JC Economics Essay Allocative Efficiency & Scarcity Model Answers
When was the last time you attempted an essay with a mixture of concepts from Market Mechanism and on Market Failure topic? Add to the central economic problem of – unlimited wants and limited resources – scarcity, JC Econs students sitting for the Cambridge – UCLES – SEAB – MOE A-Level H2 Economics examinations have to explain this type of combined topics.
Here is an important example of a typical question on this section of scarcity, (in)efficiency and rational behaviours of economic agents that is also common in the Prelim exams.
According to economic theory, consumers and producers behave rationally and are assumed to be motivated by their self-interest.
Examine critically the view that the pursuit of self-interest by consumers and producers in a market economy will always help to address the problem of scarcity in an ideal manner . 
JC Economics Essay – Market Imperfections
Clarify scarcity: of limited resources and unlimited wants.
Pursuit of self-interest by consumers & producers -> Incentive driven
Consumers ⇒ aim to max satisfaction ⇒ cast money votes in the market to signal to producers to produce goods they desire the most ⇒ leads to allocative efficiency (AE)
Producers ⇒ Incentive-driven by the need to max profits ⇒ produce consumers to earn high rev to max their profits max profits ⇒ utilizes least cost method to produce goods ⇒ in order to max profits ⇒ achieve both AE & productive efficiency (PE)
Explain how price mechanisms work to achieve AE & PE-> signalling function
Explain that “limited resources and unlimited wants” lead to the problems of scarcity and choice. The problem of scarcity results in the need to allocate resources between competing needs and wants. 1 way of allocating resources is by relying on the free market system where the pursuit of self-interests guided by the invisible hand or price signals answer questions of who to produce? What to produce? How much to produce? Resources will then be channelled to their best use.
Explain “self-interest”: Consumers seek to maximize their benefit and utility by consuming goods and services while producers seek to maximize profits through the use of price mechanism in a free market economy. Consumers signal their utility by their ability and willingness to pay for goods and services, reflected in the demand curve while producers signal their profitability by their ability and willingness to sell the goods and services, reflected by the supply curve.
Explain that consumers signal their preferences to firms by their willingness and ability to buy particular goods. o Consumers signal their maximum willingness to pay for the good based on their utility for the good and their ability to pay for the good with the demand line which maps the relationship of quantity demanded of a good its price. Explain that producers being profit-maximisers seek to use the most efficient way (least cost) to produce these goods and services, thus resulting in productive efficiency.
Producers must receive compensation for the goods they produce and therefore signal the price of the minimum willingness to accept for the goods that they produce, usually the cost of production and is therefore unwilling to accept a price lower than the cost of production. Explain how the price mechanism that is driven by self-interest works to achieve both allocative and productive efficiency.
The equilibrium price and output is then determined by the intersection of the DD and SS curve, that is, the last unit of goods sold has price equals to marginal cost. Goods will be sold and transacted as long as the price consumers are willing to pay exceeds the marginal cost of producing it, up till (Q1, P1). o When DD increases, due to various factors, there is a shortage of goods as quantity demanded for the good exceeds quantity supplied at the initial equilibrium price, this puts upward pressure on prices, inducing an increase in quantity supplied of goods as producers respond to the increase in prices as well as a decrease in quantity demanded of good (movement along SS and DD curve respectively) This continues until the shortage is eliminated at the higher price of P2, where DD once again equals to SS leading to allocative efficiency.
(Qn: Is the explanation on shortage vital?)
At the market equilibrium, both producer and consumer welfare are maximized which is allocatively efficient as every unit sold has the value placed on the goods exceeding or equal to the resources and marginal cost of producing the good, thus maximizing society’s welfare. In so doing, limited resources is being channelled to the best use as the price (value placed) on each unit transacted is higher than or equal to the marginal cost of producing the good, hence addressing the problem of unlimited wants and limited resources.
Thesis: the pursuit of self-interest by consumers and producers in a market economy will always help to address the problem of scarcity in an ideal manner, (ie leads to allocative efficiency in the absence of market distortions)
Price mechanism (buyers and sellers) allocate scarce resources in the most efficient manner for all goods and services.
Briefly explain the condition of MSB = MSC for achieving allocative efficiency.
To assess whether market forces lead to allocative efficiency, we need to examine whether MSB = MSC at the market equilibrium price.
In the absence of market distortions like externalities and/or imperfect information, the price mechanism can accurately signal the willingness and ability to pay on the part of the consumer as well as the minimum willingness to accept on the part of the producer and lead to maximized welfare as units of good will be transacted up to the last unit where marginal benefit derived of the good signalled by the reservation price equals the marginal cost of producing the good. When the market is in equilibrium at (Q, P), both producer and consumer welfare is maximized which is allocatively efficient as every unit sold has the value placed on the goods exceeding or equal to the resources and marginal cost of producing the good, thus maximizing societal welfare.
In so doing, limited resources is being channelled to the best use as the price (value placed) on each unit transacted is higher than or equal to the marginal cost of producing the good, hence addressing the problem of unlimited wants and limited resources.
(Qn; do you realise that the above is similar to the front part of the essay answers. How shall we deal with this?)
Anti-thesis: the pursuit of self-interest by consumers and producers in a market economy will NOT help to address the problem of scarcity in an ideal manner, (ie presence of market distortions)
When these conditions are not met: the price mechanism can fail when there is a divergence between marginal social benefit/cost and marginal private benefit and cost which are reflected in the price signals. This happens in the presence of externalities, or imperfect information and / or merit and demerit goods. Externalities are spillover or third party effects arising from the production and/or consumption of the good. When negative externalities arises, for e.g. from the act of smoking, the marginal social cost to becomes higher than the marginal private cost as smoking creates marginal external effects on third parties who do not like smoke and are concerned with the health effects of smoking. However the person who is smoking does not take into account the external cost to third parties, and is only concerned with maximizing his utility by smoking up till the point while his MPB = MPC, which leads to an overproduction of smoke and a deadweight loss (sketch your own diagram below as exercise), as allocative efficiency occurs where Marginal Social Cost = Marginal Social Benefit, where society’s welfare is maximised.
Merit and/or demerit goods:
Where consumers are ignorant of the true ‘benefits’ or costs of consuming a particular good, they will consume only up till the point where the ‘perceived benefits’ equal to the marginal private cost of the good. Education, for example is a merit good, where the ‘true’ benefits exceed ‘perceived benefits’, however as the consumers are ignorant of the leading to under-consumption of education, and consumes only up till the point where MSC = perceived benefits, and society’s welfare is not maximized as ‘true’ benefit exceed marginal costs at the equilibrium and there should be more consumption of education. This means that there is welfare that could have been gained with increased consumption up till the socially maximum output.
In the event that the good exhibits characteristics of a public good, the price mechanism will completely break down, as it is impossible to charge a price for the goods. This happens as it is impossible to exclude a person from enjoying such public goods, such as street lighting, due to the non-excludable and non-rivalry characteristics of the public good such everyone has the incentive to free-ride and no one will be willing to pay for the good. As a result, the free market will not allocate resources for the provision of public goods as no private firms will be willing to supply these goods at zero price. Hence resources are not allocated to producing the goods although there is an effective demand for it.
Market Dominance / Power:
Firms in the real world may have market power arising from barriers to entry (eg the undesirable Monopoly), thus increasing their ability to set price above marginal cost. As firms exhibit profit-maximizing behaviour at MR = MC, this leads to an underproduction of goods, as price and hence the value placed on the good is higher than marginal cost for the last unit of good sold. More resources should be allocated to producing these goods as welfare could be gained with increased production up to the last unit where P =MC.
Some market failures (MF) are small, and are thus negligible, no government intervention required.
Government may do a poorer job than the price mechanism, ie Government Failure.
Difficult to achieve AE in the real world.
Evaluation: more judgement options to be discussed more in class (“,)
Whether the price mechanism can achieve efficiency is dependent on whether there are market distortions. In the real world, market distortions exist in the form of externalities as well as imperfect information and more often than not, there will be a divergence between marginal social cost and marginal private cost and benefit, or perceived and true costs and benefit leading to under or overconsumption of goods and services which is not an allocatively efficient outcome. The price mechanism can also fail to allocate goods and services with public goods because of the lack of incentive to consumers to be willing to pay for the good, therefore lack of profit incentive for producers to produce the good. Profit maximizing behaviour of firms with market power also leads to prices that are higher than socially optimum, and underproduction of the good, and loss of welfare that could have been gained.
Therefore whether the price mechanism will always allocate scarce resources in the most efficient manner depends on the presence and the degree of market imperfections which can hamper the price mechanism signalling function. Therefore there is a need for the government to step in and correct these market imperfections, with various measures, such as taxes of subsidies, in the face of market failure so that resources can be allocated more efficiently.
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