2012 Essay Question 2

Question

University education in Singapore and through the rest of the world is subsidized by national governments rather than left to market forces. During 2010, several governments announced that these subsidies would be cut, stating the need to reduce large fiscal budget deficits as the reason.

Explain why countries subsidies university education and discuss whether reductions in subsidies are justified. [25]

Answer

There are two parts to the question: why some countries subsidise university education and whether reductions in the subsidies are justified.

For the first part of the question, students should explain why university education will be under-consumed in the absence of government intervention with reference to positive externalities and imperfect information. Apart from efficiency grounds, students should also justify subsidy for university education on equity grounds.

The consumption of university education leads to a more productive and innovative labour force which is beneficial to the wider community. It also contributes to the formulation of better government policies. These lead to a divergence between the marginal social benefit and the marginal private benefit resulting in under-consumption. A subsidy on university education will lead to a fall in the cost of production and hence an increase in the supply. When this happens, the price will fall which will lead to an increase in the quantity demanded and this may correct the problem of under-consumption. In this way, a subsidy on university education induces consumers to internalize the external benefits. Students need to draw the external benefits diagram with the subsidy. The external benefits of the consumption of university education are greater than those of other levels of education and hence the market failure of university education is more severe than those of other levels of education. Therefore, the need to subsidise university education is greater than the need to subsidise other levels of education on efficiency grounds. Apart from external costs, university education will also be under-consumed as people do not fully realise the beneficial effects of education. Students need to draw the imperfect information diagram with the subsidy.

In the free market where the prices of goods and services are determined by the market forces of demand and supply, income inequity may result in high income individuals with a high ability to pay pushing up the prices of some goods and services, making them unaffordable to low income individuals with a low ability to pay. This is a matter of concern particularly if the good is university education. Inaccessibility to university education by low income individuals which will hinder the development of their skills and knowledge may cause them to be trapped in poverty. A subsidy on university education will lead to a fall in the cost of production and hence an increase in the supply. When this happens, the price will fall which will increase the affordability to low income individuals. University education is more expensive than other levels of education and hence it is likely to be unaffordable to a larger number of individuals. Therefore, the need to subsidise university education is greater than the need to subsidise other levels of education on equity grounds.

For the second part of the question, students should use the TAS approach. In the thesis, students should justify reductions in the subsidies using both microeconomic concepts (i.e. efficiency and equity) and macroeconomic concepts (i.e. budget deficit). In the anti-thesis, they should counter the arguments in the thesis.

For a subsidy on university education to correct the market failure, it must be equal to the marginal external benefit, assuming no other causes of the market failure. National income generally rises. When national income rises, the demand for university education, which is a normal good, will rise which will lead to an increase in the quantity. When this happens, the marginal external benefit will fall. Assume that the subsidy on university education is initially equal to the marginal external benefit, a decrease in the subsidy will prevent over-subsidization and hence over-consumption. This may justify a reduction in the subsidy on university education on efficiency grounds.

However, due to budget constraint, the subsidy on university education may be lower than the marginal external benefit. This is particularly true in view preamble who states the need to reduce large fiscal budget deficits. If this happens, a reduction in the subsidy may not be justified on efficiency grounds.

When national income rises, low income individuals may experience a rise in income. If this happens, the same amount of subsidy on university education may not be required to make it affordable to low income individuals. This may justify a reduction in the subsidy on university education on equity grounds.

However, when national income rises, the demand for university education, which is a normal good, will rise. When this happens, the price will rise. If the price rises more than proportionate than the increase in the incomes of low income individuals, a reduction in the subsidy on university education will not be justified on equity grounds. This is particularly true in view that the increase in national income may be concentrated in the hands of high income individuals, with low income individuals experiencing only a small increase in their incomes.

A persistently large budget deficit will lead to a rising public debt-to-GDP ratio. In time to come, people will lose confidence in the government’s ability to repay its debt which will cause the government to lose its ability to borrow. When this happens, the government will not be able to meet its debt obligations which will lead to a sovereign default. A sovereign default will lead to a fall in aggregate demand resulting in a recession. A reduction in the subsidy on university education, which may be implemented as an austerity measure, may reduce the budget deficit. If this happens, the public debt-to-GDP ratio may fall which will help prevent a sovereign default and hence a recession.

However, increasing the taxes on demerit goods may be a better measure to reduce budget deficit both in terms of effectiveness and desirability. Take tobacco for example. As the demand for tobacco is price inelastic, an increase in the price is unlikely to induce consumers to reduce the consumption substantially. Therefore, an increase in the tax on tobacco is likely to enable the government to collect a large amount of tax revenue and hence reduce the budget deficit substantially. Furthermore, unlike reducing the subsidy on university education, increasing the tax on tobacco will not negatively affect the quality of labour in the economy in the long run. In addition, given that the marginal external cost of tobacco consumption increases over time due to rising national income and hence rising demand resulting in rising quantity, an increase in the tax will prevent under-taxation and hence over-consumption.

Evaluation

Point 1: Reductions in subsidies are unlikely to be justified as income gap is widening which is indicated by rising Gini coefficient.

Point 2: Reductions in subsidies are unlikely to be justified as the detrimental macroeconomic effects are likely to outweigh the potential beneficial microeconomic effects.

A more elaborate answer to 2012 Essay Question 2 will be provided in the economics tuition class.

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