(a) Explain why the fixed costs of owning a new car in Singapore are considerably higher than the variable costs and why this is likely to lead to greater car use (10)

Fixed costs of owning a car is considerably higher than the variable costs of using it.

Fixed cost – costs that do not vary with output. In the case of cars, the use of the car is quantified by the number of car journeys. As such, the ownership costs do not vary with the number of car journeys.

Ownership costs for cars in SG: COE -> Certificate of Entitlement -> vehicle quota system that limits the number of cars in SG. Through a bidding process, car owners have to bid for a limited number of COEs for that particular month in which they purchase the car. The price that they pay for COE will vary monthly depending the demand and supply conditions. The supply is perfectly price inelastic. Depending the level of demand, the price of COE is determined accordingly. In SG, the government limits the number of cars using this quota system, coupled with the high level of demand due to the high income of Singapore households since cars are normal-luxury goods (YED > 1), the demand will rise by a larger extent / proportion relative to rise in income, hence COE prices are high.

Variable cost for car usage in SG: Maintenance costs, petrol costs, ERP charges, parking charges -> cost incurred for every unit of car journey produced and hence these costs are considered smaller as compared to the ownership costs such as COE which is a one-time lump sum payment for the permit to use the car for 10 years. 

When the ownership costs is substantially greater than the variable costs for cars, this gives rise to a behavioural economic problem of sunk cost fallacy. Sunk cost fallacy arises when a person’s decision is affected by fixed rather than marginal costs. When a person pays an astronomically large sum on the COE, it makes sense to use the car more intensively to “average-down” the fixed costs of owning the car, hence this may prevent the user to make a rational consumer choice of weighing the marginal cost and marginal benefit of car journey, which excludes the fixed costs.

Marginal Benefit: satisfaction of car journey (convenience, comfort)

Marginal Costs: variable costs of car journey

To maximise utility, the car user will only weigh marginal benefit and marginal cost and produce the number of car journeys till MB = MC.

Now that the ownership costs are high, this may unintentionally result in more intensive / greater use of cars, thus making policies such as ERP become less effective in curtailing car use.

(b) Discuss whether road pricing is the most appropriate policy choice for a government that seeks to reduce the environmental damage caused by car use (15)

Introduction: define market failure. BP1: Explain briefly the market failure caused by ICE car journeys (environmental damage) 

- MPB, MPC, MEC of ICE car journey

- Diagram Analysis

- DWL Analysis

BP2: Road pricing (e.g. ERP) will increase MPC of car journeys, hence reducing the number of ICE car journeys

- rise in MPC will lead to a fall in qty of ICE car journeys -> reducing the amount of environmental damage

- limitations (effectiveness, unintended consequences)

BP3: Another appropriate policy  government providing incentives for electric vehicles in SG

e.g. Electric Vehicle owners will get $40,000 in rebates (Vehicle Emission Scheme - $25,000, EV Early Adoptor Incentive - $15,000) -> reduce MPC of owning EVs, increasing qty of EVs -> since EV and ICEs are substitutes ->  reduce MPB of ICE car journeys -> reduce qty of ICE car journeys (illustrate on diagram)

- limitation: strain on govt budget, EV being poor substitute to ICE cars due to a lack of charging infrastructure and concerns about range anxiety

Conclusion: [Time Frame] Road Pricing -> ST solution to reduce the number of ICE car journeys, hence the environmental damage. LT solution -> switch to cleaner vehicles (hybrid cars, electric vehicle) + encouraging public transport. But this requires significant investments in charging infrastructure to allow mass adoption, as well as change people mindset towards switching to public transport. [Situation] In SG -> car use transcends the utility purpose as it is also seen as a “wealth symbol” -> hence there is still a need to maintain high COE price even if it unintentionally leads to greater use of cars, but it can nudge consumers to switch to public transport.

Note: If the diagram is qty of car journeys instead of ICE car journeys, encouragement of EVs and hybrids will shift MSC closer to MPC, as it reduces MEC of each car journey.