Does economies of scale lead to market failure?

MARKET FAILURE will be taught in the first, second, third and fourth weeks of term 3 in economics tuition.

Students can refer to Economics – A Singapore Perspective for the diagrams. The book is available in the major bookstores in Singapore.

1          INTRODUCTION

In the free market, the equilibrium of a market is determined by the market forces of demand and supply. However, the equilibrium price and the equilibrium quantity of a good may not be the optimal price and the optimal quantity. For example, tobacco and alcohol will be over-consumed and education and healthcare will under-consumed in the absence of government intervention. Market failure occurs when the free market fails to allocate resources efficiently. Allocative efficiency is achieved when it is impossible to change the allocation of resources in the economy in a way that will increase the welfare of society. This occurs when marginal social benefit is equal to marginal social cost where marginal social benefit is the sum of marginal private benefit and marginal external benefit and marginal social cost is the sum of marginal private cost and marginal external cost. External costs and benefits, or externalities, are costs and benefits of consumption or production experienced by society other than the producers or the consumers. Although the free market has numerous merits, it may not allocate resources efficiently or distribute goods and services equitably. This chapter provides an exposition of five causes of market failure, namely externalities, imperfect information, market dominance, public goods and immobility of factors of production, and the distributional issue of income inequity.

2          EXTERNALITIES

2.1       Externalities as a Cause of Market Failure

Positive Externalities/External Benefits

Positive externalities, or external benefits, lead to under-consumption/production. For example, healthcare will be under-consumed in the absence of government intervention due to positive externalities. The private costs of healthcare are the costs of production incurred by firms such as the costs of materials and labour. These costs are passed on to consumers in the form of a positive price. Therefore, from the consumers’ perspective, the marginal private cost of healthcare is the price that they pay for the unit of the good. Assuming no negative externalities in healthcare consumption, the marginal social cost is equal to the marginal private cost. The private benefits of healthcare are the satisfaction derived by consumers such as immunity to flu viruses when they get flu vaccination. The consumption of healthcare produces positive externalities. For example, it prevents the spreading of diseases to others. It also contributes to a healthier and hence more productive labour force which is beneficial to the wider community. These positive externalities lead to a divergence between the marginal social benefit and the marginal private benefit. As firms and consumers consider only private costs and benefits, the divergence between the marginal social benefit and the marginal private benefit of healthcare results in under-consumption.

In the above diagram, due to external benefits, the marginal social benefit (MSB) is higher than the marginal private benefit (MPB). Therefore, the equilibrium output level (QE) where MPB is equal to marginal private cost (MPC) is lower than the allocatively efficient output level (QAE) where MSB is equal to marginal social cost (MSC). For the units of output between QE and QAE, the MSB is higher than the MSC. Therefore, the social welfare gain which is the area under the MSB curve is greater than the social welfare loss which is the area under the MSC curve resulting in a net social welfare gain. It follows that these units of output should be consumed. However, as firms and consumers do not consider external costs and benefits, they are not consumed which results in a deadweight loss equal to the unrealised net social welfare gain. The deadweight loss, which is the loss of social welfare due to market failure or government intervention, is represented by the shaded area.

Negative Externalities/External Costs

Negative externalities, or external costs, lead to over-consumption/production. For example, tobacco will be over-consumed in the absence of government intervention due to negative externalities. The private benefits of tobacco are the satisfaction derived by consumers such as a sense of ‘high’ feeling and the idea of looking ‘cool’ when they smoke, net of the costs of personal tobacco-related health problems. Assuming no positive externalities in tobacco consumption, the marginal social benefit is equal to the marginal private benefit. The private costs of tobacco are the costs of production incurred by firms such as the costs of materials and labour. These costs are passed on to consumers in the form of a positive price. Therefore, from the consumers’ perspective, the marginal private cost of tobacco is the price that they pay for the unit of the good. The consumption of tobacco produces negative externalities. For example, it leads to air pollution in the form of second-hand smoke. It also contributes to land pollution through the littering of cigarette butts. These negative externalities lead to a divergence between the marginal social cost and the marginal private cost. As firms and consumers consider only private costs and benefits, the divergence between the marginal social cost and the marginal private cost of tobacco results in over-consumption.

In the above diagram, due to external costs, the marginal social cost (MSC) is higher than the marginal private cost (MPC). Therefore, the equilibrium output level (QE) where marginal private benefit (MPB) is equal to MPC is higher than the allocatively efficient output level (QAE) where marginal social benefit (MSB) is equal to MSC. For the units of output between QAE and QE, the MSC is higher than the MSB. Therefore, the social welfare loss which is the area under the MSC curve is greater than the social welfare gain which is the area under the MSB curve resulting in a net social welfare loss. It follows that these units of output should not be consumed. However, as firms and consumers do not consider external costs and benefits, they are consumed which results in a deadweight loss equal to the net social welfare loss. The deadweight loss, which is the loss of social welfare due to market failure or government intervention, is represented by the shaded area.

Alternative Diagrammatical Representation of Externalities

In this book, external benefits, whether they occur in consumption or production, are illustrated diagrammatically with the marginal social benefit drawn above the marginal private benefit, which is shown in the first diagram of this chapter. Similarly, external costs, whether they occur in consumption or production, are illustrated diagrammatically with the marginal social cost drawn above the marginal private cost, which is shown in the second diagram of this chapter. Under this treatment, marginal social benefit is equal to marginal private benefit plus marginal external benefit, and marginal social cost is equal to marginal private cost plus marginal external cost. However, in some economics books, external benefits in consumption and external benefits in production are illustrated diagrammatically differently. Similarly, in these books, external costs in consumption and external costs in production are illustrated diagrammatically differently. In these books, external benefits in consumption are illustrated diagrammatically with the marginal social benefit drawn above the marginal private benefit, and external benefits in production are illustrated diagrammatically with the marginal social cost drawn below the marginal private cost. Similarly, in these books, external costs in production are illustrated diagrammatically with the marginal social cost drawn above the marginal private cost, and external costs in consumption are illustrated diagrammatically with the marginal social benefit drawn below the marginal private benefit. Under this treatment, marginal social benefit is equal to marginal private benefit plus marginal external benefit in consumption minus marginal external cost in consumption, and marginal social cost is equal to marginal private cost plus marginal external cost in production minus marginal external benefit in production. I use the 2-diagram treatment in this book as the alternative 4-diagram treatment has proved to be too confusing for too many students. In the Singapore-Cambridge GCE ‘A’ Level Economics examination, both treatments are acceptable. However, in case your school teachers prefer the 4-diagram treatment, you may use the following diagrams in your school tests and examinations.

In the above diagram, due to external benefits in consumption, the marginal social benefit (MSB) is higher than the marginal private benefit (MPB). Therefore, the equilibrium output level (QE) where MPB is equal to marginal private cost (MPC) is lower than the allocatively efficient output level (QAE) where MSB is equal to marginal social cost (MSC).

In the above diagram, due to external benefits in production, the marginal social cost (MSC) is lower than the marginal private cost (MPC). Therefore, the equilibrium output level (QE) where marginal private benefit (MPB) is equal to MPC is lower than the allocatively efficient output level (QAE) where marginal social benefit (MSB) is equal to MSC.

In the above diagram, due to external costs in consumption, the marginal social benefit (MSB) is lower than the marginal private benefit (MPB). Therefore, the equilibrium output level (QE) where MPB is equal to marginal private cost (MPC) is higher than the allocatively efficient output level (QAE) where MSB is equal to marginal social cost (MSC).

In the above diagram, due to external costs in production, the marginal social cost (MSC) is higher than the marginal private cost (MPC). Therefore, the equilibrium output level (QE) where marginal private benefit (MPB) is equal to MPC is higher than the allocatively efficient output level (QAE) where marginal social benefit (MSB) is equal to MSC.

Note:   Market failures due to externalities and imperfect information are generally a matter of concern and hence require government intervention if the goods are merit goods or demerit goods as there are serious social and economic implications. Merit goods are goods that society deems desirable and the government thinks people should be encouraged to consume. Examples of merit goods include education and healthcare. Demerit goods are goods that society deems undesirable and the government thinks people should be discouraged from consuming. Examples of demerit goods include tobacco and alcohol.

Externalities will be discussed in economics tuition by the Principal Economics Tutor in greater detail.

2.2       Measures to Correct Market Failures due to Externalities

Tax

To correct market failures due to negative externalities, the government can use tax to decrease the supply. For example, the Singapore government imposes a tax of $427 per 1000 cigarettes which is equivalent to $0.427 per cigarette or $8.54 per packet of 20 cigarettes. A tax on tobacco will lead to a rise in the cost of production and hence a fall in the supply. When this happens, the price will rise which will lead to a fall in the quantity demanded. In this way, a tax on tobacco induces consumers to internalise the external costs.

In the above diagram, a tax on tobacco leads to a rise in the marginal private cost (MPC). If the MPC after tax is MPC’, the new equilibrium output level (QE’) will be equal to the allocatively efficient output level (QAE).

Benefits and Limitations of Tax

Using tax to correct the market failure of tobacco has its benefits and limitations. First, a tax on tobacco allows the government to raise tax revenue which can be used to deal with the external costs of consumption or fund research to prevent or treat tobacco-related diseases. Second, the price elasticity of demand for tobacco by teenagers is likely to be high due to their low incomes and hence the large proportion of income spent on the good. Therefore, a tax on tobacco which will increase the price is likely to substantially reduce the problem of teenage smoking. Notwithstanding the benefits, there are several limitations. First, for a tax on tobacco to correct the market failure, it must be equal to the marginal external cost as the purpose of the tax is to induce consumers to internalise the external costs, assuming no other causes of the market failure. However, it is difficult to precisely measure the external costs of tobacco consumption. Therefore, a tax on tobacco may not be equal to the marginal external cost and hence may not correct the market failure. Second, a tax on tobacco expressed as a percentage of income is higher for low income individuals than for high income individuals. Therefore, a tax on tobacco is regressive and hence worsens income inequity.

Subsidy

To correct market failures due to positive externalities, the government can use subsidy to increase the supply. For example, the Singapore government gives a subsidy to public hospitals for the provision of subsidised healthcare. The amount of subsidy that consumers of healthcare at public hospitals will receive depends on their income and the type of ward accommodation they choose. For non-working consumers, the amount of subsidy that they will receive depends on the values of their residential properties and the incomes of their immediate family members. A subsidy on healthcare will lead to a fall in the cost of production and hence a rise in the supply. When this happens, the price will fall which will lead to a rise in the quantity demanded. In this way, a subsidy on healthcare induces consumers to internalise the external benefits.

In the above diagram, a subsidy on healthcare leads to a fall in the marginal private cost (MPC). If the MPC after subsidy is MPC’, the new equilibrium output level (QE’) will be equal to the allocatively efficient output level (QAE).

Benefits and Limitations of Subsidy

Using subsidy to correct the market failure of healthcare has its benefits and limitations. First, a subsidy on healthcare expressed as a percentage of income is higher for low income individuals than for high income individuals. Therefore, a subsidy on healthcare benefits low income individuals more in relative terms and hence improves income equity. Second, the use of means-testing in public hospitals means that low income individuals receive more subsidy than high income individuals which further improves income equity. Notwithstanding the benefits, there are several limitations. First, for a subsidy on healthcare to correct the market failure, it must be equal to the marginal external benefit as the purpose of the subsidy is to induce consumers to internalise the external benefits, assuming no other causes of the market failure. However, it is difficult to precisely measure the external benefits of healthcare consumption. Therefore, a subsidy on healthcare may not be equal to the marginal external benefit and hence may not correct the market failure. Second, subsidising healthcare puts a strain on the government budget which may compel the government to decrease expenditure on other important areas such as education and infrastructure to avoid a budget deficit and this may result in adverse consequences for the economy in the long run.

Regulation

To correct market failures due to positive externalities, the government can use regulation to increase the demand. For example, the Singapore government uses regulation to increase the demand for healthcare. The Singapore government makes certain vaccinations mandatory. These vaccinations include BCG, DTP, SAB, HEPB and MMR. Similarly, to correct market failures due to negative externalities, the government can use regulation to decrease the demand. For example, the Singapore government uses regulation to decrease the demand for tobacco. The Singapore government prohibits smoking in certain public places such as shopping malls, food centres, and entertainment outlets. In addition to reducing the demand for tobacco, prohibiting smoking in public places reduces the marginal external cost and hence brings the marginal social cost closer to the marginal private cost. When this happens, the allocatively efficient output level will move closer to the equilibrium output level resulting in a reduction in allocative inefficiency.

Benefits and Limitations of Regulation

Using regulation to correct the market failure of healthcare has its benefits and limitations. Unlike education on healthcare, regulations on healthcare are legally binding which means that it is mandatory for people to respond to them. However, effective regulation requires effective enforcement but the cost of effective enforcement may be very high which may render it impractical resulting in ineffective regulation. Furthermore, the cost of enforcement may largely offset or even outweigh the benefit of the reduction or elimination of the deadweight loss in the market. Using regulation to correct the market failure of tobacco has its benefits and limitations. First, unlike education on tobacco, regulations on tobacco are legally binding which means that it is mandatory for people to respond to them. Second, unlike a tax on tobacco, regulations on tobacco do not worsen income inequity. Notwithstanding the benefits, there are several limitations. First, effective regulation requires effective enforcement but the cost of effective enforcement may be very high which may render it impractical resulting in ineffective regulation. Furthermore, the cost of enforcement may largely offset or even outweigh the benefit of the reduction or elimination of the deadweight loss in the market. Second, if prohibiting smoking in public places leads to an increase in smoking in non-public places, the demand for tobacco may not fall and hence the effectiveness of the measure may be limited.

Tradable Emissions Permit Scheme (For Pollution in Production)

Under a tradable emissions permit scheme, also known as an emissions trading scheme and a cap-and-trade scheme, the government will determine the socially optimal level of pollution caused by a pollutant, such as carbon. To achieve this socially optimal level of pollution, it will set a limit on the amount of the pollutant that firms are allowed to emit. The limit is then allocated or sold through auction to firms in the form of emissions permits, which are also known as credits or allowances, which represent the right to emit a certain amount of the pollutant. Emissions permits can then be traded in the secondary market. For example, the emissions permits under the EU Emissions Trading Scheme are traded in European Union Allowances. Firms are required to hold a number of emissions permits equivalent to their emissions. Firms that need to increase their emissions beyond what their emissions permits allow must buy emissions permits from those who have surplus emissions permits. By limiting the amount of the pollutant that firms are allowed to emit, the government effectively limits the amount of a good that firms are allowed to produce which will solve or reduce the problem of over-production.

Benefits and Limitations of Tradable Emissions Permit Scheme

Using a tradable emissions permit scheme to correct market failures has its benefits and limitations. First, the use of a tradable emissions permit scheme does not require the government to precisely measure the marginal external cost which is a difficult task. The government simply needs to conduct environmental studies to determine the socially optimal level of pollution caused by the pollutant. Second, unlike education, a tradable emissions permit scheme is legally binding which means that it is mandatory for firms to respond to it. Notwithstanding the benefits, there are several limitations. First, an effective tradable emissions permit scheme requires effective enforcement but the cost of effective enforcement may be very high which may render it impractical resulting in ineffective regulation. Furthermore, the cost of enforcement may largely offset or even outweigh the benefit of the reduction or elimination of the deadweight loss in the market. Second, opponents of the tradable emissions permit scheme argue that such a scheme does not provide the incentive for firms to clean up the pollution and adopt or develop more environmentally friendly production technologies as firms can simply buy emissions permits for their pollution. This is especially true if the emissions permits are cheap. Third, they argue that such a scheme, apart from increasing the cost of production in the economy, also creates uncertainty as the emissions permits are traded in the secondary market and hence their prices are subject to speculation. This may have the adverse effect of reducing the attractiveness of the economy to foreign firms that may invest in the economy resulting in a fall in foreign direct investments.

Direct Provision

To correct market failures due to positive externalities, the government can engage in direct provision to increase the supply. For example, the Singapore government engages in direct provision of healthcare through public hospitals that are run like private hospitals to increase the supply and hence correct the market failure.

Benefits and Limitations of Direct Provision

Engaging in direct provision to correct the market failure of healthcare has its benefits and limitations. Direct provision of healthcare does not only increase the supply, the lower charges at the public hospitals also increase the affordability to low income individuals. However, public hospitals do not need to consider factors such as profitability and survival and hence are more likely to be x-inefficient and hence productively inefficient than private hospitals. Although the Singapore government runs public hospitals like private hospitals, this will only alleviate the problem to some extent.

3M Framework (For Healthcare in Singapore)

The Singapore government uses the 3M framework to increase the demand and hence correct the market failure of healthcare. The Singapore government has set up Medifund to help the very poor pay for their healthcare at public hospitals. Medifund is an endowment fund set up by the Singapore government with capital injections coming from budget surpluses. The interest income from Medifund is used to help the very poor who cannot afford the subsidised charges at public hospitals pay for their healthcare. The Singapore government has introduced a compulsory medical savings scheme known as Medisave. Under Medisave, it is mandatory for working citizens and permanent residents to make monthly contributions to their Medisave account which can be used to pay for their healthcare. The Singapore government has set up a compulsory medical insurance scheme known as MediShield Life. Under MediShield Life, it is mandatory for citizens and permanent residents to be covered under the medical insurance scheme and the premiums can be paid through Medisave.

Benefits and Limitations of 3M Framework

Using the 3M framework to correct the market failure of healthcare in Singapore has its benefits and limitations. First, Medifund does not only increase the demand for healthcare in Singapore, it also ensures that healthcare is accessible to everyone regardless of the extent of income inequity. Second, unlike a subsidy on healthcare, Medisave does not require the Singapore government to incur substantial expenditure. Notwithstanding the benefits, there are several limitations. First, Medifund only covers a limited range of healthcare services. Second, only a small proportion of the monthly CPF contribution goes to the Medisave account. Third, as it is mandatory to take up MediShield Life, the Singapore government needs to provide financial assistance to keep the premiums affordable. This puts a strain on the government budget which may compel the government to decrease expenditure on other important areas such as education and infrastructure to avoid a budget deficit and this may result in adverse consequences for the economy in the long run.

Edusave Scheme (For Education in Singapore)

The Singapore government uses the Edusave Scheme to increase the demand and hence correct the market failure of education. The Edusave Scheme includes the Edusave Contribution, the Edusave Grant, the Edusave Scholarship and the Edusave Award. Under the Edusave Contribution, all Singaporean children aged 7 to 16 will automatically be given an Edusave account and receive an annual Edusave contribution. As of 2014, for those aged 7 to 12, the annual Edusave contribution is $200, and for those aged 13 to 16, the annual Edusave contribution is $240. Under the Edusave Scholarship and the Edusave Award, Singaporean students will be given scholarships and awards for achieving good academic results, making significant improvement in their academic performance, displaying good leadership, service to community and school or excellence in non-academic activities, and demonstrating exemplary character and outstanding personal qualities. The Edusave funds can be used to pay for certain enrichment programmes and miscellaneous fees.

Benefits and Limitations of Edusave Scheme

Using the Edusave Scheme to correct the market failure of education in Singapore has its benefits and limitations. First, the Edusave contribution expressed as a percentage of income is higher for low income individuals than for high income individuals. Therefore, the Edusave contribution benefits low income individuals more in relative terms and hence improves income equity. Second, Edusave scholarships and Edusave awards encourage good academic results and behaviour. Notwithstanding the benefits, there are several limitations. First, for the Edusave contribution to correct the market failure of education, it must be equal to the marginal external benefit as the purpose of the Edusave contribution is to induce consumers to internalise the external benefits, assuming no other causes of the market failure. However, it is difficult to precisely measure the external benefits of education consumption. Therefore, the Edusave contribution may not be equal to the marginal external benefit of education and hence may not correct the market failure. Second, the Edusave Scheme puts a strain on the government budget which may compel the government to decrease expenditure on other important areas such as healthcare and infrastructure to avoid a budget deficit and this may result in adverse consequences for the economy in the long run.

Note:   The demand for tobacco is price inelastic due to the high degree of necessity and lack of close substitutes. Therefore, a tax on tobacco which will increase the price is unlikely to lead to a large decrease in the quantity demanded. However, this is not a limitation of tax as a measure to correct the market failure of tobacco. As far as the market failure of tobacco is concerned, the objective of tax is to achieve allocative efficiency rather than to decrease the consumption substantially. Therefore, the effectiveness of tax as a measure to correct the market failure of tobacco is dependent on the ability of the government to precisely measure the marginal external cost rather than the price elasticity of demand.

Students should not discuss the imposition of a ban as a measure to correct market failures due to negative externalities as such a measure is likely to lead to the loss of positive surplus while eliminating the deadweight loss. However, in the event that the external costs are very high which is likely to lead to the absence of an allocatively efficient output level, the imposition of a ban will be justifiable. Similarly, students should not discuss free direct provision as a measure to correct market failures due to positive externalities as such a measure is likely to lead to over-consumption. However, in the event that the external benefits are very high, the problem of over-consumption is unlikely to occur and hence free direct provision will be justifiable.

Measures to correct market failures due to externalities will be discussed in economics tuition by the Principal Economics Tutor in greater detail.

3          INFORMATION FAILURE

3.1       Imperfect Information as a Cause of Market Failure

Imperfect information about beneficial effects

Imperfect information about beneficial effects leads to under-consumption. For example, healthcare will be under-consumed in the absence of government intervention due to imperfect information about the beneficial effects. The perceived marginal private benefit of healthcare is lower than the actual marginal private benefit as many people do not fully realise the beneficial effects. For example, many people are not fully aware of the benefits of vaccinations against key diseases which leads to underestimation of the private benefits. As the demand for healthcare is based on the perceived marginal private benefit which is lower than the actual marginal private benefit due to imperfect information about the beneficial effects, this leads to under-consumption.

In the above diagram, due to imperfect information about the beneficial effects, the perceived marginal private benefit (MPBP) is lower than the actual marginal private benefit (MPBA). Therefore, the equilibrium output level (QE) where MPBP is equal to marginal private cost (MPC) is lower than the allocatively efficient output level (QAE) where marginal social benefit (MSB) is equal to marginal social cost (MSC). For the units of output between QE and QAE, the MSB is higher than the MSC. Therefore, the social welfare gain which is the area under the MSB curve is greater than the social welfare loss which is the area under the MSC curve resulting in a net social welfare gain. It follows that these units of output should be consumed. However, as people do not fully realise the beneficial effects, they are not consumed which results in a deadweight loss equal to the unrealised net social welfare gain. The deadweight loss, which is the loss of social welfare due to market failure or government intervention, is represented by the shaded area.

Imperfect information about detrimental effects

Imperfect information about detrimental effects leads to over-consumption. For example, tobacco will be over-consumed in the absence of government intervention due to imperfect information about the detrimental effects. The perceived marginal private benefit of tobacco is higher than the actual marginal private benefit as many people do not fully realise the detrimental effects. For example, many people are not fully aware of the types and the severity of tobacco-related diseases which leads to underestimation of the costs of personal tobacco-related health problems. As the demand for tobacco is based on the perceived marginal private benefit which is higher than the actual marginal private benefit due to imperfect information about the detrimental effects, this leads to over-consumption.

In the above diagram, due to imperfect information about the detrimental effects, the perceived marginal private benefit (MPBP) is higher than the actual marginal private benefit (MPBA). Therefore, the equilibrium output level (QE) where MPBP is equal to marginal private cost (MPC) is higher than the allocatively efficient output level (QAE) where marginal social benefit (MSB) is equal to marginal social cost (MSC). For the units of output between QAE and QE, the MSC is higher than the MSB. Therefore, the social welfare loss which is the area under the MSC curve is greater than the social welfare gain which is the area under the MSB curve resulting in a net social welfare loss. It follows that these units of output should not be consumed. However, as people do not fully realise the detrimental effects, they are consumed which results in a deadweight loss equal to the net social welfare loss. The deadweight loss, which is the loss of social welfare due to market failure or government intervention, is represented by the shaded area.

Note:   In this book, imperfect information about the detrimental effects is illustrated diagrammatically with the perceived MPB above the actual MPB, and imperfect information about the beneficial effects is illustrated diagrammatically with the perceived MPB below the actual MPB. However, in some economics textbooks, imperfect information about the detrimental effects is illustrated diagrammatically with the perceived MPC below the actual MPC. I prefer the treatment in this book as the perceived MPB is equal to the demand, and the MPC is equal to the supply, which enables students to answer questions which combine market failure and demand and supply analysis.

Imperfect information will be discussed in economics tuition by the Principal Economics Tutor in greater detail.

3.2       Measures to Correct Market Failures due to Imperfect Information

Education

To correct market failures due to imperfect information about the beneficial effects, the government can use education to increase the demand. For example, the Singapore government uses education to increase the demand and hence correct the market failure of healthcare. The Singapore government conducts health campaigns and has incorporated health education into the school curriculum to increase the awareness of the beneficial effects of good health. Education reduces the extent of imperfect information and hence brings the perceived marginal private benefit closer to the actual marginal private benefit. When this happens, the equilibrium output level will move closer to the allocatively efficient output level resulting in a reduction in allocative inefficiency. Similarly, to correct market failures due to imperfect information about the detrimental effects, the government can use education to decrease the demand. For example, the Singapore government uses education to decrease the demand and hence correct the market failure of tobacco. The Singapore government conducts anti-smoking campaigns through the Health Promotion Board to increase the awareness of the harmful effects of smoking such as heart disease, stroke, lung cancer and chronic obstructive lung disease. Furthermore, it has incorporated health education into the school curriculum to increase the awareness of the beneficial effects of good health. Education reduces the extent of imperfect information and hence brings the perceived marginal private benefit closer to the actual marginal private benefit. When this happens, the equilibrium output level will move closer to the allocatively efficient output level resulting in a reduction in allocative inefficiency.

Benefits and Limitations of Education

Using education to correct the market failure of healthcare has its benefits and limitations. First, incorporating health education into the school curriculum may help people stay healthy from a young age. Second, unlike regulations on healthcare, education on healthcare does not incur enforcement costs. Notwithstanding the benefits, there are several limitations. First, education is not legally binding which means that it is not mandatory for people to respond to it. Second, even if it is effective, the effects will only be realised in the long run and this is particularly true for preventive healthcare whose benefits are not immediately obvious. Using education to correct the market failure of tobacco has its benefits and limitations. First, incorporating health education into the school curriculum may prevent young people from getting into the habit of smoking in the first place. Second, unlike regulations on tobacco, education on tobacco does not incur enforcement costs. Notwithstanding the benefits, there are several limitations. First, education is not legally binding which means that it is not mandatory for people to respond to it. Second, even if it is effective, the effects will only be realised in the long run and this is particularly true for smoking due to the addictive nature.

Regulation

To correct market failures due to imperfect information about the beneficial effects, the government can use regulation to increase the demand. For example, the Singapore government uses regulation to increase the demand for healthcare. The Singapore government makes certain vaccinations mandatory. These vaccinations include BCG, DTP, SAB, HEPB and MMR. Similarly, to correct market failures due to imperfect information about the detrimental effects, the government can use regulation to decrease the demand. For example, the Singapore government uses regulation to decrease the demand for tobacco. The Singapore government prohibits firms from engaging in tobacco advertising. Furthermore, it has implemented the Standardised Packaging (SP) Measure which mandates tobacco manufacturers to remove all logos, colours, images and promotional information on the packaging of tobacco products, and display graphic health warnings covering at least 75 per cent of the packaging of tobacco products. It also prohibits the sale of tobacco to people under 18 years of age and the consumption of tobacco by people under 18 years of age.

Benefits and Limitations of Regulation

Using regulation to correct the market failure of healthcare has its benefits and limitations. Unlike education on healthcare, regulations on healthcare are legally binding which means that it is mandatory for people to respond to them. However, effective regulation requires effective enforcement but the cost of effective enforcement may be very high which may render it impractical resulting in ineffective regulation. Furthermore, the cost of enforcement may largely offset or even outweigh the benefit of the reduction or elimination of the deadweight loss in the market. Using regulation to correct the market failure of tobacco has its benefits and limitations. First, unlike education on tobacco, regulations on tobacco are legally binding which means that it is mandatory for people to respond to them. Second, unlike a tax on tobacco, regulations on tobacco do not worsen income inequity. Notwithstanding the benefits, there are several limitations. First, effective regulation requires effective enforcement but the cost of effective enforcement may be very high which may render it impractical resulting in ineffective regulation. Furthermore, the cost of enforcement may largely offset or even outweigh the benefit of the reduction or elimination of the deadweight loss in the market. Second, regulations are subject to parliamentary debates and approvals. In countries where lawmakers often vote along party lines such as the United States, the passage of some regulations may take a long time, if ever.

In addition to education and regulation, direct provision, the 3M framework and the Edusave Scheme can be used to correct market failures due to imperfect information, and they have been discussed in Section 2.2.

Note:   Measures to correct market failures due to imperfect information will be discussed in economics tuition by the Principal Economics Tutor in greater detail.

3.3       Asymmetric Information as a Cause of Market Failure

Asymmetric information is a situation where some economic agents involved in a transaction have more information than other economic agents which leads to adverse selection and moral hazard.

Adverse Selection

Adverse selection is a situation where the parties on the side of the market who have more information self-select in a way that adversely affects the parties on the other side of the market who have less information. Adverse selection is a form of opportunistic behaviour before a transaction takes place.

Sellers have More Information than Buyers

Take the used car market for example. In the used car market, sellers (i.e. used car dealers) have more information about the conditions of their cars than buyers. In order to fetch a higher price for their cars, sellers may conceal certain information about the conditions of their cars from buyers such as a high frequency of breakdowns. Taking this into consideration, buyers of used cars will lower the prices that they offer in view of the possibility that they will be buying low quality cars, which are commonly known as lemons due to a famous article written by George Akerlof, ‘The Market for “Lemons”’, which was published in 1970. However, at these lower prices, some sellers of high quality cars will not be willing to sell their cars. As buyers come to the realisation that the mix of cars in the used car market has shifted towards low quality cars, they will further lower the prices that they offer which will induce even more sellers of high quality cars to be unwilling to sell their cars. Therefore, asymmetric information in the used car market may lead to a situation where mainly only low quality cars are bought and sold and hence the term adverse selection. As high quality used cars which buyers value more than sellers are not bought and sold, market failure occurs.

Buyers have More Information than Sellers

Take the health insurance market for example. In the health insurance market, buyers have more information about the conditions of their health than sellers (i.e. insurance companies). In order to pay a lower premium for their health insurance, buyers may conceal certain information about the conditions of their health from insurance companies such as a history of ill health. Taking this into consideration, insurance companies will raise the premiums that they charge in view of the possibility that they will be selling health insurance to high risk individuals. However, at these higher premiums, some low risk individuals will not be willing to buy health insurance. As insurance companies come to the realisation that the mix of individuals in the health insurance market has shifted towards high risk individuals, they will further raise the premiums that they charge which will induce even more low risk individuals to be unwilling to buy health insurance. Therefore, asymmetric information in the health insurance market may lead to a situation where mainly only high risk individuals are insured and hence the term adverse selection. As low risk individuals who wish to have their health insured are priced out of the market, market failure occurs.

Moral Hazard

Moral hazard is a situation where the party to a contract who has more information about their actions does not bear the consequences of their actions and hence engages in risk-taking behaviour which adversely affects the other party to the contract who has less information. Moral hazard is a form of opportunistic behaviour after a transaction takes place. Take the health insurance market for example. In the health insurance market, individuals whose health is insured are more likely to engage in risk-taking behaviour than those whose health is not insured. More specifically, individuals whose health is not insured are more likely to pursue a healthy lifestyle which involves eating healthy food, taking health supplements and exercising regularly which will make them less prone to health problems. In contrast, individuals whose health is insured are less likely to do so which will make them more prone to health problems. Such risk-taking behaviour of insured individuals inflicts financial losses on insurance companies and hence the term moral hazard. As individuals whose health is insured are more likely to engage in risk-taking behaviour which will make them more prone to health problems, this will lead to over-consumption of healthcare by these individuals resulting in market failure. In addition, taking the problem of moral hazard into consideration, insurance companies will raise the premiums that they charge in view of the higher payouts that they will need to provide to insured individuals. However, at these higher premiums, some individuals, particularly those who pursue a healthy lifestyle will not be willing to buy insurance for their health. As individuals who wish to have their health insured are priced out of the market, market failure occurs.

3.4       Measures to Correct Market Failures due to Asymmetric Information

Mandatory Consumption

The government can address the problem of adverse selection which arises due to asymmetric information through regulation in the form of mandatory consumption. Mandatory consumption will prevent asymmetric information from resulting in a situation where sellers only sell to buyers with less desirable characteristics. For example, in the health insurance market, mandatory consumption will ensure that insurance companies do not sell health insurance to only high risk individuals as all individuals will be insured under the regulation. An example of mandatory consumption for health insurance is Singapore where the government has made it mandatory for people to buy MediShield Life which is a health insurance plan.

Limitations of Mandatory Consumption

Mandatory consumption requires government financial assistance to make the good affordable. For example, the Singapore government provides premium subsidies to make premiums for MediShield Life affordable. This exerts a strain on the government budget which may compel the government to decrease expenditure on other important areas such as education and infrastructure to avoid a budget deficit and this may result in adverse consequences for the economy in the long run.

Lemon Law

The government can address the problem of adverse selection which arises due to asymmetric information through regulation in the form of a lemon law. A lemon law is a consumer protection law which provides remedies for consumers against defective goods that fail to meet standards of quality or performance at the time of delivery. Such goods are commonly known as lemons. Under a typical lemon law, if a good is found to be defective, the buyer can ask the seller to repair or replace the good. They may also choose to keep the defective good and request a reduction in the price, or return the defective good for a refund if the seller did not provide repair or replacement within a reasonable period of time without causing them significant inconvenience, or repair or replacement by the seller is impossible. Typically, if a defect is found within six months of delivery, it is assumed that the defect existed at the time of the delivery, unless the seller can prove otherwise. Passing a lemon law will prevent asymmetric information from resulting in a situation where sellers sell defective goods to buyers. For example, the Singapore government passed a lemon law which took effect on 1 September 2012.

Limitations of Lemon Law

Reporting a case of a defective good to the relevant authority incurs a transaction cost which includes the cost of time and the cost of transport. If the value of the good is low relative to the transaction cost, the buyer may not be willing to report to the relevant authority in the event that the good is found to be defective. Therefore, they may decide not to buy the good.

Screening

The problem of adverse selection which arises due to asymmetric information can be addressed by the party who has less information obtaining information from the party who has more information. For example, an insurance company can screen buyers of health insurance by making it compulsory for them to declare their medical history and do a medical check-up before considering selling health insurance to them. A buyer of a used car can screen the car by paying a car mechanic to check the car before considering buying it.

Limitations of Screening

Screening incurs costs which include the transaction cost consisting of the cost of time and the cost of transport. Therefore, if the costs of screening are high, buyers may not be willing to incur the costs and hence may decide not to buy the good.

Signalling

The problem of adverse selection which arises due to asymmetric information can be addressed by the party who has more information passing information to the party who has less information. For example, a used car seller can signal to buyers that its cars are of high quality by offering warranty.

Limitations of Signalling

Exercising a warranty claim for a defective good incurs a transaction cost which includes the cost of time and the cost of transport. If the value of the good is low relative to the transaction cost, the buyer may not be willing to exercise the warranty claim in the event that the good is found to be defective. Therefore, they may not find the warranty appealing and hence may decide not to buy the good.

Co-payment

The problem of moral hazard which arises due to asymmetric information can be addressed by including a co-payment in the insurance plan. In the event of a claim, a co-payment will require the insured to pay a proportion of the cost which they incur and this will provide them with the incentive to look after their health or properties which are insured. For example, under MediShield Life, claimants are required to pay a deductible of between $1500 to $3000 and a co-insurance of between 3 and 10 per cent of the cost of the treatment net of the deductible.

Limitations of Co-payment

As a co-payment in an insurance plan will require the insured to pay a proportion of the cost which they incur in the event of a claim, it may induce some individuals to be unwilling to buy insurance for their health or properties. Furthermore, the higher the co-payment, the more effective it will be as a measure to address the problem of moral hazard. However, a high co-payment may lead to a high price which may cause hardship for low income individuals, and this is particularly true if the good is a necessity such as healthcare.

4          PUBLIC GOODS

4.1       Public Goods as a Cause of Market Failure

Public goods will not be produced in the absence of government intervention. Public goods are goods that are non-excludable and non-rivalrous. A good is non-excludable when it is impossible or prohibitively costly to prevent non-payers from consuming the good once it has been produced. A good is non-rivalrous when the consumption of the good by a consumer will not reduce the amount available to other consumers. Examples of public goods include national defence and street lighting. As public goods are non-excludable, consumers can consume them without paying for them. Therefore, consumers will want to consume public goods without contributing to their production which is known as the free-rider problem. As consumers have no incentive to pay for public goods, private firms which are profit-oriented have no incentive to produce them. Therefore, in the absence of government intervention, public goods will not be produced due to the characteristic of non-excludability. Furthermore, as public goods are non-rivalrous, the marginal cost of provision, which is the additional cost resulting from providing a good to one more consumer, is zero. Therefore, for allocative efficiency to be achieved, the price should be zero, assuming no externalities. However, private firms are profit-oriented and hence will only produce a good at a positive price which corresponds to a quantity demanded lower than that at a zero price. Therefore, even if public goods were produced by private firms, assuming away the characteristic of non-excludability, they would be under-consumed in the absence of government intervention due to the characteristic of non-rivalry.

Note:   Unlike public goods, private goods are goods that are excludable and rivalrous. A good is excludable when it is possible and not prohibitively costly to prevent non-payers from consuming the good once it has been produced. A good is rivalrous when the consumption of the good by a consumer will reduce the amount available to other consumers. Examples of private goods include personal computers and smartphones. Free goods are goods that exist in quantities that are more than sufficient to meet demand at a zero price. Examples of free goods include desert sand and sea water. Economic goods are goods that exist in quantities that are less than sufficient to meet demand at a zero price. Examples of economic goods include cars and televisions. In addition to private goods and public goods, economic goods include club goods and common resources. Club goods are goods that are excludable and non-rivalrous. Examples of club goods include cable television and golf courses. Common resources are goods that are non-excludable and rivalrous. Examples of common resources include fishes in the sea and pastures.

Apart from very high external benefits, free direct provision can also be justified on the grounds of non-rivalry. As non-rivalry leads to a zero marginal cost of provision, and private firms are profit-oriented and hence will not produce a good at a zero price, free direct provision is the only measure to achieve allocative efficiency.

Public goods will be discussed in economics tuition by the Principal Economics Tutor in greater detail.

4.2       Measures to Correct Market Failures due to Public Goods

To correct market failures due to public goods, the government can engage in direct provision. For example, the Singapore government directly provides national defence and street lighting. The expenditure on these public goods is financed through taxation. The Singapore government engages in the direct provision of public goods as other measures such as tax, subsidy, regulation and education do not solve the free-rider problem caused by non-excludability which is the root cause of the non-provision of public goods. However, state-owned firms do not need to consider factors such as profitability and survival and hence are more likely to be x-inefficient and hence productively inefficient than private firms.

5          MARKET DOMINANCE

5.1       Market Dominance as a Cause of Market Failure

Market dominance occurs when the firm or firms in a market have substantial market power which leads to severe under-production. An example of a firm with substantial market power is Microsoft Corporation in the market for PC operating systems. Market dominance occurs in monopolistic markets and oligopolistic markets due to the high barriers to entry. To maximise profit, a firm with market power will restrict output and charge a price higher than its marginal cost which will lead to under-production, and this problem is particularly severe when the market power is substantial. In the case of monopoly, the demand for the good is likely to be price inelastic due to lack of close substitutes and hence the difference between the price and the marginal cost, which is a measure of the extent of allocative inefficiency, is likely to be large.

In the above diagram, the allocatively efficient output level where marginal social benefit (MSB) is equal to marginal social cost (MSC), or price (P) is equal to marginal cost (MC), is QAE. However, if the firm increases output beyond Q0 where MC is equal to MR, the increase in total cost will be greater than the increase in total revenue as MC will be higher than MR. If this happens, profit will fall. Therefore, the firm restricts the output level to Q0 which is lower than QAE and charges a price (P0) higher than the marginal cost (MC0). The less price elastic the demand and hence the steeper the demand curve is, the larger will be the difference between the price and the marginal cost. The deadweight loss, which is the loss of social welfare due to market failure or government intervention, is represented by the shaded area.

In addition to allocative inefficiency, market dominance is a cause of market failure due to productive inefficiency. A firm is productively efficient when it produces on its long-run average cost curve, from firm’s perspective. This occurs when it is x-efficient and technically efficient. A firm is x-efficient when it is not lax in cost control. In other words, it uses the most efficient production technology, it is not overstaffed, it does not occupy premises that are larger than necessary for its output level, etc. A firm is technically efficient when it uses the least-cost combination of factor inputs to produce its output level which means that the last dollar of each factor input that it employs produces the same additional output. From society’s perspective, a firm is productively efficient when it produces at the minimum efficient scale. Due to the absence of competition in the market, a monopoly may be lax in cost control. Therefore, a monopoly may be x-inefficient and hence productively inefficient. Although less of a concern than allocative inefficiency and income inequity, productive inefficiency is also a cause of market failure.

Note:   As monopolists and oligopolists can make supernormal profit in the long run, market dominance is a cause of income inequity which is a cause of market failure. However, market dominance is not a major cause of income inequity in reality. Therefore, unless the question specifically asks so, students need not discuss this in the examination.

5.2       Measures to Correct Market Failures due to Market Dominance

Marginal Cost Pricing, Average Cost Pricing, Subsidy and Nationalisation

Marginal cost pricing, average cost pricing, subsidy and nationalisation are some of the measures to correct market failures due to market dominance and these measures have been discussed in Chapter 6. In addition to these measures, the government can increase competition in the market or set a maximum price to correct the market failures.

Increasing Competition

The government can increase competition in the market through increasing the number of firms to decrease economic inefficiency due to market dominance. The entry of potential firms into a monopolistic market will create substitutes for the good produced by the incumbent firm. When this happens, the price elasticity of demand for the good produced by the incumbent firm will rise which will lead to a decrease in the difference between the price and the marginal cost resulting in a decrease in allocative inefficiency. This may occur to a large extent if there is little differentiation among the products produced by the firms.

In the above diagram, the entry of a potential firm into a monopolistic market leads to an increase in the price elasticity of demand and hence a flatter demand curve (D) from D0 to D1 resulting in a decrease in the difference between the price (P) and the marginal cost (MC) from (P0 – MC0) to (P1 – MC1). Furthermore, increasing the number of firms in a monopolistic market will create competition for the incumbent firm. In an attempt to reduce the loss of market share, the incumbent firm may increase cost competitiveness to increase price competitiveness by eliminating x-inefficiency and hence productive inefficiency. However, if a monopolistic market is a natural monopoly, increasing the number of firms in the market will still result in only one firm in the market and hence will not decrease economic inefficiency in the long run.

Maximum Price

To correct market failures due to market dominance, the government can use maximum price. For example, the public bus services and the public train services in Singapore are operated by two large firms, namely SMRT and SBS Transit. Therefore, the public transport market in Singapore is an imperfect market. To regulate the public transport market, the government has set up the Public Transport Council. SMRT and SBS Transit are required to seek approval from the Public Transport Council for any fare increments. Furthermore, the Public Transport Council has implemented a fare adjustment formula which allows a maximum fare increment of 2.8 per cent. These pricing regulations effectively act like a maximum price regulation which will increase the output level in the public transport market and hence may correct the market failure.

In the above diagram, a maximum price set at P1 results in the new profit-maximising output level (Q1) equal to QAE. However, setting a maximum price in a market may cause the firms to make a loss. Therefore, the government may need to give the firms a subsidy to allow them to cover their losses. However, if the government is unwilling or unable to do so, maximum price will not be feasible.

Note:   Measures to correct market failures due to market dominance will be discussed in economics tuition by the Principal Economics Tutor in greater detail.

6          IMMOBILITY OF FACTORS OF PRODUCTION

6.1       Immobility of Factors of Production as a Cause of Market Failure

Immobility of factors of production may cause a market to be in a constant state of disequilibrium resulting in allocative inefficiency. When the market forces of demand and supply change, firms will respond by changing their output levels and hence the amount of factor inputs they employ. However, owners of factors of production may be slow to respond due to immobility. For example, workers may be slow to respond due to occupational immobility and geographical immobility. Occupational immobility occurs when workers do not have the relevant skills and knowledge to move to the industry. Therefore, they need time to undergo education and training to acquire the skills and knowledge before they can move to the industry. Geographical immobility occurs when workers do not reside in the place where the industry is located. Therefore, they need time to relocate before they can move to the industry. As workers move to the industry over time and hence the market moves towards the equilibrium, the market forces of demand and supply change which moves the equilibrium and this causes the market to be in a constant state of disequilibrium resulting in allocative inefficiency.

In the above diagram, the demand (D0) and the supply (S0) lead to the equilibrium (e0). When the demand increases from D0 to D1, the equilibrium changes from e0 to e1. However, as the market moves slowly to the new equilibrium (e1) due to immobility of factors of production, the demand increases from D1 to D2 which leads to a new equilibrium (e2).

6.2       Measures to Correct Market Failures due to Immobility of Factors of Production

Education and Training

Education and training will reduce occupational immobility of labour. For example, the Singapore government provides education and training directly by setting up educational institutes. Examples include the Institute of Technical Education, polytechnics and Continuing Education and Training campuses. It also provides education and training indirectly by giving subsidies and tax incentives to firms to induce them to send their workers for education and training. Examples include Workfare Training Support, Skills Programme for Upgrading and Resilience, Workforce Skills Qualifications System and Skills Training for Excellence Programme. Business expenses on education and training are tax deductible in Singapore.

Better Transport System

A better transport system will reduce geographical immobility of labour. For example, the Singapore government has taken measures to improve the transport system such as building the Mass Rapid Transit system, the Light Rapid Transit system and expressways, and improving the traffic signal system through implementing the Green Link Determining System.

Limitations of Education and Training and Better Transport System

Education and training will equip workers with new skills and knowledge only in the long run and this long effectiveness time lag makes it ineffective for reducing occupational immobility in the short run. Improving the transport system puts a strain on the government budget which may compel the government to decrease expenditure on other important areas such as education and healthcare to avoid a budget deficit and this may result in adverse consequences for the economy in the long run.

Note:   Measures to correct market failures due to immobility of factors of production will be discussed in economics tuition by the Principal Economics Tutor in greater detail.

7          INCOME INEQUITY

7.1       Income Inequity as a Distributional Issue

Income inequity may lead to failure of the free market to allocate some goods and services to the people who need them more. Effective demand is the desire to buy backed by the ability to pay. Ineffective demand is merely the desire to buy not backed by the ability to pay. The free market only responds to effective demand which means that it only distributes goods and services to the people with the willingness and the ability to pay for them. However, the ability to pay for a good does not reflect the need for the good. Therefore, individuals who need some goods and services but do not have the ability to pay for them have to go without the goods and services. In the free market, the prices of goods and services are determined by the market forces of demand and supply. If the income gap is large, high income individuals with a high willingness and ability to pay may push up the prices of some goods and services to the levels which make the goods and services unaffordable to low income individuals with a low ability to pay. This is a matter of concern particularly if the goods and services are necessities. For example, education is a necessity particularly to low income individuals who have a high need to increase their skills and knowledge and hence their income earning power. Therefore, inaccessibility to education by low income individuals due to a high price which will make it difficult for them to increase their skills and knowledge is likely to cause them to be trapped in poverty.

7.2       Causes of Income Inequity in Singapore

Globalisation

Globalisation is a cause of income inequity in Singapore. Globalisation refers to the increased integration of economies through an increase in flows of goods and services, capital and labour across international borders. The production of high value-added goods such as pharmaceuticals requires high-skilled labour. Singapore has a comparative advantage in producing high value-added goods due to the large amount of high-skilled labour. Therefore, globalisation which has increased the export market has led to an expansion of the high value-added industries and this has increased the demand for high-skilled workers resulting in a rise in the wages.

In the above diagram, an increase in the demand for high-skilled labour (DHSL) from DHSL0 to DHSL1 leads to a rise in the wage rate (w) from w0 to w1. Furthermore, as the supply of high-skilled labour is inelastic due to the long period of time needed to acquire advanced skills, an increase in the demand is likely to lead to a substantial rise in the wage rate. However, the production of low value-added goods such as disk drives requires low-skilled labour and hence Singapore has a comparative disadvantage in producing low value-added goods due to the small amount of low-skilled labour. Therefore, globalisation has led to a contraction of the low value-added industries and this has decreased the demand for low-skilled workers resulting in a fall in the wages. The rise in the wages of high-skilled workers and the fall in the wages of low-skilled workers due to globalisation have caused income inequity to worsen.

Technological Advancement

Technological advancement is a cause of income inequity in Singapore. Technological advancement has increased the demand for high-skilled workers in Singapore as they are required to operate advanced machines such as computer-assisted machines and this has led to a rise in the wages. However, the innovation of labour-saving machines such as labour-saving cleaning machines has decreased the demand for low-skilled workers resulting in a fall in the wages. The rise in the wages of high-skilled workers and the fall in the wages of low-skilled workers due to technological advancement have caused income inequity to worsen.

Loose Foreign Worker Policy

A loose foreign worker policy is a cause of income inequity in Singapore. The Singapore government adopts a loose foreign worker policy to increase the quantity of labour in the economy. The objective is to increase the production capacity in the economy and hence aggregate supply to achieve high economic growth. Although this has indeed led to high economic growth, it has resulted in a substantial increase in the supply of low-skilled workers and this has reduced the wages. Although the loose foreign worker policy has also increased the supply of high-skilled workers, the extent of the increase is smaller than that of low-skilled workers and this has caused income inequity to worsen.

In the above diagram, an increase in the supply of low-skilled labour (SLSL) from SLSL0 to SLSL1 leads to a fall in the wage rate (w) from w0 to w1.

Shift from Direct Taxes to Indirect Taxes

A shift from direct taxes to indirect taxes is a cause of income inequity in Singapore. The Singapore government has been cutting corporate income tax and personal income tax to attract foreign direct investments and foreign talents to achieve high economic growth. However, as income taxes are progressive, the decrease in these taxes has worsened income inequity. Furthermore, to avoid a persistent budget deficit, the Singapore government has raised goods and services tax to offset the fall in income tax revenue. However, as goods and services tax is regressive, the increase in this tax has also caused income inequity to worsen.

7.3       Measures to Address the Problem of Income Inequity in Singapore

Transfer Payments

The Singapore government gives transfer payments to reduce income inequity. Transfer payments are payments made by the government to the recipients not in exchange for any goods or services. In 2007, the Singapore government introduced the Workfare Income Supplement (WIS) Scheme. Under the scheme, the Singapore government will supplement the wages of older low-wage workers who are 35 years of age and above and who earn $1900 and below a month, provided they meet certain eligibility criteria. These workers will receive a payout from the Singapore government of up to $875 per quarter and hence up to $3500 per year, 40 per cent in cash and 60 per cent in Central Provident Fund contribution. The WIS scheme increases the after-transfer wages of older low-wage workers and hence reduces income inequity. In 2013, the Singapore government introduced the Wage Credit (WC) Scheme. Under the scheme, the Singapore government will co-fund 40 per cent of wage increment given to workers who earn less than $4000 a month for 3 years. The WC Scheme incentivises firms to increase the wages of low-wage workers and hence reduces income inequity. However, transfer payments schemes put a strain on the government budget which may compel the government to decrease expenditure on other important areas such as education and infrastructure to avoid a budget deficit and this may result in adverse consequences for the economy in the long run. Furthermore, the WIS scheme may decrease the incentive for older low-wage workers to upgrade their skills which will negatively affect the growth of labour productivity in the economy.

Progressive Taxes

The Singapore government imposes progressive taxes to reduce income inequity. A progressive tax is a tax that increases more than proportionate with income. The marginal rate of tax on personal income in Singapore rises with the tax bracket. Therefore, higher income individuals pay a larger proportion of their personal incomes in tax to the government which will lead to a decrease in income inequity. Although the corporate income tax in Singapore is a flat rate of 17 per cent, it is also progressive due to the partial tax exemptions of 75 per cent and 50 per cent on the first $10000 and the next $290000 of chargeable income respectively. Given that higher income individuals generally own larger firms that make more profits, they pay a larger proportion of their corporate incomes in tax to the government which will lead to a decrease in income inequity. The Singapore government also uses a property tax system with three tiers of tax rates for residential properties granted owner-occupied concession. The annual value of a property in Singapore is the estimated annual rent of the property if it were to be let. The first $8000 of annual value will be exempted from property tax, the next $47000 will be taxed at 4 per cent, with the highest tax rate of 16 per cent applicable to the balance above $130000. Furthermore, up to 20 per cent tax rate is imposed on non-owner-occupied residential properties and other immovable properties. Given that higher income individuals generally own larger and more properties, they pay a larger proportion of their incomes in property tax to the government which will lead to a decrease in income inequity. However, high corporate income tax and high personal income tax may make the economy unattractive to foreign direct investments and foreign talents. Therefore, in an attempt to attract foreign direct investments and foreign talents, the Singapore government has been cutting corporate income tax and personal income tax. Furthermore, higher marginal rates of tax on personal income in higher tax brackets may disincentivise work effort and investment in education and training.

Education and Training

The Singapore government uses education and training to reduce income inequity. In 2010, the Singapore government introduced the Workfare Training Support (WTS) Scheme. Under the scheme, the Singapore government will subsidise older low-wage workers 95 per cent of the course fees for all training courses offered under the Workforce Skills Qualifications (WSQ) System. This means that older low-wage workers, or their employers, need to pay only 5 per cent of the course fees for all WSQ courses. An increase in the skills and knowledge of older low-wage workers will lead to an increase in their productivity. When the productivity of older low-wage workers rises, firms that employ these workers will experience a fall in their costs of production. When this happens, they will be able to increase the wages of the workers which will lead to a decrease in income inequity. However, older low-wage workers are generally less able and willing to expend effort on education and training and hence such a training funding scheme may not reduce income inequity significantly. Furthermore, education and training will increase the skills and knowledge of workers only in the long run and this long effectiveness time lag makes it ineffective for reducing income inequity in the short run.

Foreign Worker Policy

The Singapore government has tightened restrictions on low-skilled foreign workers to reduce income inequity. The Singapore government has tightened restrictions on low-skilled foreign workers by increasing the foreign worker levy, decreasing the dependency ratio ceiling and increasing the eligibility criteria for application of work passes. The resultant fall in the quantity and the rise in the cost of low-skilled foreign workers has increased the demand for low-skilled domestic workers and this has led to an increase in their wages resulting in a decrease in income inequity. However, tightening restrictions on low-skilled foreign workers will lead to a rise in the cost of production in the economy which may lead to macroeconomic problems such as low economic growth, high unemployment and high inflation. Furthermore, tightening restrictions on low-skilled foreign workers may cause some industries such as the construction industry to experience a shortage of workers as the domestic workers shun jobs in these industries.

Affordability of Necessities

The Singapore government takes measures to ensure the affordability of necessities such as housing, education and healthcare to reduce the undesirable effects of income inequity. The Singapore government builds housing, schools and hospitals to increase the supply and hence decrease the prices. In addition, these public housing units are sold at subsidised prices, these public schools provide education at subsidised fees and these public hospitals provide healthcare at subsidised charges. Furthermore, special provisions are made for the very poor who cannot afford the subsidised rates for these necessities provided by the Singapore government. For example, Medifund has been set up to help the very poor who cannot afford the subsidised charges at public hospitals pay for their healthcare, cheap rental housing is provided to the very poor who cannot afford the subsidised housing built by the Housing Development Board and free education is provided to the children of the very poor who cannot afford the subsidised fees at public schools.

Minimum Wage (Not used in Singapore but is used in Many Countries)

A minimum wage is the lowest wage that firms are legally allowed to pay their workers. By setting a minimum wage above the equilibrium wage, the wages of low-wage workers will rise which will lead to a decrease in income inequity. However, a minimum wage will cause some low-wage workers to lose their jobs as they will become more costly to employ. When this happens, although low-wage workers who are able to keep their jobs will be better off, those who will lose their jobs will be worse off. Therefore, a minimum wage may lead to a fall in the welfare of low-wage workers.

In the above diagram, the initial wage rate (w) and quantity of labour (QL) are w0 and QL0. A minimum wage rate (wMIN) leads to a rise in the wage rate from w0 to wMIN and a fall in the quantity of labour demanded from QL0 to QLD. Although QLD of workers will earn a higher wage, (QL0 – QLD) of workers will lose their jobs which means that these low-wage workers will be worse off. Furthermore, without a rise in labour productivity, a minimum wage which will increase the wages of low-wage workers will lead to a rise in the cost of production in the economy. When this happens, aggregate supply will fall which will lead to lower economic growth and higher inflation.

Note:   Economists sometimes use the term ‘distributive inefficiency’ to describe the situation where some goods and services are not allocated to the people who need them more. 

The income gap in Singapore is one of the highest in the world due to years of worsening income inequity.

Measures to address the problem of income inequity in Singapore will be discussed in economics tuition by the Principal Economics Tutor in greater detail.

8          GOVERNMENT FAILURE

Government failure occurs when government intervention fails to achieve an efficient allocation of resources.

Imperfect Information

Government intervention may fail to achieve an efficient allocation of resources due to imperfect information. For example, tobacco will be over-consumed in the absence of government intervention due to negative externalities, apart from imperfect information about the detrimental effects. To correct the market failure of tobacco, the government can use tax to decrease the supply. A tax on tobacco will lead to a rise in the cost of production and hence a fall in the supply. When this happens, the price will rise which will lead to a fall in the quantity demanded. In this way, a tax on tobacco induces consumers to internalise the external costs. However, for a tax on tobacco to correct the market failure, it must be equal to the marginal external cost as the purpose of the tax is to induce consumers to internalise the external costs, assuming no other causes of the market failure. In reality, it is difficult to precisely measure the external costs of tobacco consumption. Therefore, a tax on tobacco may not be equal to the marginal external cost and hence may not correct the market failure. If this happens, government intervention will not achieve an efficient allocation of resources.

Administrative Costs

Government intervention may fail to achieve an efficient allocation of resources due to administrative costs. For example, alcohol will be over-consumed in the absence of government intervention due to negative externalities and imperfect information about the detrimental effects. To correct the market failure of alcohol, the government can use regulation to decrease the demand. For example, the government can prohibit the sale of alcohol to people under a certain years of age. However, effective regulation requires effective enforcement but the cost of effective enforcement may be very high which may render it impractical resulting in ineffective regulation. Furthermore, the cost of enforcement may largely offset or even outweigh the benefit of the reduction or elimination of the deadweight loss in the market. Therefore, government intervention may not achieve an efficient allocation of resources.

Political Objectives

Government intervention may fail to achieve an efficient allocation of resources due to political objectives. For example, in order to win votes in an upcoming election, the government may increase subsidies for certain goods such as housing and healthcare to increase its popularity. However, as the objective of the increase in subsidies is to increase popularity rather than to achieve allocative efficiency, it is likely to lead to over-subsidisation of the goods resulting in an over-allocation of resources to the markets. If this happens, government intervention will not achieve an efficient allocation of resources.

Note:   Apart from imperfect information, administrative costs and political objectives, there are also other causes of government failure such as policy myopia and bureaucratic inefficiency. However, these other causes of government failure are not useful for the examination and hence are not discussed in this book. 

Some economists define government failure more narrowly as a situation where government intervention causes a more inefficient allocation of resources. By this definition, government failure will occur if the deadweight loss with government intervention is greater than that without government intervention. The broader definition of government failure which is used in this book is more useful for the examination.

Government failure will be discussed in economics tuition by the Principal Economics Tutor in greater detail.

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