Economic management help essay on: Market forces of demand and supply
(a) (i) Advocates of free market believe that the invisible hand of price mechanism (i.e. the market forces of demand and supply) produces the most efficient outcome, and government intervention only worsens the outcome. That is, not only does it make someone worse off while making others better off, but in total, the total efficiency reduces. That is if every citizen is to be treated equally, then the total society is worse off. Market failures are an answer from the advocates of government ruled economies.
Market failure is an economic situation where the market forces of demand and supply do not produce the most efficient outcome. In other words, governments can intervene and produce an externality.
By default, we know that every economic activity has an externality attached to it. Any activity which has its benefits and costs associated with a particular individual or an institution is but a myth. More than one party does get involved in either as a) victims in that the costs are bone by them. For ex passive smoking harms the society at large and b) as beneficiaries, for example an educated person helps the society at large. In other words, the externalities associated may be both negative and positive. Another example is screening a horror movie. It proves to be leisure for some, but also creates a nuisance for others. Purely public goods have only externalities and no private effects, while opposite is the case with private goods. In case of market failures, externalities are positive.
There are broadly six types of market-failures. They are enlisted below along with the examples:
a) Natural monopoly- A situation where one producer best suits the market conditions in that costs are lowest. For ex electricity distribution business.
b) Externalities- The pros and cons of any economic activity, be it production, consumption, or even a transfer payment, is classically understood through invisible hand. However in reality, price mechanism is not all that decides who bears the costs and who enjoys the benefits. This is known as externality. In its essence, externalities as the word suggests are borne by external agents. Even though it is sometimes undesirable, externalities form an inherent part and can’t be avoided.
c) Public Goods- public goods are defined as goods which suffice two criteria’s, that of non-rivalry and non-excludability. For ex- public bridges are a public good and a case of market failure.
Asymmetric information- It is a case where one economic agent possesses more information than the other. For example- in case of second hand car markets, suppliers of ‘lemons’ have more information than the buyers.
d) Moral hazard- An economic situation where economic agents have no incentive to take actions which make the society better off. A prominent example is insurance industry.
e) Transaction costs- Such costs prevent the economic exchanges to happen. And there by the production and consumption surplus are not generated. Such market failures are very common. For ex-transportations costs.
(ii) The primary market discussed here is the cigarette market in India. The two market forces of supply and demand are assumed to be thus: suppliers do have the option of increasing production at a short notice and hence supply is pretty elastic. Moreover, the suppliers are entering the market all the time. Cigarette market is characterized by many large and small suppliers. Moreover, over time, substitutes have emerged. For ex- raw tobacco, bide, etc. The demand, however, is pretty inelastic especially for chain smokers. Even though it is such for the chain smokers, it is elastic, for the light ones. This was proved from the market survey carried out in a complimentary market of alcohol, in which a tax on alcohol reduced drinking by light drinkers, but created almost a nil effect on chain smokers. The cigarette industry in India is also adversely affected by some high handed regulation from government. The whole answer deals with the assumption that it is easy for the government to tax it effectively. This implies that there is hardly a black market existing in this industry. Hence, the presence of public enterprises is implied in this industry. However, the critics argue the opposite. They claim cigarette consumption has benefits associated with it. This is because the heavy consumers live for short periods. And hence their being a part of welfare schemes using citizens is for a shorter time and hence a low drainage on the public exchequer. There is also a mismatch of information between smokers and suppliers. The consumers are not fully aware of the health hazards of cigarette consumption, as only partial information is published on cigarette packs. However over the recent years, due to heavy regulation, this has changed considerably.
A market failure is an undesirable consequence resulting from the free reign of the market forces. The undesirability may stem from various fronts. This may cause inconvenience to consumers, suppliers, external agents or the government itself. In the case of the cigarette industry, it is the production of more chain smokers rather than light ones. This overconsumption of cigarette, according to various researchers, is leading to 80 % of cancer problems. This disease, in turn, is claimed to account for good proportion of total medical expenses in Indian healthcare industry. Hence this constitutes a major market failure. Though no one denies the repercussions of lung problems, the heavy leap lies in stating that and coming to the conclusion that cigarette smoking necessarily causes cancer problems. Whatever is the case, and however strong is this correlation between lung cancer and cigarette consumption, this is a market failure. As shown in the diagram, the equilibrium quantity in the market is more than desirable. The desirability implies the quantity at which the consumption is not increasing the costs for society at large. With the help of heavy taxation, government is leading the demand curve back to where it cuts supply curve at “optimal quantity”. For this. The demand has to be actually elastic. The area above the optimal quantity is the portion of deadweight losses.(iii) Suggest other options for dealing with negative externalities in your case studies (relate this
back to your answer in part (i)). (8 marks)
Before shelling out the alternative, we should first discuss why the policy of imposing taxes is not the best tool to curb cigarette smoking. Various reasons have been cited below:
a) Inelastic supply: As per the survey conducted and talked about earlier, chain smokers face an inelastic supply. In other words, they do not react to minimal price changes. Hence even if substantial taxes are imposed on cigarette, and the suppliers manage to share the burden well with chain smokers, there will hardly a reduction in consumption.
b) Correlation- At best, we can say cigarette consumption and lung cancer are correlated. And correlation does not imply causation. This is a serious matter of concern since taxation might reduce cigarette consumption which in turn may reduce its positive externalities.
c) Alternatives- The cross price elasticity of cigarette proves to be very substantial for both its substitutes as well as complements. Secondly, some substitutes are shown to be very dangerous, if not more. Hence, when the taxes rise, substitutes’ consumption rises by default. And there may not be any benefit from the reduction of cigarette consumption. In fact the total surplus generated in the society reduces all the more.
d) Economic efficiency- As in other areas of production, which has externalities to the society, in cigarette production too, it is almost impossible to find just the right amount of tax. This is because it is impossible to find the optimal quantity to be consumed. And any direction behind and beyond this optimal quantity creates negative utility for the society at large. For ex any taxes collected might get siphoned off. Or that they may not be expended in the optimal way. Hence any heavy taxation as a result of heavy handedness or any form of Pigouvian tax may be more undesirable on the part of the society.
e) Deadweight loss- This is an inevitable result of any kind of taxes. The deadweight losses are defined as the reduction in total utility generated for the society at large. Moreover, any tax increase in turn increases the prices and equilibrium quantity falls. This result in some elimination of the total surplus in the market, since government revenue in the form of taxes doesn’t completely account for loss of surplus.
Not only are these deadweight losses not needed at all, but the disadvantages to these taxes are multi-fold. An alternative that can be touted to replace these taxes can be charging higher insurance premiums. By charging the premiums as higher, the insurer effectively differentiates the market between chain smokers and light ones, which is impossible to do so without charging premiums to be different for different profiles.
With all these reasons, the case for not taxing becomes very very strong. Even though tax is adjudged to rationally optimum in many cases, i.e. alternatives are more impractical, in the present industry, higher industry premiums for higher consumers is not only more productive, but also more practical! Moreover, taxes are welfare oriented only if the consumers are well to do, so that the taxes turn out to be productive. That is, there is a transfer from rich section to poor ones. However in the cigarette industry, where poor ones consume too, the taxes will amount to be regressive. This is especially in the case light cigarette consumers who are also poor.
Energy prices are very basic to every industry in that almost all industries are dependent on some or other form of energy in one of the other way. For ex- transportation costs are an integral part of most industries, from real estate to IT industry. In turn, transportation costs are determined by fuel costs which are nothing but energy prices. It is in this sense that any Carbon tax imposed will trickle down to most industries and affect different industries in different ways. For industries heavily dependent on transportation, for ex-steel, carbon tax will change the whole dynamics of intra as well as inter industry trade. For industries in which transportation costs are not very significant, for example jewellery, this will not have a major effect. Let us talk more about this Carbon tax to appreciate its price impacts through an illustration.
Carbon tax essentially takes the form of excise duty on every unit of CO2 emitted, due to any form of production. However, not everything is crystal clear. While it makes some sense to tax the production/consumption at the time of emission, it is not very realistic to do so, especially doe to the production and consumption at various levels. For this taxation to be efficient, the scale of taxing would have to be very deep and efficient otherwise, and this is clearly not the case in Australia. Again, a specific tax, and not ad valorem, or on value basis, is more suited since the volume of emission is directly proportional to the volume of fuel used, and not its pre-tax price.
A carbon tax is essentially levied to internalize the social costs in the cost of product (intermediary of final good). Hence the main objective is to account for any negative externalities. For ex-health hazards due to higher CO2 component in atmosphere, or death of fisheries due to polluted water resources. However, for this, the price elasticity of fossil fuel as well as the cross-price elasticity’s of other fuels is needed. This is very difficult to arrive at. (Herber & Raga, 1995)
Having said that, there are various pros too. Jus experiment on this. Had it been possible to arrive at an optimal amount of taxation, and imposed upon the right place, then carbon tax invariably mitigates the maximum amount of emissions. If carbon taxes are successful, then the price of fuels would reflect true costs. Moreover any negative externality will be compensated for by the government with the tax it collected. (Cline, 1992) The government would not need to interfere in microeconomic affairs, then. Since, all costs are internalized, there is no market failure, and the most optimal quantity of CO2 is emitted. Now compare this with a situation when there is an intervention in the sense that carbon taxes are not the most efficient one, or that taxes are not collected at the end of emissions. Here lessons need to be drawn from what are called European Pigouvian tax. An efficient alternative is charging only to the amount of energy content in the fuel. This is an efficient attempt at countering the impossibility of charging at the time of emission! To conclude, there are two main results occurring from a price on carbon emissions: a) It provides incentives to businesses that would not find it worthwhile otherwise to bring out low-carbon emitting products which prove to be carbon saving. b) It also negates any disincentives of generating more than optimal (i.e. according to carbon efficiency) carbon.
(ii) To explore which industries will be significantly affected, it deserves to be looked into what the Australian fuel market looks like. Let’s look into the comparative feasibility vis-a-vis Australian fuel market. Australian fuel market constitutes a significant part of a larger Asia-pacific market; Singapore forms the important part for distribution from various ends. Few firms: Exxon Mobil, Caltex, BP, Woolworths and Coles, play the major part (Singapore being the benchmark). Moreover the distribution of information is not symmetric, since ACCC serves as an effective transparency facilitator. For ex- it was decided to pass on the increased fuel prices to motorists. (Gale, 2011) Australia’s carbon emission, in addition, has grown twice the world average rate over the last 25 years. Also, despite having just around 0.32% population, it emits around 1.4% of total carbon emission in the world (Deborah, 2007) this tantamount to a per capita that is 4.5 times world per capita!
Before zeroing on a single policy tool for Australia, we should note two things: 1) Australia has already tried all of the tools at some point of time and with varied success. It used Carbon Pollution Reduction Scheme (CPRS) which was, in effect, a tax on carbon
On emissions. This was proposed by the Rudd Government in 2008, when six Labour parties were in opposition. This proposition saw the fall of the Government. Australia had done this for the first time for any country. In the context of ceilings, Australia is historically known for its heavy handedness in environmental policies. (Carbon Pollution Reduction Scheme-Green paper, 16.07.2008) And regarding the subsidisation of alternative cleaner energies, Australia has been particularly aggressive in the last year, especially in wind energy et al. 2) No single policy is going to suffice here because of the gargantuan nature of Australia’s emissions. As much as 4.5 times world per capita would take a mix of the three policies which go on to complement each other rather than working standalone. Individual policies have failed in Australia’s past already.
Having said that, the focus necessarily has to be in encouraging international cooperation in the area of global carbon emission mitigation. Since the costs of action taken earlier would be much less than action later. As far as policy toll at the economy level is concerned, for Australia, having some kind of price mechanism which prices carbon emissions in an effective way is definitely the most optimal way out, however with qualifications. This is for following reasons: 1) the whole climate market in Australia in particular and Asia pacific in general is very dynamic and lot of changes occur happen on a daily basis. This might lead to a situation where subsidy may not have a substantial effect. In other words, any generation of clean energy which would anyway have happened, whether subsidies or not, is a waste on economy’s resources simply because no investment here has had an additional effect. 2) For Some sectors like mining, which essentially generate foreign exchange for the economy, there needs to be a system in place which generates free permits to transit to a low emission sector. In Asia at large, and especially in India and China, there has developed a huge market of emission reductions (in the form of Carbon Emission Reductions or CERs under Clean Development Mechanism or CDM) which Australian economy (which can never match the size of markets talked about above) can make any use of.
So, in a snapshot, agriculture and fishing industry will be significantly affected. While high value goods like ornaments, jewels, etc. will be less affected by such a tax.
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