Market Failure – Positive Externalities

Positive Externalities - Ace Your Econs

In a free market, prices and quantity of goods are optimally determined by the price adjustment process and demand and supply of respective goods, for example an iPhone or even a plate of chicken rice. However, as the name of this topic suggests, there are instances when prices and quantity of goods are not determined optimally and the price mechanism used in the free markets fail, causing market failure.

In this topical summary, we will uncover one aspect of market failure, which are positive externalities, in particularly positive externalities of consumption. We will use education in Singapore as an example and learn what is the implication of positive externality and how to rectify this form of market failure.

For example when an NUS student, Susan chooses to pursue tertiary education, she only takes into consideration of the few personal benefits:

  1. Future job prospect – employers prefer him/her to have a degree;
  2. Future wage prospect – degree holders tend to earn higher wages.

But there are additional external benefits created by Susan that she did not account for:

  1. Educated degree holders are less likely to commit crime (Susan definitely did not consider this point when applying for University);
  2. When Singaporeans are all highly educated as a whole (inclusive of Susan), Singapore will be able to attract a higher level of Foreign Direct Investments into Singapore;
  3. Education reduces poverty in Singapore, promotes gender equality, lower child mortality rate etc.

In Economics, we call this positive externality of consumption – goods like Education will be regularly under consumed at Qe instead of socially optimum quantity Qs  because consumers of education like Susan do not take into account of the substantial external benefits when they make decision to invest in tertiary education.

Subsidy Positive Externality - Ace Your Econs
Source: Economics in Public Policy


So what is Singapore Government doing to encourage more consumption?

In 2013, Singapore spent 3% equivalent of its GDP on Education.  A portion of these spendings can be used as subsidies to education providers i.e the Government generally subsidises 75% or more of the cost of education for general courses such as Engineering, Humanities and Social Sciences provided by the autonomous universities, or about $76,000 to $105,600 for a four-year course per student. Students are expected to bear their fair share of the cost of education as they are the prime beneficiaries who would benefit from higher starting pay and successful careers after graduation.

This reduces the cost of production of universities by the subsidy amount and shift the supply curve rightwards, encouraging consumption of education at Qs. Amount of education consumed is at the social optimum quantity and this creates three winners

  1. Students like Susan are winners because they can enjoy subsidised rate of tertiary education;
  2. Education Providers like NUS and NTU are winners because they are able to attract more of such students with lower tuition fee;
  3. Singapore Government is happy because positive externality is rectified!

In my classes, I will be regularly using specific Singapore examples like this to illustrate economics principles. If you want to learn more about how you can apply economics principles to your daily lives, join me and Ace Your Econs together!

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