Essay, Micro: Using the concepts of production possibility frontier

  • Using the concepts of production possibility frontier and opportunity cost, explain the problem of scarcity and whether a country should only produce capital goods. (10)
  • Assess the microeconomic policies taken by the Singapore government to arrive at a more efficient allocation of resources. (15)
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a) def Scarcity exists whenever there is an excess of human wants over the actual ability of the economy to fulfil those wants. Since human wants are essentially unlimited, scarcity is a universal problem, faced by the very poor to even the world's richest.

Due to the problem of scarcity, a choice has to be made by economic agents as to what exactly should be produced, and concomitantly, what should not be produced. In other words, when a resource or factor input is chosen to produce one thing, it cannot be used to produce one other thing, and there is sacrifice made. This is known as the opportunity cost, defined as the cost of any decision made in terms of the next best alternative forgone.

The problem of scarcity can be explained using a production possiblity curve (PPC) as sketched here:

From the picture above, the PPC shows the combinations of all guns and butter output that can be achieved when all resources are fully and efficiently employed, given a state of technology. If a country prefers guns to butter, they may choose bundle B over bundle D. In this case, the opportunity cost of the gain in guns produced is the loss in the butter produced moving from D to B.

Bundle X is preferred to D since it contains more of both butter and guns. However, it is not possible to produce bundle X as it is outside the PPC. The fact that the country cannot produce more of one good without reducing producing of another when it is already at full employment illustrates scarcity.

Another way to draw the PPC is where we have consumer goods on the x-axis and capital goods on the y-axis. Consumer goods are produced for immediate consumption, while capital goods are added to a country's capital stock and used in producing more goods.

By producing more capital goods, the PPC will enlarge as more goods can be produced in the future and raise the standard of living. However, there will be a negative tradeoff effect on present consumption. A country should therefore not produce only capital goods as there will be an adverse effect on consumption.

A country may be able to produce only capital goods and trade them for consumption goods. However, this is not done in real life as no country would be willing to be wholly reliant on trade for its domestic consumption.


Assess the microeconomic policies taken by the Singapore government to arrive at a more efficient allocation of resources. (15)

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The efficient allocation of resources in an economy is generally acheived by the market mechanism in a free market. However, market failures may occur in the case of 1) externalities, 2) market power, and 3) public goods.

Externalities

def An externality is a cost or benefit that affects a party who did not choose to incur that cost or benefit.

For example, a negative externality exists when non smokers suffer the health costs of secondhand smoke due to cigarette smokers smoking nearby. In such a case, smokers will smoke until their marginal private cost (MPC) of smoking is equal to their marginal private benefit (MPB). They will consume Q_P of cigarettes.

However, in addition to the marginal private cost of smoking, an external marginal cost of secondhand smoke is imposed on passive smokers. This causes the marginal social cost of smoking to be higher. The optimal level of smoking should be at Q_S, where the marginal social benefit of smoking is equal to the marginal social cost.

Hence, negative externalities cause sub-optimal overconsumption.

In Singapore, a steep tax is imposed on smoking, which internalises the external costs of smoking on smokers. This aligns the social cost of smoking with smokers' private cost.

eval However, in practice it is difficult to assess the monetary value of the negative externality in order to impose a tax equal to the marginal external cost. This leads to either over or under taxation.

eval It may also be politically difficult to implement high taxes in the case of price inelastic demand, as in the case of cigarette smoking. A study by the World Bank showed that for every 10% increase in the real inflation adjusted price, there will be a decrease in the consumption of cigarettes by 2% - 8%.

eval However, if the tax is too high, it will bring the level of smoking below the socially efficient outcome and a overall loss of welfare to society.

Merit Goods

def Merit goods are goods that have positive externalities and deemed socially desirable by the government. Such goods would be underconsumed in a free market as private individuals would fail to take into account its external benefits.

For instance, education can be considered a merit good. Apart from the private benefits which accrue to an individual such as improvements in future wages, there are social benefits to having an educated population, such as increased productivity and synergies in the workforce. In the picture below, the optimal level of consumption is at Q_s, where the marginal social benefit is equal to the marginal social cost. However, the equilibrium is at Q_p, where individuals choose to consume education up to the level where their marginal private benefit is equal to the marginal social cost/supply.

The Singapore government promotes the consumption of education by subsidising education through a variety of schemes. This shifts the supply/marginal social cost to the right, which brings education consumption closer to the optimum.

eval An advantage of this is that it allows the market mechanism to work. However the government may not have perfect information or ability to determine the monetary value of the external benefits and the right amount of subsidy.

The Singaporean complements subsidies with legislated compulsory primary school education, which aims to bring the level of education closer to the optimum at Q_s.

eval Legislation is straightforward to understand and simple to implement. However, it could be difficult and costly for the government to monitor the level of compliance.

Conclusion

The Singapore government uses a wide range of economic polies such as subsidies, taxes, public provision, and legislation to correct for market failures. These attempt to improve upon the failure of the free market in reaching an optimal allocation of goods and resources. If the costs of implementing these policies are less than the benefits of better resource allocation, we can say that the government has succeeded.

The government should at the same time be mindful of the distributionary effects of such policies, and ensure that they do not disfavour lower income groups.

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