Economics Model Essay 5

This question will be discussed in economics tuition in the sixth week of term 2.

Discuss the economic effects of a redirection of government subsidy from petrol to education. [25]

Answer

Introduction

The economic effects of a redirection of government subsidy from petrol to education can be discussed in terms of the effects on allocative efficiency, income equity, the balance of payments, national income, unemployment and inflation.

Decrease in Allocative Inefficiency: Petrol Market

If the government redirects subsidy away from petrol, allocative inefficiency in the market will decrease. Allocative efficiency is achieved when it is impossible to change the allocation of resources in the economy in a way that will make someone better off without making anyone else worse off. This occurs when marginal social benefit (MSB) is equal to marginal social cost (MSC) where MSB is the sum of marginal private benefit (MPB) and marginal external benefit (MEB) and MSC is the sum of marginal private cost (MPC) and marginal external cost (MEC). External costs and benefits, or externalities, are costs and benefits of consumption or production experienced by society other than the producers or the consumers. The consumption of petrol produces negative externalities. For example, it leads to air pollution in the form of carbon emissions and this leads to a divergence between the MSC and the MPC resulting in over-consumption. A subsidy on petrol will lead to a fall in the cost of production and hence a rise in the supply. When this happens, the price will fall which will lead to a rise in the quantity demanded and this will worsen the problem of over-consumption.

In the above diagram, due to external costs, the MSC is higher than the MPC. Therefore, the equilibrium output level (QE) where MPB is equal to MPC is higher than the allocatively efficient output level (QAE) where MSB is equal to MSC. The deadweight loss, which is the loss of social welfare due to market failure or government intervention, is represented by area A. A subsidy on petrol leads to a fall in the MPC from MPC to MPC’ and hence the new equilibrium output level rises from QE to QE’. Since QE’ is further from QAE than QE is, the subsidy worsens the problem of over-consumption and hence the deadweight loss increases from area A to the sum of area A and area B. If the government redirects subsidy away from petrol, the cost of production will rise. Therefore, the MPC will rise back from MPC’ to MPC. When this happens, the equilibrium output level will fall back from QE’ to QE which will result in a reduction in problem of over-consumption and hence the deadweight loss.

Decrease in Allocative Inefficiency: Education Market

If the government redirects subsidy to education, allocative inefficiency in the market will decrease. The consumption of education produces positive externalities. For example, it 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 positive externalities lead to a divergence between the MSB and the MPB resulting in under-consumption.

In the above diagram, due to external benefits, the MSB is higher than the MPB. Therefore, QE is lower than QAE. The deadweight loss is represented by the shaded area. Furthermore, the perceived MPB of education is lower than the true MPB as many people do not fully realise the beneficial effects and this leads to under-consumption.

In the above diagram, due to imperfect information about the beneficial effects, the perceived MPB (MPBP) is lower than the true MPB (MPB). Therefore, QE is lower than QAE. The deadweight loss is represented by the shaded area. If the government redirects subsidy to education, the cost of production will fall. Therefore, the MPC will fall. If the MPC after subsidy is MPC’, the new equilibrium output level (QE’) will be equal to QAE which will result in the elimination of the problem of under-consumption and hence the deadweight loss.

Worsen Income Inequity

A redirection of government subsidy away from petrol will worsen income inequity. A subsidy on petrol expressed as a percentage of income is higher for low income individuals than for high income individuals. Therefore, if the government redirects subsidy away from petrol, low income individuals will be hurt more in relative terms and hence income inequity will worsen. The effect, however, may not be substantial because high income individuals consume more petrol than low income individuals as they drive bigger cars.

Improve Income Equity

A redirection of government subsidy to education will improve income equity. A subsidy on education expressed as a percentage of income is higher for low income individuals than for high income individuals. Therefore, a subsidy on education will benefit low income individuals more in relative terms and hence will improve income equity. Furthermore, a subsidy on education will make education affordable to more poor families which will increase their income earning power resulting in lower income inequity.

Undesirable Macroeconomic Effects

A redirection of government subsidy away from petrol will have undesirable macroeconomic effects. Aggregate supply is the total supply of goods and services in the economy over a period of time and is determined by the production capacity and the cost of production in the economy. When the government redirects subsidy away from petrol, the cost of production will rise which will lead to decrease in the supply resulting in an increase in the price. For example, Malaysia ended subsidy on petrol in 2014 which led to an increase in the price. A rise in the price of petrol will lead to a rise in the cost of production in the economy. When the cost of production in the economy rises, firms will increase prices at the same output levels to maintain profitability. In other words, they will decrease output at the same prices which will lead to a decrease in aggregate supply resulting in a decrease in national output. When firms decrease production, they will employ less factor inputs from households and hence will pay them less factor income which will lead to a decrease in national income.

In the above diagram, a decrease in aggregate supply (AS) from AS0 to AS1 leads to a decrease in national output and hence national income (Y) from Y0 to Y1. A decrease in national output will lead to a fall in the demand for labour in the economy resulting in a rise in unemployment. A decrease in aggregate supply will lead to a shortage of goods and services resulting in a rise in the general price level and hence higher inflation. This is undesirable particularly if the economy is overheating where aggregate demand is rising rapidly relative to aggregate supply resulting in high inflationary pressures. The balance of payments is a record of all the transactions between the residents of the economy and the rest of the world over a period of time and is made up of the current account and the capital and financial account. When the general price level rises, domestic goods and services may become relatively more expensive than foreign goods and services which will lead to a decrease in net exports resulting in a deterioration in the current account and hence the balance of payments, assuming the demand for exports is price elastic.

Desirable Macroeconomic Effects

A redirection of government subsidy to education will have desirable macroeconomic effects. Aggregate demand is the total demand for the goods and services produced in the economy over a period of time and is comprised of consumption expenditure, investment expenditure, government expenditure on goods and services and net exports. Education will lead to greater human capital which will increase the skills and knowledge of labour in the economy. Therefore, an increase in education will lead to an increase in labour productivity in the economy which will decrease the cost of production in the economy resulting in an increase in expected returns on planned investments and hence investment expenditure. As a proportion of the increase in investment expenditure will be foreign direct investment, the capital and financial account and hence the balance of payments will improve. Furthermore, aggregate demand will rise which will induce firms to increase production resulting in an increase in national output and hence national income.

In the above diagram, an increase in aggregate demand (AD) from AD0 to AD1 leads to an increase in national output and hence national income (Y) from Y0 to Y1. When firms increase production in response to an increase in aggregate demand due to an increase in investment expenditure, they will employ more factor inputs from households and hence will pay them more factor income. When households’ income rises, they will increase consumption expenditure which will lead to a further increase in aggregate demand and this will induce firms to further increase production. When this happens, firms will employ even more factor inputs from households and hence will pay them even more factor income. The further increase in households’ income will induce them to further increase consumption expenditure resulting in a further increase in aggregate demand. Therefore, the initial increase in aggregate demand due to the increase in investment expenditure will lead to increases in consumption expenditure and hence further increases in aggregate demand resulting in a larger increase in national output and hence national income. This is commonly known as the multiplier effect. An increase in national output will lead to an increase in the demand for labour in the economy resulting in a fall in unemployment. An increase in investment expenditure and the skills and knowledge of labour in the economy will lead to a more rapid increase in the production capacity in the economy and hence aggregate supply in the long run, assuming net investment is initially positive. When this happens, assuming aggregate demand is rising which is the normal state of the economy, national output and hence national income will rise at a faster rate which may decrease unemployment, and the general price level will rise at a slower rate resulting in lower inflation which may improve the balance of payments.

Evaluation

In the final analysis, a redirection of government subsidy away from petrol to education is likely to be desirable for the economy. A redirection of government subsidy away from petrol to education which will lead to an increase in the quantity of education will lead to a more rapid increase in the skills and knowledge of labour in the economy. When this happens, the production capacity in the economy and hence aggregate supply will increase at a faster rate which will lead to higher potential economic growth. Given that actual economic growth is constrained by potential economic growth, higher potential economic growth will allow higher actual economic growth and this may lead to a more rapid rise in the standard of living. However, a subsidy on petrol is typically given in less developed economies. In many less developed economies, many poor households own private motor vehicles due to a poor public transport system and hence a sharp rise in petrol prices is likely to lead to hardship for the people. Therefore, the government should implement a redirection of subsidy away from petrol to education in a modest and gradual manner to give households sufficient time to make the necessary adjustments. It should also give households a one-off transfer payment to help them cope with the effect of the rise in petrol prices. In addition, the government should reduce the reliance on private motor vehicles with measures such as improving the public transport system through increasing the level of convenience and the level of comfort. This will not only reduce petrol prices, it will also reduce pollution and traffic congestion.

The question will be discussed in greater detail in economics tuition by the Principal Economics Tutor.

Author’s comments

Students simply need to explain the economic effects of a redirection of government subsidy from petrol to education in terms of the effects on allocative efficiency, income equity, the balance of payments, national income, unemployment and inflation.

Students should understand that as the question is asking about economic effects, they should discuss both microeconomic effects and macroeconomic effects.

Students should understand that many governments have started moving subsidy away from petrol.

Students should explain the multiplier effect as it is an important concept in the Singapore-Cambridge GCE ‘A’ Level Economics.

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