Suggested Answers of BT2 Revision Package - ASKnLearn

(6) 2011 NJC Prelim H1 Paper Q3(a) Explain how the presence of externalities results in inefficiency in the markets for airtravel and education.[10](b) Discuss measures the government can adopt to address the inefficiency in themarket for air travel.[15]Suggested Answers:(a) INTRODUCTIONThe free market fails to take into account the fact that there are externalities in theproduction and consumption of certain goods. In this case, when left to the free market, it willresult in a market failure situation where there is an overconsumption of air travel due to thepresence of positive externalities and an under-consumption of education due to thepresence of positive externalities, both of which are not taken into account by the privateconsumers.BODYIn the education market, consumers only take into account of their own private benefits ofeducating themselves (we assume that there is no externalities in the production ofeducation, where Marginal Social Cost (MSC) = Marginal Private Cost (MPC) ). Theseprivate benefits include the ability to earn higher earnings currently and in future, the abilityto enrich oneself with the power of knowledge etc.However, these consumers fail to take into account that when they educate themselves, theycan benefit society as well through spill over effects known as external benefits, whichinclude a society that becomes more productive as a whole with a more educated workforcethat can help the country to generate economic growth via foreign and local investments, aswell as reducing the level of social problems such as crime rates as a country becomesmore educated.Therefore we see that Marginal Social Benefit (MSB) = Marginal Private Benefit (MPB) +Marginal External Benefit (MEB). Because individuals do not take into account the MEB, wesee a divergence between the MSB and MPB. Looking at Figure 1, individuals only equateMPB and MPC, and consume up to a level Q 0 . However the socially optimal point is at Q * ,where the society’s consumer welfare will be maximise, therefore the under-consumption ofeducation results in a deadweight loss (ABC) to society that is captured by no one.