure adherence. EV: policy
The opportunity costs are especially high for Singapore with a
smaller population size and labour force. Enforcement workers
could have been deployed to work in other key industries instead.
∙ (-) Also, unlike market-based solutions, legislation is not sensitive
and cannot be customised to the needs and circumstances of
individuals.
Development 3: Direct Provision What it is🡪
[What it is]: Direct provision refers to a situation where the define
government directly controls the supply of vaccinations that are policy,
made available in the market. It could be provided free of charge if
a 100% subsidy is given by the government.

[How it works]: Assuming the extent of positive externality How it

generated is extremely large at EQ*. Without government works🡪
intervention, there exists a severe underconsumption of QQ*. Free Analyse
government provision of vaccinations results in MPC incurred to policy with
all consumers to be at 0 (MPC2). With free provision of vaccines reference
(P=0), the new private output occurs at MPB=MPC2 and to diagram,
consumption coincides with the socially optimal level of Q*. link back to
addressing
mkt failure.

There is
effectively a 100% subsidy by the government. Deadweight loss of
CDE is eliminated and the right amount of right goods is being
produced thereby achieving allocative efficiency. In this instance,
providing vaccines free leads to an efficient and equitable
allocation of an economy’s resources.

[How well it works]: How well it

∙ (+) Direct provision ensure the government has control over the work🡪
quality and quantity of the vaccines provided. For instance, explain at
Singaporeans under the age of 18 will be eligible for full least one
subsidies for vaccinations under the National Childhood advantage,
Immunisation Schedule (NCIS) and the government can one
control the appropriate immunisations against diseases and disadvanta
doses that it deems socially optimal. If left to the private sector, ge of
 it is likely market failure will still persist. policy

∙ (+) State provision of vaccines also ensures that the poor are not
left out and reduces inequity.
∙ (-) However, direct provision requires significant spending which
may worsen the government’s budget position. This could lead
to unintended consequences including opportunity costs as
mentioned in subsidies.
∙ (-) There is also a higher possibility of overconsumption of the
good, especially if the extent of the market failure is much
smaller than the government anticipated. Direct provision may
result in a higher overconsumption of vaccines, resulting in a
larger welfare loss.
Conclusion: Provide
In conclusion, whether the Singapore government should overall
implement one of the policies mentioned, or a combination will judgement
depend on: in
conclusion.
[Extent of market failure]: Assuming the extent of market failure
is large due to the introduction of an extremely contagious disease You may
but can be easily prevented by vaccines. Given the urgency of pick and
such a problem, the use of legislation (compulsory vaccinations) choose 1-2
may be more beneficial compared to market based solutions for criteria of
bringing about faster and greater certainty in outcomes, especially judgement
in the context of Singapore where monitoring and enforcement of to
law is more effective. substantiat
e your
[Government objectives]: If the Singapore government has opinion.
prioritised equity as one of its main goals, the benefit of using
subsidies or direct provision in lowering prices and improving
affordability of vaccines to lower income groups will be more
significant compared to legislation.

[Time period]: However, given the added government expenditure

required for subsidies and direct provision, it may not be a
sustainable long term policy (even Singapore financial reserves
are not infinite). The government may have to use other policies
like provision of information alongside subsidies to reduce the
burden on government expenditure in the long term.

[Weigh cost and benefits]: Despite the high costs of subsidies,

this can be mitigated by the flexibility of subsidies. For example
subsidies can be adjusted according to the extent of market
failure. This is especially applicable for higher risk population
groups like children and elderly who are more susceptible to falling
ill. The government may still provide higher subsidies for these at
risk groups to ensure they benefit from the timely consumption of
vaccines. This reduces one of the costs of subsidies.

Level Descriptor Marks

L3 A well-developed discussion of a range of policies that the 8-10

Singapore government can implement to address the market
failure in vaccinations arising from positive externalities.
 L2 An underdeveloped discussion of policies that a government 5-7
can implement which shows a lack of application to
Singapore market for vaccinations.
OR
A well-developed one-sided evaluation of the costs OR
benefits of policies.

L1 Descriptive answer which shows some knowledge of policies 1-4

to correct market failure.

3. Essay Q3 (focus on imperfect and asymmetric information): (a) Explain how

imperfect and asymmetric information can lead to market failure in the markets
for healthcare services and healthcare insurance. [10] (b) Evaluate the measures
that are currently used by the Singapore government to correct the sources of
market failure in healthcare services. [15]
Suggested answer to (a)
Approach:
∙ Explain how:
1) imperfect information exists in healthcare services market
2) asymmetric information in the healthcare insurance market
∙ Explain how the sources can lead to market failures.
Introduction:
Market failure exists when resources are not allocated efficiently, therefore leading to
welfare loss in the society. Imperfect information exists when the economic agents do not
have perfect information about the product/service. Asymmetric information is when one
party has more information than the other. There is imperfect information in the market
for healthcare services and asymmetric information in the market for healthcare
insurance.
Therefore, without any form of government intervention, both markets fail. Point 1:
Imperfect information leads to under-consumption of healthcare services. Private
benefits of healthcare services underestimated:

In the case of healthcare services, individuals who make decisions about how much
healthcare services to consume do not fully appreciate the private benefits that will be
received through more healthcare. For example, consumption of more healthcare
services increases the productivity of individuals due to better health, and raises their
salaries over their working lives. However, the increases in income are in the future,
uncertain and difficult to estimate accurately. This lack of information leads consumers to
underestimate the private benefits of healthcare services where consumers perceived
the marginal private benefit to be at MPB perceived which is lower than the actual MPB
(MPB actual) if consumers have more information.
Hence, with no government intervention, consumers will only be concerned about MPB
perceived and MPC in their decision making process and consume education at Q. This is
below the socially optimal output, Q* (where MSC = MSB) where society’s welfare is
maximised. This leads to an under-consumption of healthcare services by QQ* due to
the under-allocation of resources. Society should increase consumption to increase
society’s welfare as MSB>MSC at Q. There is a welfare loss to the society reflected by
area ABC.

Cost/Benefit
MPC = MSC

A∙
C
B ∙

MPB actual = MSB

MPB perceived
Quantity
of
0 Q
Healthcare services
Q*
Point
2: Asymmetric information leads to market failure in the healthcare insurance
market (adverse selection and/or moral hazard).
[Adverse Selection] In the health insurance market, consumers have to pay insurance
premiums when they purchase health insurance. These premiums are often linked to
their health status/conditions. The better the health condition, the lower the insurance
premium.
Therefore, some consumers may hide certain bad habits such as smoking or their
true physical medical conditions from the health insurers, in order to pay lower
premiums. Without any form of intervention, health insurance companies may not be
able to ascertain whether the information provided by the consumers are factual or not.
Therein, this means that the consumers will have more knowledge about their own
medical conditions than the health insurers.
As a result of such asymmetric information, the health insurers may charge higher
premiums for all consumers, therefore consumers who indeed have healthy
medical status are adversely selected against, as they are less willing to pay for such
high premiums since they are healthy. It is likely that the market may be left with those
who have poor medical health, who are willing to pay the higher premiums if they view
that the premiums can be offset by the sum they are insured of. This is a situation of
adverse selection as there is an underproduction and underconsumption of healthcare
insurance by consumers with a healthy medical status
[Moral Hazard] On top of that, after the consumption of health insurance, some
consumers may be more reckless in their consumption habits, since they know they
are insured. As a result, they may engage in more risky behaviour such as drinking and
binge eating, as their medical costs can be claimed from the insurance companies. In
addition, they when consuming healthcare services, they have no incentive to
economise on their treatments. Demand for healthcare services increases. This results
in moral hazard. There is thus an overconsumption of healthcare services. Deadweight
loss results and the healthcare services market has failed.
Conclusion:
In conclusion, there is market failure in both markets for healthcare services and market
for health insurance. The government will have to implement appropriate measures to
reduce the imperfect information and asymmetric information in these markets, so as to
achieve maximum social welfare and a socially optimal level of resource allocation.
Marking scheme:
Level Descriptors Marks

L3 For an answer which: 8 - 10

∙ Explains both sources of market failure in the two

markets [e.g. explain imperfect information in
healthcare services AND asymmetric information
in insurance market]

∙ Good and accurate use of economic analysis

∙ Has sufficient support with good examples
 L2 For an answer which: 5-7

∙ Either only explain one source of market failure in either

markets (max 6m) [E.g. only imperfect information
in healthcare services OR only asymmetric
information in insurance market]

∙ Explain either sources of market failures with some use

of economic analysis but contain several inaccuracies

∙ Attempts to support answers with some examples

L1 For an answer which: 1–4

∙ List the various sources of market failure without
economic explanation.

∙ Has no or minimal contextualised to either of the markets

∙ Contains several gross inaccuracies

∙ Does not have any examples used

Suggested answer to (b):

Approach:
For each measure, students should address:
1. What it is
2. How it works
3. How well it works (one strength and one weakness)

Intro
The Singapore government has used a variety of policies to address the sources
of market failure in healthcare services.

Measure #1
To correct market failure in the healthcare services market that is
associated with ignorance due to imperfect knowledge, SG government
uses public education and campaigns

[What it is]
For example, many campaigns in Singapore have been undertaken to educate
citizens on the importance of healthcare services. With a greater awareness of
the full private benefits of the merit goods, society might now consume the right
amount. Public education programmes have been launched to educate
Singaporeans on the risks of Hepatitis B infection and to encourage the public to
be immunized against Hepatitis B infection. This was done through the mass
media, pamphlets, and a Health Line was also set up to answer queries on the
disease.

Once people are aware of the full benefits of the immunization, MPBperceived will
rise. Private benefits will be accurately valued and demand for the good will
increase, increasing production and consumption of healthcare services towards
socially optimal level. If such a measure is successful in addressing the
information failure and thus increasing the perceived marginal private benefit
from MPB perceived to the actual MPB (MPB actual). The new market output has now
increased from Q to Q*, the socially optimal output. Hence the allocative
inefficiency would be eliminated.

How well public education works:

Advantage:

1. Directly addresses information failure (root cause): Public education is

particularly useful in addressing one of the 2 problems of merit goods -
information failure. The provision of information helps consumers more accurately
value the private benefit of healthcare services, and thus directly solves the root
 of the problem by correcting information failure. Consumers’ valuation of private
benefit thus rises, bringing the level of consumption lower to that which is
socially optimal.

Limitations and Disadvantages:

1. Long Term: Furthermore, as the policy merely encourages but does not enforce
the higher consumption of healthcare services, it may take a long time before
substantial effects can be felt. This is especially when norms and habits take
time to be developed, making it even more difficult for consumers to change
their consumption patterns and increase consumption levels within a short time
period.

2. Uncertainty. Public education is a long-term and costly process to undertake

with uncertain outcomes. The success of this measure depends on the
receptivity of the target audience which may be unpredictable.

Measure #2

Government subsidies are used to correct market failure in the market for
healthcare services

What subsidies are:

Subsidies are transfers from the government to the firm for the provision of goods
and services.
In a move to raise Singaporeans’ health level through early detection and treatment
of medical problems as well as to prevent bills from spiralling out of control later,
the government in 2017, launched a highly subsidised national health screening
programme. They can get tested for diabetes, cholesterol, blood pressure and
cervical cancer for $5 at most, at the Community Health Assist Scheme (CHAS)
clinics across the island. Thus heavy subsidy from government will reduce the
underconsumption and correct market failure.

How subsidies work:

When the government grants a per unit subsidy of CD equivalent to MEB at Q*, this
reduces the private cost of consumption to consumers, shifting MPC down by the
amount of the subsidy to MPC’. This increases the consumption of healthcare
services to Q* where the MPB intersects the MPC’. As the consumption of
healthcare services increases to the socially optimal output, the deadweight loss is
eliminated and allocative efficiency is achieved.
Cost/Benefit

MPC = MSC
A∙ B ∙
 MSB
MPB
MPC’
C ∙

Subsidy per unit = Quantity of

MEB healthcare
services

D∙

0
Q
Q*

How well subsidies work:

Advantages:
1. Being a market-based solution, subsidy can be easily implemented to bring
about socially ideal level of resource allocation without excessive government
monitoring as compared to other measures. It has greater flexibility and fairness
relative to legislation as the amount of subsidy can be varied to reflect the
external benefit. In addition, it gives the individual an incentive to undertake
healthcare
since it reduces additional private costs of healthcare at any given level of output.

2. Subsidies lower the price of healthcare and provide access to the poor who may
otherwise not be able to afford this merit good. This ensures greater equity.

Limitations and Disadvantages:

However, the implementation of subsidy may not lead to a more efficient outcome
due to government’s information failure and unintended consequences.

3. Information Failure resulting in government failure. There is difficulty in

measuring the exact value of the MEB in monetary terms, as externalities are
“unpriced” effects. If the external benefits are not accurately estimated, the
government could either provide too much subsidy or too little subsidy. Too
much subsidy given (over-correction) will cause consumption of the good to be
 higher that socially optimal, resulting in welfare losses from over consumption.
Too little subsidy, on the other hand, will result in persistence of the deadweight
loss, although it is now reduced.

4. Problems of financing. Subsidies require a high level of government

expenditure; in order to finance these subsidies, there could be unintended
consequences incurred.
∙ Opportunity Cost Argument (Trade off Argument): When the subsidy is
funded with resources from other uses, e.g. government may have to
channel part of its funds from other uses such as expenditure from
education or infrastructure development, there is an opportunity cost or
trade-off. If the loss
in benefits from reduced infrastructure spending > gain in benefits from
increased healthcare spending, there is a misallocation of resources.

EV: However, provision of subsidies is not a long-term solution as it is taxing on the

government budget to finance such subsidies in the long term. This problem may be
especially more severe as Singapore’s population ages and will require more
healthcare services. Singapore circumvented this by providing targeted subsidies
instead of blanket subsidies. This is done through means-testing, where the
households from lower income will receive greater subsidies from the Singapore
government.

Measure #3

Direct Provision

Impact of free direct provision

What direct provision is:

Direct provision is a situation where the government directly controls the supply of
the good/service that will be made available in the market. It can be provided at a
lower cost through subsidies or even free of charge if a 100% subsidy is given by
the government.

How free direct provision (100% subsidy) works:

For example, the Singapore government could perceive the extent of market failure
in the market to be extremely large and chooses to provide free healthcare services
to its citizens. Assume that the extent of positive externality and information failure
generated is extremely large at EQ*. Without government intervention, the market
output is at MPB = MPC where there exists a severe under-consumption of QQ*.
Free government provision of healthcare services results in the marginal private
cost incurred to all consumers to be at 0 (MPC2). With free provision of healthcare
services (P=0), the new private output is now at MPB = MPC2 which coincides with
the socially optimum level of Q* (where MSB=MSC).
There is effectively a 100% subsidy by the government. Deadweight loss of CED is
eliminated and the right amount of the right goods is being produced thereby
achieving allocative efficiency.

How well does direct provision works

Advantages:

1. Government has control over the quality and quantity of goods and services
provided. Direct provision means the government can ensure the “right” amount
of right good is produced. For example, it is important not only that healthcare
services are provided, but that the level of quality of healthcare services is high
as well.

2. Reduces inequity. State provision of healthcare services ensures that the poor
are not left out and there is equality. There are some things that should be
provided not according to the ability to pay but according to need. It should be
provided as a right. Given the inequality in income, people have unequal access
to merit goods and lower income groups might not be able to afford them. If
healthcare services are left to market forces, healthcare services will only be
accessible to the higher income groups.

Limitations and disadvantages:

1. Inefficiency occurs. State-run enterprises may lack the incentive to minimize

costs due to lack of profit-motive and also poor quality services may be provided
due to lack of competition.

2. Greater welfare loss due to over-consumption of the good. If the extent of the
market failure is small, direct provision may instead result in an
over-consumption of the good, resulting in a larger welfare loss.
Alternative: Any policy to correct asymmetric information in the market for
healthcare services.

Conclusion

As there are 2 distinct sources of market failure in healthcare services

[Reasoning], the government should therefore use a combination of policies to
address this [Opinion]. Campaigns can be used to address the information failure,
while subsidies can be used to address the under-consumption due to ignoring of
positive externalities.
However, in the case of Singapore [Criterion: Contextual Considerations],
where there is a high literacy rate, it more likely that the level of information
failure with regard to healthcare services is small. Also, as cost of living
(including healthcare costs) are high [Reasoning], it is therefore important that
the government focuses on providing either subsidies or free direct provision of
healthcare services. [Opinion]

Mark scheme:
Level Descriptors

L3 - An answer that explains 3 measures (2 in detail), addressing both

7-10 sources of market failure
- Answer must include an analysis of strengths / weaknesses of
measures - Include application to Singapore’s context

L2 - explains at least 1 government measure in detail

5-6 - OR 2 government measures adequately done

L1 - A generally descriptive answer lacking in economic analysis

1-4 - Limited explanation of different government measures to deal with
the market failure

Level Descriptors
E3 For an answer that uses analysis to support an evaluative conclusion
or judgement. Made reasoned attempt at evaluation on limitations of
4-5
policies relevant to the question
Articulates clear criteria on how to judge when measures are effective

E2 For an answer that makes some attempt at evaluation or a

2-3 judgement Attempts to justify the conclusion but answer is lacking in
rigour

E1 For an answer that gives a largely unsupported evaluative statement

1