JC Economics Essay Series #25 – Free Market & Allocative Efficiency

JC Economics Free Market & Allocative Efficiency Essay Model Answers 

For the essays on Market Failure topic, JC Econs students have to explain the concept of economic efficiency in your H2 Econs exams too. Did you know that efficiency concepts relate to the 3 basic economic questions?

Here is a sample of a 25-mark, no-part essay on efficiency, market mechanism in Singapore.

 

Question
Discuss whether the free market is the most efficient way of allocation resources in Singapore. [25m]


JC Economics Essay – Allocative Efficiency Concept

Suggested Answer:

Explain the free market mechanism and how it can be used to allocate resources The price mechanism is a system which allocates resources through the free forces of market demand and supply, both in the goods and factor markets. The price mechanism in the goods market determines what and how much of the goods and services are to be produced. Similarly, the price mechanism in the factor market determines what and how much of the factors of production are employed.

 -> explain increase in dd of one good relative P ↑ (signal)  -> profits increase incentive for producers to enter helps allocate resources automatic, decentralised decision making

• Explain allocative EFF
Allocative efficiency would require firms to produce at the output level where the marginal social benefit (MSB) is equal to the marginal social cost (MSC) thereby maximising the society’s welfare.

Note: is productive efficiency required here?
Productive efficiency is attained when firms produce at the output level at any point on the long run average cost curve. 

 

• Explain why price mechanism achieves efficiency

The price mechanism is the best mechanism for efficient allocation of resources provided that it is operating in a perfectly competitive market with perfect information and under the situation of no externalities and public goods. In the absence of externalities and public goods and with perfect knowledge of market conditions, D-MPB-MSB, and S-MPC= MSC, hence the actions of consumers. and producers through the working of the price mechanism have caused the individual consumers. and producers to interact at a price where the associated output also the output where MSC = MSB.

 

• Explain how externalities, public goods, imperfect competition, factor immobility might lead to an inefficient allocation of resources

Firstly the market fails to internalize external costs generated from productive activities. For example, car consumption gives rise to air pollution caused by exhaust fumes. This creates third party costs such as breathing difficulties and lung problems. The external cost arising from pollution are neither paid by the producer nor the consumers. Examples in Singapore: car consumption, cigarette consumption.
[Explain market failure with diagram] 

 

Secondly, the price mechanism also fails to internalize external benefits. In the case of education or retraining, a person who pursues the course merely considers the private benefit he gains like raising his level of knowledge and skills and in anticipation of higher expected future returns and he weigh against the cost incurred in pursuing it. He ignores external benefits generated from education and skill training which raises his productivity and hence increases his contribution in terms of output to the society and a more civilized society. Hence, taking into account the external benefits that education or training provides, the good will be underconsumed by individuals in the society when left to the working of the price mechanism. Examples in Singapore: Education, healthcare, HDB flats 
[Explain market failure with a diagram]

 

Thirdly, in reality, market is far from perfect. Take the case of monopoly. Being a profit maximiser, a monopolist will produce where MC =MR at output OQm units and charge a price much higher than marginal cost.
[Explain market failure with a monopoly or market dominance diagram]

[Note: market dominance and anti-competitive conduct of firms are monitored by Competition & Consumer Commission in Singapore]

 

Fourthly, public goods which generates substantial external benefits to the society will not be provided under the working of the price mechanism. Public goods are goods which possess the characteristics of non-rivalry and non-excludability in consumption. Non-rivalry in consumption means that the consumption of the good by one person does not deprive another of its consumption. Hence, its marginal cost is zero. For efficiency reason to be attained, that is, P=MC, the good should be provided free to everyone. Hence, it does not encourage private producers to supply the good. Non-excludability in consumption means that the provision of the good to any one person automatically make it available to others. National defence once made available cannot be excluded even to the non- taxpayers. This gives rise to free rider problem.

 

Conclusion
In conclusion, the extent of government intervention must be determined by her level of efficiency and by using cost-benefit analysis. Too much intervention could also results in inefficiency as a result of government failure. 

 

Econs tutor’s comments:
Not a difficult question, even though it is a 25-mark, no-part question. A similar one in part (b) would be like the following:

(a) Explain the term public good, and explain whether public toilets and national defence are examples of public good. [10]
(b) Assess the view that public goods & merit goods should be the major causes intervention within SG in achieving its microeconomic goals. [15]

 

For such MF essay question, you should be able to answer any type of failures, including imperfections, divergences, externalities, dominance, etc, as long as you have a step by step approach to it. Targeting at least 19 out of 25 marks for your H2 essays for questions on inefficiency and market imperfections? Join us for your accelerated success to Economics NOW!