C1 BT 2021 (Essays)

Question 2
(a) Explain why markets might fail in the case of public goods and where positive externality is
present. [10]
(b) Discuss whether government’s free provision of the good is the best way to correct the
abovementioned sources of market failure. [15]

Part (a)

Introduction
Market failure occurs when free markets, operating without any government intervention, fail to allocate
scarce resources efficiently and hence society’s welfare is not maximised. This essay will explain why
markets might fail in the case of public goods and where positive externality is present.

Body
Explain how markets might fail in the case of public goods
Public goods are goods or services that have the characteristics of non-excludability and non-rivalry in
consumption. Non-excludable in consumption refers to the situation where the consumption or use of the
good or service cannot be limited to the consumers who have paid for it. For example, once street lighting is
provided, there is no inexpensive or practical way to restrict the availability of the service to only people who
pay for their use. Non-rivalry in consumption refers to the situation where the consumption or use of the
good or service by one consumer does not reduce its availability to another consumer. For example, the use
of the street lighting by one pedestrian will not reduce the amount of light available to others. The benefit of
street lighting can be shared jointly by everyone who happened to be in the vicinity of the street lights

When a good is non-excludable in consumption, it results in the free rider problem where people have no
incentive (or willingness) to pay for the good or service. As a result, there is no effective demand (i.e.
absence of price signal) and private firms will not supply such goods or services. This results in zero
production (i.e. non-provision) of public goods in the free market.

Once produced, a good or service that is non-rival in consumption can be provided for and enjoyed by
additional users at no additional cost to the producer. Thus, the marginal cost of providing for additional
users is zero. To maximise society’s welfare, the condition of allocative efficiency (P=MC) must be fulfilled.
Hence, it should be provided free to as many users as possible (none should be excluded) to enjoy the utility
of consuming the good or service.

Given these two characteristics, the private producer who is motivated by profits will not be keen to produce
the good at all. Hence, there is total market failure in the case of public goods.

Explain how markets might fail where positive externality is present

Positive consumption externalities occur when the consumption of a good positively affects the well-being
of third parties. In the market for vaccines, Marginal Private Cost (MPC) measures the cost to producers of
producing additional units of vaccines such as the cost of raw materials and wages of workers. Marginal
Private Benefit (MPB) measures the benefit to consumers from consuming additional units of vaccines such
as the improved immunity against certain diseases.

Vaccine consumption generates marginal external benefits (MEB) to third parties who are neither vaccine
consumers nor vaccine producers. For each unit of vaccine consumed, third parties who do not immunise
themselves will also benefit in the form of a lower risk of contracting the illness as there will now be less
people who they can potentially contract the illness from. This positively translates into a healthier and hence
more productive workforce for the economy which benefits employers too.

The third parties (the non-immunised and employers) do not compensate vaccine consumers for the external
benefits that they enjoy. Hence such external benefits are unpriced by the market and not reflected in MPB
which reflects only the private benefits of consumption. Hence, external benefits cause a divergence between
private and social benefits, with MSB lying above MPB as MSB = MPB + MEB as seen in Figure 1.
 Figure 1: External Benefit from vaccines

The socially efficient quantity of vaccines is at Qs where MSC = MSB. However, if left to the free market, the
market output is at Qm, where MPC=MPB. Hence, there is under-consumption of Qs – Qm units of
vaccines and an under-allocation of resources to the vaccines market. Area QmQSBC is the total social
benefit gained while Area QmQSBA is the total social cost incurred from the under-consumption of Qm – QS.
Since total social benefits gain exceeds the total social costs incurred, area ABC represents the deadweight
welfare loss due to under-consumption of Qm – QS.

Conclusion
Hence, markets might fail in the case of public goods and where positive externality is present. This might
lead to government intervention to correct these market failures, which will be discussed in part (b).

Level Descriptors Marks

L3 Breadth 8-10
● Explains how market failure occurs due to non-provision of public goods
● Explains how market failure occurs due to positive externality
● Positive externality must be illustrated with diagram
Depth
● Applies relevant economic concepts or theories
● Explains with rigour and detail
● Illustrates with relevant example
L2 ● Lacking in any one of the L3 criterions 5-7
L1 ● Largely irrelevant response 1-4
● Descriptive response with non-existent or minimal or application of economic
concepts or theories
● Serious and pervasive conceptual errors
Part (b)

Introduction
Government intervention can often improve the efficiency of resource allocation when addressing market
failure due to non-provision of public goods and where positive externality is present. This essay will discuss
if the government’s free provision of the good is the best way to correct the abovementioned sources of
market failure.

Body
Government’s free provision of public good is the best way to correct market failure
Due to the problem arising from the non-rivalry and non-excludability characteristics of public goods, there is
total market failure and hence the government has to provide public goods, which are beneficial for society.
For example, street lighting ensures safety and enables driving on the road at night and national defence
ensures that the country is well guarded and deters any possibility of potential war. Both goods are beneficial
to society but will not be provided by private producers. As the marginal cost of providing for additional users
is zero, to maximise society’s welfare, the condition of allocative efficiency (P=MC) must be fulfilled. Hence,
public goods should be provided free (P=0). The government can choose to produce the goods or services
themselves or they can outsource to a private company to do it but bear the full cost.

Limitations:
However, government, like any economic agents, rarely possess complete information on which to base a
decision. There is an issue of how a government can possibly identify accurately the optimal level of public
demand for the provision of public goods when there is no price signals, possibly leading to overproduction
or underproduction. For the former, it will cause a strain to the government budget. Even so, it is still probably
better than no production in a free market. Hence, government’s free provision of the good is the best way to
correct the non-provision of public good

Government’s free provision of goods that generate extremely large positive externalities is the best
way to correct market failure
For the case of positive externalities, the goods should be provided for free if the MEB is extremely large so
that when the subsidy=MEB at Qs is given, the new market equilibrium where MPC-subsidy = MPB will
coincide with the socially efficient outcome where MSC=MSB. There will no longer be under consumption of
the good and society’s welfare will be maximised. This is the case of the Covid-19 vaccines where the
vaccines are fully subsidised by governments all around the world and provided for free.

Limitations;
Subsidies are funded out of tax revenue. As such, a full subsidy will impose a significant strain on the
government’s budget, which may lead to the imposition of higher taxes to meet funding requirements. This
in turn have both unfavourable economic and political consequences. Higher taxes may zap the economic
incentive to be more productive and they are politically unpopular as well with the voters. Moreover, for most
goods, the MEB is not so large and free provision will result in over-consumption instead. Hence, the
government should provide partial subsidy = MEB at Qs instead.

Government should not provide full subsidy (i.e. free provision of goods that generate positive
externalities)
If we consider the case of healthcare screening, it has long-term benefits to society such as a healthier
workforce in our economy generating MEB in terms of higher productivity which the consumer does not take
into account. With reference to Figure 2 below, there is under-consumption of Qs – Qm.

Figure 2: Measures to internalise MEB from healthcare screening

Given that the MEB is not extremely large, a full subsidy will result in over-consumption. However, if a partial
subsidy = MEB at Qs is given, the new market equilibrium where MPC-subsidy = MPB will coincide with the
socially efficient outcome Qs where MDC=MSB and correct the market failure.

Limitations:
One major limitation in this case is that governments do not have perfect information. Whether a full or partial
subsidy is the best will depend on whether the government is able to estimate the monetary value of MEB
accurately and the exact amount of subsidy to be given in order to attain the socially efficiently level of
vaccine. It also depends on whether consumption is forthcoming after supply has increased

Evaluation
In the case of public goods, government’s free provision of the goods is the best way to correct the market
failure as the two characteristics of non-excludable and non-rival in consumption have resulted in complete
market failure. However, in the case of positive externality, there is only partial market failure where resources
are misallocated but the market still exists. Hence, whether free provision of the goods is the best way
depends on the extent of the MEB. In cases where the MEB is extremely large, like the current Covid-19
pandemic, the government should provide free vaccination (i.e. full subsidy). However, if the MEB is not so
huge, like university education, museum, healthcare screening, etc., the government should consider a partial
subsidy to achieve the socially optimal output.

Last but not least, free provision of the goods might be the best way in terms of appropriateness in tackling
the root cause of the problems, e.g. individuals’ failure to internalise the MEB but it might not be the most
effective. E.g. even after full subsidy, many governments in the world struggled to get their Covid-19
vaccination rates high enough to achieve herd immunity. In situations like this, the best way might be to
impose regulations or legislation to make vaccination compulsory.

Note: Direct provision may not necessarily be free

Common misconception is to think that when the government provides a good directly, it will charge a
zero price. In other words, many think that direct provision is free. This is erroneous. Direct provision is
not necessarily free. In the case of direct provision of face masks by the Singapore government in times
of severe haze, the face masks are provided free. Such direct provision is called free direct provision.
However, although direct provision is free in some cases, it is not so in all cases.

In other words, direct provision may be chargeable; chargeable direct provision. Chargeable direct
provision occurs when the government engages in the provision of a good directly and charges a positive
price. For example, the Singapore government provides healthcare directly and charges a positive price.
Indeed, healthcare provided at public hospitals in Singapore which are commonly known as restructured
hospitals is rather costly, despite government subsidy. Therefore, one should not equate direct provision
with free direct provision. Rather, they should think of free direct provision as one of the two types of direct
provision.

Level Descriptors Marks

L3 Breadth 8-10
● A well-developed answer that covers both sources of market failure and whether
government free provision is justified: Public good should be provided by government
due to complete market failure while cases of positive externality will depend on the
extent of the external benefit due to partial market failure
● Analyses with the expected theoretical scope (e.g. public good, positive externality,
appropriate measures, etc)
● Analyses entire scope as suggested by the question
● Explains at least 3 distinct points of analysis
Depth
● Applies relevant economic concepts or theories
● Explains with rigour and detail
● Explains and illustrates with relevant diagrams and examples
L2 ● Lacking in any one of the L3 criterions 5-7
L1 ● Largely irrelevant response 1-4
● Descriptive response with non-existent or minimal or application of economic
concepts or theories
● Serious and pervasive conceptual errors

Evaluation
E3 ● Takes a clear overall stand that is comprehensively justified by providing 4-5
convincing evaluative comments on the relative importance of most of the points
covered in the body
E2 ● Takes a clear overall stand which is only partially justified as 2-3
○ Only some of the points in the body were evaluated
○ The overall stand was largely justified by the inclusion of additional
concluding points to sway the overall argument
○ The arguments used to evaluate individual points were unconvincing or
somewhat flawed
● Evaluates at least one of the points covered in the body but the overall stand is
unclear
● Provides insightful opinion(s) which are however not directly relevant to the
requirements of the question
E1 ● Provides unsubstantiated opinion(s) 1