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Free markets make the most efficient use of resources and are the foundation of a successful economy.’ To
what extent do you agree with this? [25]

Quick Answer:

A market system is associated with the capitalist ideology where all resources are privately owned. Hence all economic decisions are made by indi vidual households and firms who act in their own self interest. The essence of a market system is price mechanism, often quoted as “invisible hand”. Operating on its own, without government inter vention, price mechanism allocates resources through million of decisions taken each day by consumers and businesses. This system operates through signaling w’here a rise or fall in prices eliminates shortages and surpluses. This means that market prices will automatically adjust to where resources are required and where they arc not required. Thus resources are allocated and reallocated according to the preferences of con sumers and therefore consumers are said to be sov ereign. So it is believed that apparently chaotic system of millions of transactions would not onlv allocate resources but it would do it efficiently. Efficiency generally relates to how well an economy uses its scarce resources to satisfy maximum wants of consumers. When economists use the term efficiency they actually mean allocative and productive efficiency. An economy is said to achieve allocative efficiency when right amount of scarce resources are allocated to produce right products. In other words allocative efficiency occurs when the consumer valuation (P) of a product equals the cost of resources (marginal cost) used up in its production. Productive efficiency refers to firms' costs of production and can be applied both to the short iun and long run. Productive efficiency exists when producers minimize the wastage of resources i.e when they produce a product using the least possible resources or generating the lowest pos sible per unit cost.

In other cases market failure exists when even the competitive outcome of markets is not efficient from the point of view of society as a whole. The result is a loss of economic and social welfare generally known as social inefficiency. This is because the benefits that the free-market confers on individuals or businesses carrying out a particular activity diverge from the benefits to the society as a whole. I he existence of externalities, for instance, causes market forces to fail to allocate resource at socially optimum level. An externality occurs whenever actions by firms or consumers impose costs or confer benefits on others that are not involved in rhe transaction. The essence of the problem of externalities is that market forces will lead to either too little or too much production. With a positive externality, a competitive free market will produce loo little of the good and with a negative externality it produces too much of the good. Thus the presence of externalities, even when all markets are perfectly competitive, leads to socially inefficient outcomes. Another important cause of market failure is imper fect information. The reason for this is that party io a transaction can often lake an advantage by shilling costs onto the other party, l he other party loses because they do not have the same informa tion. More generally, whenever either party to a transaction lacks information that the other party has, or is deceived by false claims, the outcome of market forces changes and these changes may lead to inefficiency. Merit and demerit goods arc a clear case of imper fect information. Consumers don't perceive quite well how good or bad a particular product is for them: either they do not have the right information or they simply lack some relevant information. The problem is that imperfect information causes market forces to lead to an inappropriate amount of merit and demerit goods being produced or consumed.

A distinct type of market failure exists in case of public goods. 1 he issue here is not over and under
allocation but weather resources are allocated at all. A good must possess three distinguishing
characteristics to qualify as public goods. It mustbe non-excludible, non-rival and non-rejectable

These features give rise to the free rider problem; people receiving benefits from a good without contributing to its cost. Thus it develops a situa tion in which everyone believes that others will take on the burden of paying for goods such as national defense and streetlights. Since the exclu sion principle does not apply to these goods, private enterprises have no economic incentive to supply them. So we have goods which yield substantial benefits but to which the market system fails to allocate resources. In conclusion it can be stated that market system though allocates resources efficiently in most cases yet it fails to achieve socially desirable outcome in certain situations known as market failures. Thus there is a justified economic role for government. However, government intervention in excess of market failure could hamper the efficient role of markets and therefore create further ineffi ciencies.

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