RI Market Failure 2013

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Year 6 Preliminary 9732 [Turn over] © RI 2013

3. How far can efficiency in resource allocation be achieved by encouraging competition

in Singapore? [25]

Introduction: � Identify that “encouraging competition” is a form of government intervention undertaken to resolve

market failure that arises from market dominance. � Explain market failure - failure of the unregulated free market to allocate resources fully and

efficiently. � Explain key sources of market failure – market dominance, presence of externalities, imperfect

information and failure of the free market to provide public goods. � Explain the objective of government intervention in the markets for goods and services

Î In the event of the failure of the free market, the government‟s intervention aims to achieve the microeconomic aim of allocative efficiency

� Explain concept of allocative efficiency o Net social benefit or maximum total surpluses occurs at an output level where the valuation of

(or benefits to) consumers for the additional unit of the good produced (P) is equal to the opportunity costs incurred in using resources to produce that additional unit (MC) (i.e. Price Marginal Cost)

o The optimum output for the society is at QC where the price, PC is determined by the point of intersection of the market demand curve (AR) with the supply curve or the MC in the case where there is no market dominance (i.e. in a perfectly competitive market).

o At output QC and price PC, total societal surpluses (consumers‟ and producers‟) could be maximized, where P MC.

ody:

1. rief explanation of how market dominance causes market failure. � Explain what is meant by „market dominance‟ – ability of the firm to control price and exclude

competition o Monopoly – sole firm in the industry Æ capture total market DD o Oligopoly – a few dominant firms in the industry Æ few firms each having a significant/large

market power o Examples of monopolistic or oligopolistic markets : Oligopolies include telecommunication industry in Singapore, Integrated Resorts (MBS and RWS), Banking industry in Singapore (explain wrt characteristics above) while a Natural Monopoly would be that of Public Transport (egg. MRT) Industry/ Media

� Explain how market dominance leads to market failure (with the aid of a diagram) o Identify the objective of the firmÆ to profit maximize o The high market share implies firm‟s demand curve (AR) is rather price inelastic. Hence there

is a fairly large degree of exploitation for every unit of output produced when there is market dominance by a firm.

o So when firms choose to restrict /set output at the level where the additional revenue gained for an additional unit produced (MR) equals the additional costs incurred for that additional unit produced (MC) i.e. at Qm where MR MC (profit-max condition) and MC is rising

o Setting output where profits are maximized (MR MC) results in an equilibrium price, Pm, set above marginal cost (P MC) at Qm.

o At Qm ,the valuation of (or benefits to) consumers for the additional unit of the good produced (P) is greater than the opportunity costs incurred in using resources to produce that additional unit (MC) – the vertical distance of the divergence represents a degree of consumer or monopolistic exploitation, representing the extent of allocative inefficiency caused by market dominance.

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o Hence so long as the output produced and sold is where P MC, the output produced will be less than the socially optimum level, at Qc (underproduction of goods and services by the amount QcQm) Æ consumers‟ and producers‟ surpluses (total surpluses or societal welfare) are not maximized Æ there is market failure and an inefficient allocation of resources Æ Deadweight loss on the society of area BCD.

2. Thesis: Efficiency in resource allocation be achieved by encouraging competition in

Singapore

� Highlight the role of the Competition Commission of Singapore (CCS) in the case of market dominance: o Increasing competition in markets Æ include pro-market government policy such as

liberalization, deregulation o Singapore Competition Act: legislation / regulationÆ anti-competitive laws

� Explain rationale for Intervention (Use economic framework):

o The introduction of greater competition into the Singapore markets Æ reduces market power amongst firms Æ DD falls (AR1 and MR1 shifts left to AR2 and MR2) and price elasticity of demand increases (potential weakening of market power due to availability of substitutes) Æ lower prices from P1 to P2 Æ decreasing the divergence between P and MC Æ reducing the extent of allocative inefficiency. Also, because total level of output increases in the entire industry due to the increase in number of producers Æ move the equilibrium level of output closer to allocatively efficient level.

o The introduction of greater competition Æ increase dynamic efficiency and responsive to consumers‟ needs Æ better, more innovative services, more promotional offers Æ consumers enjoying a wider variety and quality of products or services egg. Telcos provision of cable TV include on demand TC, type of programs etc.

MC

D

Price/Revenue/Cost

MC SS PC Industry

AR DD PC Industry

Quantity

Pm

0 MR

Qm

Pc

Qc

C

B

A

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o The introduction of greater competition Æ reduces cost-inefficiency (X-inefficiency) of a firm with market dominance due to the lowering of supernormal profits that can be used to cushion unnecessary increase in costs Æ forcing firms to be more productively efficient from the firm‟s point of view.

3. Anti-thesis: Efficiency in resource allocation may not necessarily be achieved by encouraging competition in Singapore (i) Explain that encouraging competition need not necessarily help achieve allocative efficiency in

the case of a natural monopoly (market dominance that arises due to natural BTE) � Briefly explain the case of a natural monopoly & how it is inevitable but may still result

in the failure to achieve allocative efficiency.

� As shown above, a natural monopoly possesses the distinct characteristic in which the

LRAC of the firm falls continuously as output expands as the MES is large and there is room for only one firm to fully exploit all of the available economies of scale, hence being able to supply the entire market at a lower price than two or more smaller one.

0

Quantity Q2

P2

MR2

MR1

Price

AR1 AR2

MC P1

Q1

MC1 MC2

AR(1/2)

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� The key point is that a natural monopoly exists when there is scope for economies of scale to be exploited over a very large range of output relative to the entire market demand.

� In such industries where there is a high ratio of fixed to variable costs. The high fixed costs of building a national or regional infrastructure distribution network for a product might be enormous, but the marginal (variable) cost of supplying extra units of output may be very small. In this case, the ATC will continue to decline as the scale of production increase, because fixed (overhead) costs are being spread over high and higher levels of output. Examples include the national grid for electricity transmission, gas transmission; the building and maintaining a country‟s telecommunications network for broadband industry; etc.

� Explain that in the case of a natural monopoly, introducing competition is detrimental to its existence since it is not possible for 2 or more firms to exist, each charging the same price and supplying half of the industry‟s output as there is no price that would allow them to cover cost. Introducing competition in this case will only result in firms leaving the industry due to subnormal profits reaped Æ non-provision of the good Æ allocative inefficiency rises

� Instead, for natural monopolies, there are other better ways of government intervention such as engaging in price regulation i.e. MC pricing in order to achieve allocative efficiency.

� Briefly explain how MC pricing works to achieve AE in natural monopolies, with reference to the diagram.

(ii) Explain that there are other significant sources of market failure in Singapore that are not

necessarily resolved by encouraging competition. (Provide real life examples for each of them)

� Market failure arising from the presence of externalities, in particular negative externalities in

Singapore from the usage of motor vehicles, is a major source of market failure due to the long-term impact of prolonged damage of environment because of pollution as well as the immediate negative impact such as traffic congestion. o Explain how market failure arises from the use of motor vehicles (use a diagram) o Briefly explain why such a source of market failure cannot be resolved by introducing or

encouraging competition. (failure in addressing the root cause of over-consumption) o Instead, in order to achieve allocative efficiency, the government has to employ market based

(ERP charges that work like a tax) as well as non-market based policies (COE that is a quota on purchases of new cars) to resolve the market failure problem of over-consumption of motor vehicles. (Briefly explain how these policies work)

� Market failure arising from positive externalities and imperfection of information manifests itself in the form of the under-consumption of merit goods that are deemed by the government to be socially desirable, such as basic healthcare, education and public housing. o Using a diagram, explain how market failure arises from the consumption of merit goods.

(failure to take into account of external benefits on 3rd parties in the case of positive externality associated with consumption of merit goods as well as ignorance of potential private benefits associated with consumption of the good, hence underestimating the private benefits in the case of imperfect knowledge)

o Briefly explain that the allocative inefficiency that has resulted from under-consumption cannot be resolved through the introduction of competition.

o Instead, in order to achieve allocative efficiency, the government has to intervene in the provision or subsidization of merit goods through market based policies such as subsidies (targeting the internalization of external benefits) or non-market based policies such as launching mass public education programmes to raise awareness of the importance of consuming such services, hence resolving imperfection of information. (briefly explain how these policies work)

� Market failure arising from the non-provision of public goods by the free market, in the form

of provision of national defence and street lighting etc. o Explain how the twin characteristics of non-rivalry and non-excludability of public goods

present a case of market failure (missing market)

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o Briefly explain that in the case of the non-provision of the public good by the free market, introducing competition does not resolve the allocative inefficiency problem since the free market chooses not to produce the good in the first place.

o Instead, in order to achieve allocative efficiency, the Singapore government has to intervene through non-market based policy to directly provide public goods like national defence though MINDEF, police services (SPF) and civil defence (SCDF) in order to achieve domestic stability, and at the same time ensuring there is positive business confidence in Singapore.

� Any other potential sources of market failure (explain using economic framework and accompanied with real life examples within the Singapore context)

Conclusion: x Make a stand regarding the effectiveness of encouraging competition in correcting market failure

and achieving allocative efficiency in Singapore. More specifically, encouraging competition can only be applied to market failure arising from market dominance and only in non-natural monopolies.

x There are other forms of market failure in Singapore that cannot be corrected with the encouragement of competition.

x As Singapore is an open economy, Singapore firms would be exposed to foreign firms‟ penetration and hence, increased international competition, making the case for control of market domination less important for Singapore, hence introduction of competition by the CCS is not the main and most significant form of government intervention to achieve allocative efficiency in Singapore.

x On the other hand, direct provision of public goods and subsidies in merit goods market failure could be argued to be more effective at achieving allocative efficiency. For egg. Public goods such as National Defence and merit goods such as education, healthcare and public housing provision takes up a sig. proportion of Singapore‟s budget either through direct provision or subsidies.

x The intervention in public and merit goods also serves as a building block in which the government can achieve internal stability and create a more business-friendly environment to continue to encourage foreign direct investment (FDI) into Singapore.

Mark Scheme:

Level Descriptors Marks L1 Answer fails to address the question.

Answer is mainly irrelevant. Answer that shows some knowledge of the concepts but does not show that the meaning of the question is grasped.

1-9

L2 Attempt to show a balanced answer i.e. whether AE can be achieved through encouragement of competition but explanation may not be sufficiently developed. Egg. Explanation of why government intervenes for reasons other than market dominance (i.e. other sources of market failure), but analysis lacks rigour. Some reference to Singapore context is provided.

10 - 16

L3 Well-developed two-sided argument that is able to examine the extent to which introduction of competition achieves AE in Singapore‟s context. Candidates are also able to analyse the different causes for government intervention in the Singapore context as well as the use of alternative policies to resolve these other sources of market failure. Good use of economic framework and supported with relevant examples and clearly illustrated diagrams.

17 - 21

E1 Unexplained judgement or not supported by economic analysis. 1-2 E2 Evaluative discussion based on economic analysis. 3-4

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RI Market Failure 2013