Key learning points:

Content: positive externalities and information failure

Policies to address the above sources of market failure

Context: (1) Electric vehicles

(2) Vaccination
(3) Education
(4) Renewable energy (solar, wind and hydro)

Exam skills: answering structure

- to explain each source of market failure using key economic concepts, MSB-MSC
diag and application to the context
- to explain and evaluate policies to address the above sources of market failure

Context 1: Electric vehicles

(e) (i) With the use of a diagram, explain 1 reason why electric vehicles are underconsumed. [5]

The underconsumption of EV shows that resources are not allocated efficiently and hence society’s welfare
is not maximized. The underconsumption is caused by positive externalities and information failure.

Positive externalities – refers to the external benefits are enjoyed by third parties who are not involved
in the production or consumption of the goods and for which no payment/compensation is made.

[1m] Apply to the context of EV & use case materials

In the context of electric vehicles, people who stay near the heavy traffic areas will benefit as EV emit
‘significantly less carbon” [Ext 1 para 3] and hence they enjoy better health and incur less healthcare
cost due to medical condition arising from pollution.
The presence of positive externalities creates a divergence between MPB and MSB with MSB higher
than MPB at all levels of consumption.

[1m] Explain how individuals make decision

Individuals make their decision by considering their private benefits such as the convenience that the
EVs bring about. They would also consider the private costs that will be incurred from the consumption
of EVs such as the cost of purchasing the EV.
Driven by self-interest, the level of consumption will be at MPB=MPC to maximise net private benefits,
as shown by Qf at Fig.1

[1m] Diag

[1m] Explain how positive externalities leads to underconsumption relative to socially optimal level
The presence of MEB creates a divergence between the MSB and the MPB, where MSB>MPB. The
MSB curve lies above the MPB curve by the amount of MEB. Assuming that there are no negative
 externalities, the MPC=MSC.

If left to the free market, the consumers consume Qp units of EVs, where MPB=MPC as they only
consider their own private benefit and costs to maximise net private benefits. However, to maximize
society’s welfare, the social optimal level of consumption is at Qs units, where MSB=MSC. As Qs>Qp,
there is an underconsumption of EVs.

[1m] Explain how underconsumption leads to deadweight loss

Due to the underconsumption of Qf to Qs, the society incurs a deadweight loss denoted by the area
ABC. This is because over the range of output QfQs, the total benefit (QfabQs) is greater than the total
cost (QfcbQs), and the potential welfare of area abc is not realised due to underconsumption.

Or
Second source of Mkt Failure: Information failure

[1m] Apply to the context of EV & use case materials

Motorists underestimate the benefits arising from the use of EV. They are not aware of how the
use of EV can reduce greenhouse effects and global warming. Due to the underestimation of the
full/true benefits of using EV, there is a divergence between perceived MPB and actual MPB, with
actual MPB higher than perceived MPB at all levels of consumption.

[1m] Explain how individuals make decision

Motorists use the car based on MPBperceived and MPC to make their decision to buy EVs. The
consumers will make their decision by considering their private benefits such as the convenience that the
EVs bring about and will also consider the private costs that will be incurred from the consumption of
EVs such as the cost of purchasing the EV.

[1m] Diag

[1m] Explain how information failure leads to underconsumption relative to socially optimal level
From extract 2, with ‘concerns over environmental footprint’ consumers do not have perfect information
when making decisions, and are unaware of the costs and true/ full benefits in the long run. The
MPBperceived is lower than MPBactual, as they underestimate the MPB, which is the ‘significantly less
carbon’ emitted by EVs.
Assuming that there is no externalities, MPBactual equals to MSB. Hence, in the absence of govt
intervention, the level of consumption is below the socially optimal level at MSB=MSC. Hence, there is
an underconsumption of EVs.

[1m] Explain how underconsumption leads to deadweight loss

This results in the deadweight loss because the Qp and Qs units of the EVs, the total social benefits
(QsabQp) is greater than the total social costs (QpcbQs). Market failure arises as a result of true benefits
not fully taken into account, and hence fails to bring about a socially optimal allocation of resources.
 (ii) Assess the alternative measures that Singapore government can adopt to address the
market failure in the use of electric vehicles.
3 Categories: for each, needs to explain how it works and evaluate its limitations
Context 1: Electric Vehicles
(1) Market-based measure
Explain how it works
1 a - subsidy
Diag:
Govt can provide subsidy equivalent to MEB to
producers/consumers. This helps to lower MPC as
individuals will now internalise the external benefit. As
such, MPC curve will shift downwards from MPC to
MPC’. In response to this, consumers will now consume
at MPB=MPC’ at Qf’. This coincides with the socially
optimal output at Qs. Hence, deadweight loss is
eliminated and allocative efficiency is achieved.
(2) Long term policy
To address underconsumption due to information failure,
government can undertake public campaign to close the
information gap. By raising the awareness of the benefits
of using EV, campaign can increase the MPBperceived,
shifting the MPBperceived closer to MPBactual.
Draw a diagram to illustrate
Evaluation
Strength
(+) subsidy is flexible as the amount can be
adjusted based on the size of MEB.
Limitation
(-) subsidy is costly and hence it will be a strain
on govt budget. The large amount of fund on
subsidy means that society incurs an opportunity
cost as less financial resources are available for
education and healthcare. Hence, there is
welfare forgone from education and healthcare.
(-) difficult to estimate the size of MEB and
hence the amount of subsidy to be provided by
the govt. As a result of the lack of information,
there may be oversubsidy or undersubsidy.
Over-subsidy means that govt policy brings
about overconsumption of EV instead.
(-) effectiveness of lowering price on increasing
consumption depends on price elasticity of
demand. If consumers see EV not a close
substitute due to the lack of charging stations
(Ext , para ), the use of subsidy will be
limited in effectiveness.
Strength
(+) Campaign/ public education address the root
cause of underconsumption due to information
failure. Hence, it is an appropriate policy.
Limitations
(-) However, it takes time to raise the
awareness and change people’s attitude and
mindset. Hence, the benefits are only realised in
the long run.
To score final 3m for evaluation, need to do a comparative evaluation of the policies instead of
commenting on 1 policy in isolation.

Eg.

Among the policies discussed, it can be concluded that campaign/ public education is the best/ most
effective policy in the long run. Given that the benefits can only be realised in the long run, government
still needs to adopt short term policy such as subsidy to promote the use of EV in the long run.

Take note:

Market-based measures cover:

- Subsidy equivalent to MEB

- Free provision means that MEB is so significant that only at zero price then socially optimal
output can be attained

Rules and regulations:

- Context of vaccination: only fully vaccinated individuals can be admitted to eateries.

- Context of education: compulsory primary education and it is illegal for parents not to send
children to schools unless there is permission given by the Ministry

Long run policy

- DD side: public campaign

- SS side: Context of EV – improve the infrastructure of charging stations in the economy.