With reference to examples, discuss whether there is a need to change the current policies adopted

by the Singapore government to deal with market failure caused by externality. [25]

The issue of the question is to find out whether there is a need to change the current policies
adopted by the Singapore government to deal with market failure caused by externality. Externality
is the external cost or benefit borne to a third party who is neither the consumer nor the producer of
a good. However, before touching on the issue, we have to find out what the possible sources of
externalities are and how externalities cause market failure.

One possible source of externality is the production of cigarettes. Smoking causes negative
externalities such as air pollution and potential health risks for people around the smoker when they
breathe in second hand smoke. This thus generates an external cost borne to the production of
cigarettes. This is shown on Figure 1.
Cost, Benefit MSC = MPC + MEC

MPC
Deadweight loss

Figure 1: Negative externality due

c to production of cigarettes
b

MPB = MSB

0 Quantity of cigarettes
Qs Qf
produced

As illustrated on Figure 1, the distance ab is the marginal external cost (MEC) due to the over
production of cigarettes from QsQf. This cost diverges the marginal social cost (MSC) curve to the
left, resulting in a deadweight loss of area abc, when producers produce at the free market optimal
quantity, Qf.

Another source of market failure is littering. Littering in the environment results in environmental
pollution, which causes people who do not litter to lose out on having a nice view of the
environment, which thus results in the divergence of the marginal social benefit (MSB) curve to the
left as shown in Figure 2.
 Cost, Benefit

MPC = MSC

a Figure 2: Negative externality due to

littering
c
b
MPB
MSC

0 Qs Qf Amount of litter in
the environment

As seen in Figure 2, the distance ab represents the marginal external cost borne to the third party.
MSC shifts to the left, causing the overconsumption of QsQf, resulting in the deadweight loss in area
abc.

Another possible source of externality is the provision of healthcare. The provision of healthcare
gives a positive externality as people who cannot pay for healthcare will not be denied of hospital
care. This thus shifts the marginal social benefit (MSB) curve to the right as shown in Figure 3.

Cost, Benefit

MPC = MSC

a Figure 3: Positive externality

c due to healthcare provision

MSB
MPB

0 Qf Qs Amount of
healthcare provided

As seen on Figure 3, the deadweight loss is represented by the area abc as when there is an external
benefit to the consumption of provided healthcare, there is an inefficient allocation of resources.
 The fact that there is a deadweight loss in all three scenarios; it shows that there is inefficient
allocation of resources. This means that resources can be reallocated to have a more optimal
outcome where MPB = MSB = MPC = MSC. There will be market failure, and policies are required to
correct these sources of market failure.

Now that we have discovered some possible sources of market failure and how externality causes
market failure, let us now move on to discussing whether there is a need to change the current
policies adopted by the Singapore government to deal with market failure caused by externality.

One policy the Singapore government has used to reduce the production of cigarettes is having high
import taxes on cigarettes. A tax is a good policy as it raises the cost of production of cigarettes,
which cause the suppliers to be less willing and able to produce and export cigarettes. A pigovian tax
is a tax levied to correct the effects of negative externality. A tax which raises the cost of production
will shift the PMC curve up, resulting in the internalisation of the externality borne by the production
of cigarettes. This is shown on Figure 4.

Cost / Benefit MSC = MPC*=MPC + Tax

MPC

Tax

Figure 4: Effects of a per unit

tax on production of cigarettes

MPB = MSB

0
Q* Qf Amount of cigarettes produced

As seen on Figure 4, a tax on production shifts the MPC upwards by the amount of tax. The tax
forces the firm to internalise the externality. If the tax is equal to the negative externality, it would
result in production at Q*.

A policy used by the Singapore government to reduce the problem of environmental pollution is
regulation. The government makes use of tradable pollution permits. Tradable pollution permits is a
combination of regulations and market-based system. Each firm is given a fixed number of permits
for emission of pollutants. For example, firm A and firm B are producing 20 units of a particular
pollutant each. Assume the government wants to reduce pollution by 20%, so each firm is given a
permit to emit up to 16 units of that particular pollutant. If firm A is able to reduce its pollutants to
14 units, then, it would be given a credit of 2 units. If firm B can reduce its pollutants to only 18
units, it will buy 2 units from firm A at a price that is mutually beneficial. The total reduction in
pollutants is still 8 units or 20% of the original amount. This will thus internalise the externality of
pollution by making it costly for firms to pollute.

A policy used by the Singapore government to reduce the positive externality borne by healthcare is
direct provision. The government may choose to provide healthcare free of charge or at a subsidized
rate when it feels that their consumption confers relatively large social benefits on society which
outweigh their cost of provision. In Singapore, healthcare for all Singaporeans are subsidized by the
government. State provision of healthcare encourages greater consumption. It also allows the poor
to be able to receive healthcare for free if they are under government care.

However, not all policies adopted by the government in Singapore are the most effective. Taxes on
the production of cigarettes may not be effective as due to imperfect information, the government
does not know the correct amount of tax to set for the producers as it cannot be quantified.
Therefore, if the government taxes too much or too little, the problem of externalities will still be
present, thus the problem of market failure is not solved. Also, by allowing firms to trade in pollution
permits, pollution can be reduced more in firms that are best able to do it at a lower cost. However,
this may lead to pollution being concentrated in certain geographical areas and reduce pressure on
dirtier factories or countries to reduce their emissions. This system only leads to significant cuts in
pollution if the maximum permitted levels are low and also it does not consider the real public
interest. Furthermore, although direct provision of healthcare may be freely available to consumers,
but they still have to be paid by the state or society. This may involve high rates of taxation or
government borrowing than might otherwise be the case. The former might have disincentive
effects while the latter may cause crowding out effect. Also, to subsidize healthcare, it makes no
distinction between those who can afford to pay the full amount, and those who cannot afford
healthcare, which thus may also encourage over consumption and consequently divert resources
away from other, more productive activities.

Even though there are such limitations to the policies that are currently adopted by the Singapore
government for the market failure caused by externalities, the policies are very effective in
internalising the externalities. Therefore, there is no need to change the current policies adopted by
the Singapore government to deal with market failure caused by externalities.