Market failure—externalities and common pool or common access resources Paper 2

IBDP Economics  HL – Microeconomics – Market failure—externalities and common pool or common access resources -Paper 2 Exam Style Practice Questions

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Market failure—externalities and common pool or common access resources Paper 2? 

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Exam Style Question for IBDP Economics HL- Market failure—externalities and common pool or common access resources -Paper 2

Solar power in Kenya

  1. Kenyan shopkeepers are able to use mobile phones and a small deposit to buy solar panels. This gives them 24-hour access to electricity and also lowers their fuel bills. Before this, the shopkeepers struggled to get a connection to electricity. M-Kopa is the company that provides these solar panels.
  2. M-Kopa estimates that 80 % of its customers live on less than US\($\)2 a day, and without access to credit, are caught in a poverty trap (poverty cycle). Many of them rely on subsistence farming or run a small business as their source of income. Energy accounts for a significant amount of their spending.
  3. Kopa means “to borrow” in Swahili, and each panel the company sells is in effect a loan of about US\($\)165. M-Kopa’s solar panels cost US\($\)200. Clients pay US\($\)35 upfront and agree to make a daily payment of 45¢ for a year, after which the solar panel is theirs.
  4. When M-Kopa’s customers are reaching the end of their loan terms, an M-Kopa representative calls to offer another product, in exchange for reopening the account and making payments for another few months. M-Kopa has sold around 325 000 solar panels so far and 50 000 of their buyers, who have already paid off their loans, have extended their credit to buy other products offered by M-Kopa. Ideally, these new products will also save customers money over time. They include fuel efficient stoves that save charcoal, a bicycle that cuts transportation costs and water tanks to store rainwater. M-Kopa also sells Samsung smartphones and offers loans to pay for school fees.
  5. M-Kopa is replacing kerosene lamps with solar power technology. Kerosene lamps emit a dangerous smoke that burns the eyes, irritates the throat and slowly turns walls and ceilings black. They are also expensive. According to a 2014 survey, an average household in Kenya, without access to electricity, spends about US\($\)164 a year on kerosene. M-Kopa estimates that a customer saves about US\($\)750 over the first four years by switching to solar panels. Given Kenya’s climate, solar power is an obvious source of energy.
  6. Since its commercial launch in October 2012, the company’s total revenue has risen rapidly, from US\($\)15 million in 2014 to US\($\)30 million in 2015, and the company says it will double this in 2016. Every day, about 600 new customers are purchasing solar panels, meaning that the company is extending loans of almost US\($\)100 000 a day to people who might otherwise not have access to credit.
  7. According to a company representative, “If you take the long-term view and if you treat low-income people as customers, not charity cases, you can change the world. In our view, it is one of the advantages that foreign direct investment can bring to a country. Our customers’ lives are improved as our lives are improved”.

Question

Using an externalities diagram, explain how the widespread use of solar panels will decrease the negative externalities of consumption caused by the use of kerosene lamps (paragraph [5]).

▶️Answer/Explanation
An externalities diagram with MPB>MSB and showing a decrease in the MPB moving closer to the MSB, reducing output (towards the socially efficient level of output)
OR
An externalities diagram with MPB>MSB with an explanation of a decrease of MPB to MSB
AND
As the demand for solar panels increases, the MPB for kerosene lamps decreases (substitutes). As a result, the output of kerosene lamps decreases towards the socially efficient level of output
OR the externalities caused by kerosene lamps are reduced.

China’s increasing presence in Bolivia

  1. Between 2000 and 2014, annual bilateral trade between China and Bolivia increased dramatically from US\($\)75.3 million to US\($\)2.25 billion. China has become the fifth-largest market for Bolivian exports, which mostly consist of raw materials such as minerals, hydrocarbons, wood and soybeans.
  2. At the same time, China has become Bolivia’s main source of imports. China now supplies half of Bolivia’s clothing, cars, motorcycles, cell phones, computers and other electronics. Bolivia’s expenditure on Chinese imports significantly exceeds the revenue that is received from its exports to China. Since 2014, Bolivia has experienced significant current account deficits with China.
  3. In recent years, the Bolivian government has taken loans from Chinese banks to support the purchase of Chinese imports of goods and services, along with Chinese-built roads, bridges, railways, hydroelectric power plants and mining facilities. In 2015, the Bolivian government owed more than US\($\)600 million to Chinese banks.
  4. The socialist Bolivian government wants to implement an ambitious Five-Year National Development Plan from 2016 to 2020. Faced with sharply declining export revenues and commodity prices, it will rely increasingly on foreign capital to fund its projects.
  5. All projects financed by Chinese loans must be awarded to Chinese companies, which come with their own materials, equipment and technology, and often their own labour. The new loans will have a combination of commercial interest rates, between 2.5 % and 4 %, and concessional interest rates, up to 1 %. The Bolivian government is expecting to be able to repay the loans through continued growth of the economy.
  6. China’s foreign direct investment (FDI) is mostly being aimed at energy and infrastructure development. Chinese firms are currently involved in major road-building projects, hydroelectric power station projects, expanding airports and developing a steel-producing plant. These projects have created problems for local communities in terms of water contamination and the overuse of Bolivia’s scarce water supply.
  7. This FDI strategy generates profits for Chinese firms in the short term, as they build and improve the infrastructure. Since Bolivia is a resource-rich country, Chinese firms will be looking to invest in profitable mining projects in the future, once the infrastructure is in place.

Question

▶️Answer/Explanation

Using an externalities diagram, explain how the Chinese infrastructure projects have caused negative externalities (paragraph [6]).

For drawing a correctly labelled externalities diagram, showing: MSC > MPC and identifying both the socially optimal quantity of output and the quantity of output determined by the market forces
The vertical distance between MSC and MPC labelled
externality/external costs or the shaded welfare loss due to the negative externality of production.
AND
For explaining that Chinese infrastructure projects cause water contamination/overuse, creating costs to third parties/local communities/society.

Economic development in two West African countries

      Ghana

  1. Ghana is the world’s second largest cocoa producer and Africa’s second largest gold producer. It is one of Africa’s fastest growing economies and has made major progress in achieving persistent economic growth.
  2. Over the last decade, Ghana has enjoyed increasingly stable and improving democratic governance. Four successful elections during the decade have strengthened the effectiveness of key national institutions, improved investor confidence and created an environment that promotes investment and growth.
  3. Ghana enjoys a high degree of media freedom; the private press and broadcasters operate without significant restrictions. The media are free to criticize the authorities without fear of punishment, says the non governmental organization (NGO) Reporters Without Borders. The private press is allowed to express criticism of government policy, which increases the accountability and transparency of the government.
  4. Although Ghana’s growth has been fairly strong, the source of growth has always been dominated by commodities and the capital-intensive services sector. Neither of these has a direct effect on poverty reduction. Growth in rural areas is often limited by basic infrastructure, such as roads. This limits the ability of people in rural areas to access markets in urban areas.

    Nigeria

     

  5. Nigeria is Africa’s leading oil producer. In 2016, it experienced its first full year of recession in 25 years. Global oil prices reached a 13-year low and oil production was drastically cut. Oil has continued to dominate Nigeria’s growth pattern, but the volatility of oil-dependent growth prevents progress in social and economic development.
  6. On the political front, the transition from military dictatorship to democratic rule has been acclaimed as one of Nigeria’s major successes in the last decade. The 2011 general election, supported by the United Nations, was widely acknowledged by international observers and domestic monitors as one of the freest and fairest elections conducted in the country in recent years.

    Ghana and Nigeria

  7. Both Ghana and Nigeria have cut fuel subsidies in order to reduce their budget deficits. This has had severe consequences for low-income households.

Question

▶️Answer/Explanation

Using an externalities diagram, explain why the percentage of infants receiving measles vaccinations in Nigeria indicates the existence of a market failure (Table 1).

For drawing an accurate positive externalities of consumption diagram showing:
 
  • MSB > MPB and identifying both the socially optimal quantity of output and the quantity of output determined by the market forces
  • The vertical distance between MSB and MPB labelled
    externality/external benefit or the shaded welfare loss/potential welfare gain.

AND
an explanation that the consumption of measles vaccinations brings external benefits, but a large percentage of infants are not vaccinated because the market under-allocates resources to the consumption of measles vaccines/market operating below socially optimal level of output, indicating market failure or welfare loss.

 

Economic growth in Cambodia

  1. Economic growth in Cambodia Cambodia has become one of the fastest growing economies in Asia and has now been classified as an upper middle-income country, according to the World Bank.
  2. Export promotion has helped Cambodia to grow. It has used low-cost labour to manufacture products for export. This has been helped by the fact that the price of labour has increased in China and other Asian countries. Cambodia’s large supply of inexpensive, low-skilled labour has attracted much foreign direct investment (FDI) into the production of garments and footwear for export and contributed to its economic growth. Last year, there was a 10.2 % increase in the export of garments and footwear in Cambodia, which makes up 70 % of its exports.
  3. Throughout Asia, hundreds of millions of people have been lifted out of poverty through manufacturing jobs that allowed them to better educate their children, who could then have a better life.
  4. However, Cambodia’s manufacturing competitiveness is being challenged by other countries in the region, particularly those that manufacture low-cost clothing. A recent increase in the minimum wage may also pose problems. Industry representatives have raised concerns that the garment industry may lose investors, who may leave to find cheaper places, if the minimum wage continues to increase.
  5. Cambodia needs to further diversify its economy if it hopes to maintain the high growth rates it has achieved in recent years. To support diversification, the government has launched an industrial development policy aimed at upgrading industry from low-cost, labour-intensive manufacturing to production with higher value added. The policy encourages the expansion and modernization of small and medium-sized enterprises, stronger regulations and enforcement, and a better environment for doing business.
  6. There remain many challenges to deal with. One of them is growing inequality—there is income inequality between urban and rural areas—as well as gender inequality. Women continue to face disadvantages in gaining access to higher education, well-paid employment opportunities and decision-making roles in government.
  7. Approximately 30 000 young Cambodians enter the labour force each year but often do not have the required skills to meet the needs of the labour market. While a large proportion of the labour force is employed, many jobs are informal, vulnerable, unstable and poorly paid. There is a critical need to address problems in education and training and to help children complete school. While 98 % of children attend primary school in Cambodia, many drop out later due to a lack of funds. Only 30 % of young people complete high school.
  8. The rapid economic and population growth in Cambodia is leading to significant environmental pollution. Environmentalists have identified garment factories as being one of the four main industrial activities that significantly contribute to air and water pollution.

Question

Using an externalities diagram, explain why the garment industry is a source of market failure (paragraph [8]).

▶️Answer/Explanation
For drawing an accurate, labelled negative externalities of production diagram for the garment market showing:
 
  • MSC > MPC and identifying both the socially optimal quantity of output and the quantity of output determined by the market forces
  •  the vertical distance between MSC and MPC labelled externality/external costs or the shaded welfare loss due to the negative externality of production.

AND
an explanation that the production of garments creates external costs such as air and water pollution and as a result garments are over-produced/over allocation of resources/is greater than social optimal level of output. and therefore there is a market failure (or there is welfare loss).

São Tomé and Príncipe Economic Development Challenges

  1. São Tomé and Príncipe (STP) is an island nation and is one of the smallest economies in Africa. STP faces many economic development challenges including: a limited range of export products (mostly commodities) and markets, limited human capital, insufficient infrastructure, vulnerability to supply-side shocks due to climate change, limited access to credit, political instability and poor governance. All these challenges have led to a high dependence on foreign aid.
  2. International organizations estimate that approximately 50 % of STP’s population is living in relative poverty. Its economic growth rate has been consistent at 4–5 % between 2013 and 2018, but the International Monetary Fund (IMF) suggests that STP will need an economic growth rate of 6 % to have an impact on the poverty rate.
  3. To increase economic growth and reduce its dependence on foreign aid and cocoa exports (80 % of its total exports), STP is planning to extract offshore oil and develop the comparative advantage it has in tourism. Over 50 % of its exports go to the European Union. It is hoped that diversifying STP’s exports will increase the number of its potential trading partners. To achieve this aim, STP is seeking membership with the World Trade Organization (WTO) and the Central African Economic and Monetary Community. Developing export markets could help STP benefit from economies of scale and overcome the restrictions of its geographical remoteness and high transport costs. However, STP will need help from multinational oil companies to exploit its oil reserves, and the government needs to improve transparency to ensure that oil revenues are used to support economic development.
  4. In STP, foreign aid accounts for 57 % of gross domestic product (GDP) and 93 % of public investments, including a significant portion of health and education spending. In addition, concessional loans have been provided by the IMF. However, STP had to agree to decrease the budget deficit as a condition of the loan from the IMF.
  5. There are some government officials who believe that aid will not solve the economic development challenges in STP. It did not meet the nutrition targets set by the Millennium Development Goals and continues to struggle with providing adequate clean water and nutritional intake for its population. Clean water is becoming scarce in STP due to business pollution and poor household sanitation, which is also spreading diseases. Other environmental concerns are climate change, deforestation and erosion of coastal areas due to the sand extracted for the construction of roads and buildings.

Question

Using an externalities diagram, explain why “business pollution” is leading to market failure in STP (paragraph [5]).

▶️Answer/Explanation
An externality of production diagram showing MSC above MPC, and market equilibrium quantity indicated above the social optimum level of output with either the welfare loss/externality identified.
AND
Explaining market failure exists because the businesses are polluting water/increasing scarcity of water, creating a negative impact on a 3rd party.
Leading to MSC>MPC, (MSC # MSB)/welfare loss/external cost/Socially optimum quantity is lower than the market quantity.

Can the Democratic Republic of the Congo achieve its economic potential?

  1. The Democratic Republic of the Congo (DRC) is a nation of great potential. It has large mineral resources and an abundance of fertile land. The mining and export of cobalt, copper and gold are the main source of government revenue. However, the abundance of natural resources causes devastating conflicts as rebel groups fight for control of the DRC’s resources. With a population of 80 million and gross domestic product (GDP) per capita of only US$457, the DRC is one of the world’s poorest nations. It is ranked 176 in the world in terms of the Human Development Index (HDI).
  2. The government has been accused of relying too much on tariffs, but to improve living standards, the government needs revenue to spend on agriculture, electricity and roads. Furthermore, business owners in the DRC complain of corruption and increasing “red tape” (excessive regulations).
  3. The government believes that a strong agricultural sector could boost economic growth but only 10 % of the land is used for farming. Rice, maize and other crops grow well in the tropical climate and yet the government spends US$1 billion per year importing basic foods. According to a government spokesperson, the lack of infrastructure is a major barrier to the processing and transporting of agricultural products. The DRC’s road network is so bad that farmers and traders often make a two-week trip in small boats down the Congo River to sell their produce. The DRC has just 27 877 kilometres (km) of roads. It is estimated that 90 000 km of national roads and 150 000 km of rural roads must be built.
  4. In addition, the World Bank reports that only 17 % of the DRC’s population has access to electricity, despite the capacity of the Congo River to generate enough electricity to satisfy the needs of the region.
  5. To make matters worse, the regional conflicts have affected the availability of healthcare services. It is estimated that half of the health centres have been looted*, burnt or destroyed. Government expenditure on healthcare per capita remains one of the lowest in the world. Non-governmental organizations (NGOs) are relied on to protect the health and wellbeing of citizens. NGOs help to achieve this by distributing medicine and teaching families about hygiene and proper sanitation.

Question

Using an externalities diagram, explain the benefits of hygiene and sanitation education programmes (paragraph [5]).

▶️Answer/Explanation
For an externalities diagram showing an MSB curve to the right of the MPB curve and indicating under-provision of healthcare/education services and welfare loss (potential welfare gain)/external benefit.
AND
for an explanation of any plausible external benefit that might be gained from healthcare/education, such as:
 
  • the external benefits of a more educated/healthier workforce a reduction in the spread of disease
  • a reduction in the welfare loss
  • a capture of the potential welfare gain
  • a movement towards the socially efficient level of output.

New policies for Brazil

  1. From 2010 to 2014, Brazil experienced an economic boom with annual gross domestic product (GDP) growth of 8 %. During this time, the government spent heavily on social programmes (including cash transfers and pensions) that helped millions to get out of the poverty cycle. The poverty rate decreased from 22 % to 9 % and the Gini coefficient dropped from 0.581 to 0.515. However, the spending on social programmes resulted in fiscal deficits and a large public debt, which is currently 80 % of GDP.
  2. In 2015, Brazil entered a recession that lasted until 2017. During the recession GDP declined by an average of 3 % per year. By 2017, the number of Brazilians living in absolute poverty climbed by 13 %, inequality worsened, and unemployment was 12 %. From late 2017 to 2019, Brazil struggled to recover, with only approximately 1 % annual economic growth.
  3. Some economists blamed the slow recovery on the lack of investment in education and technology during the economic boom. According to those economists, investment in human and physical capital was necessary to improve productivity and decrease the reliance on the production of primary commodities. Historically, spending on education has not been effective in reaching the very poor.
  4. In 2018, a newly elected government, aiming to stimulate economic growth, introduced market-oriented policies. Since Brazil has a large economy, the new government believed that Brazil should take advantage of world trade and foreign investment to boost economic growth and achieve economic development.
  5. The new government aimed to increase the number of multinational corporations (MNCs) investing in Brazil through deregulation and trade liberalization. Furthermore, in 2020 several state-owned enterprises were privatized.
  6. Additionally, new labour market and tax reforms were introduced to create jobs, increase labour force participation and make it easier for firms to hire and fire workers. The reforms included increasing the retirement age and reducing transfer payments. However, trade unions claim that the reforms are unfair and will lead to the exploitation of workers.
  7. There is concern that deregulation, privatization and market liberalization will put pressure on Brazil’s environment, threaten sustainable development, and benefit only urban areas. In 2017, the government introduced “green GDP” as an official measure and committed to environmental protection goals. This is necessary because, for example, over 40 % of the population live in areas without access to a sewage system and manufacturing companies are dumping untreated wastewater in rivers, contributing to water pollution.

Question

Using an externalities diagram, explain how manufacturing companies in Brazil are contributing to market failure (paragraph [7]). 

▶️Answer/Explanation

For drawing an accurate, labelled negative externalities of production diagram for the garment market showing:

  • MSC > MPC and identifying both the socially optimal quantity of output and the quantity of output determined by the market forces 
  • the vertical distance between MSC and MPC labelled externality/external costs or the shaded welfare loss due to the negative externality of production.
    AND
    For an explanation that the manufacturing companies are dumping wastewater into rivers, leading to water pollution which negatively impacts a 3rd party / creating external costs.
    therefore manufactured products are over-produced/over
    allocation of resources/greater than social optimal level output/ create a welfare loss.

Text A — Overview of Tanzania

  1. Tanzania is one of Africa’s fastest growing economies with an average of 7% annual economic growth since 2000. It is a politically stable country, rich in wildlife and natural resources. However, the growth has been concentrated in urban manufacturing, using capital intensive production. The benefits from this growth have not reached all people and significant inequalities exist between urban and rural areas. Although the relative poverty rate has fallen over the last 15 years, the number of people living in absolute poverty has increased.
  2. Most people are employed in the slow-growing agricultural sector that relies on unskilled labour. Although incomes increased from 2008 to 2018, the demand for agricultural goods only increased by 21% during this time period. Over 70% of Tanzania’s population lives in rural areas, relying on subsistence farming with limited tradable crops. Only 30% of land is being used for agricultural production. With investment, the remaining unused land could be developed and generate income for farmers.
  3. The rural sector struggles to meet Tanzania’s food requirements due to low levels of skilled labour and productivity. Additionally, high youth unemployment leads to large numbers of unskilled rural youth migrating to the cities, often finding employment in the informal sector where wages and working conditions are poor. Insufficient investment and lack of government support for diversifying the agriculture sector have been blamed for the persistent inequalities and poverty.
  4. Tanzania’s cities have experienced a growing middle class with strong purchasing power and political influence who have placed demands on the government for cheaper electricity, better infrastructure, and more imported goods. In response, the government provided subsidies for electricity in city centres and tax benefits to foreign companies operating in Tanzania. There is concern that these measures may worsen inequality and lead to social unrest.
  5. The growth of Tanzania’s manufacturing and service sector was funded through aid and large government borrowing, resulting in high national debt. Most of the government borrowing was from foreign sources and in US dollars (US\($\)), which is a concern due to a recent depreciation of the Tanzanian shilling (Tanzania’s currency) against the US\($\). Some of the debt was borrowed domestically and placed upward pressure on interest rates. Higher interest rates have resulted in crowding out but helped keep inflation under control.


Text B — Strategies and opportunities for Tanzania

  1. Previous governments have used interventionist supply-side policies to improve access to water, education, and health services. However, the health service improvements are not keeping up with population growth and many young people are still not completing secondary school. Infrastructure has improved, but it is still insufficient as producers in the rural sector find it difficult to reach markets and access supplies.
  2. Aid organizations are currently supporting new sustainable businesses in rural areas through training programmes, especially for women and young people, who make up most of the unemployed in rural areas. Economists have advised the government to improve access to credit through microfinance organizations and to simplify regulations to make it easier to start new businesses.
  3. The government is establishing property rights in rural areas to provide security for farmers. Historically, farmers could easily lose their land, which reduced their incentive to invest in productive farming methods. The government wants to develop Tanzania’s land resources and lower its reliance on imported food. To reduce food imports, a subsidy will be granted to dairy farmers to allow them to compete against imported dairy products.
  4. Tanzania is a member of the East African Community (EAC) customs union and common market. However, Tanzania needs to improve human capital and encourage diversification so that the benefits of regional integration can reach the poor. These policies can also help attract foreign direct investment (FDI). Opportunities for growth through trade will expand as the EAC works towards becoming a monetary union in 2024.


Text C — Oil pipeline to be constructed

Tanzania and Uganda plan to construct a major oil pipeline from Uganda through Tanzania, ending at a port in Tanzania. This will attract FDI which could help fund infrastructure and generate jobs. However, environmentalists are concerned about potential ecological damage due to the waste created during the construction of the pipeline. Economists have suggested the waste could be avoided through a circular economy approach in the planning and construction stage.

Question

▶️Answer/Explanation

Using an externalities diagram, explain how the construction of an oil pipeline through Tanzania could result in market failure (Text C).

For a correct negative externality of production diagram with appropriate labelling showing MSC above MPC and market equilibrium quantity indicated above the socially optimum level of output with the welfare loss or externality identified.
AND
For explaining that market failure exists because the oil pipeline creates a negative externality of production due to the negative impact on a 3rd party/environment [1] resulting in a welfare loss/external cost/socially optimum quantity is lower than the market quantity/ MSC≠ MSB [1].
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