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Role of Enterprise and Imperfect Information in Consumer Outcome

‘The factor enterprise and the free working of the price mechanism always ensure a satisfactory outcome for consumers even when imperfect information exists.’ Discuss this view.

Category:

Market Structures and Competition

[CIE AS level May 2016]

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Answer


Step ➊ : Define ‘enterprise’ and ‘price mechanism’ in the introduction.


The free market relies on the price mechanism and enterprise in order to determine the allocation of resources. Firms start when entrepreneurs organise resources and take risks in the expectation of earning a profit. In order to achieve this, firms will respond to consumer demands and preferences. In a free-market economy, there is no government intervention at and all decisions are taken by individuals and firms. However, due to information failure, consumers may not be aware of the beneficial or harmful effects of certain goods and services. Consequently, it will be seen that the free market will not always ensure a satisfactory outcome for consumers.


Step ➋ : Discuss whether the factor enterprise and the price mechanism is beneficial to consumers.


2.1 In a free market resources are allocated through the price mechanism and enterprise, this ensures that all consumer needs and wants are met.

2.1.1 The benefit of the price mechanism to consumers.

In a free market, the price mechanism determines the production, utilization of resources, and pricing. This means that the customers make the ultimate decision on which products succeed or fail. The forces of demand and supply determine what goods and services will be produced, how they will be produced and for whom will they be produced. For example, if consumers decide they want more of a good, demand will exceed supply and prices will rise. This is a signal to suppliers to expand production to meet the higher demand.

2.1.2 The benefit of the enterprise to consumers.

As there is an increase in the demand for a good enterprise will commit more factors to the production of that good in the expectation of further profit. Consumers will also benefit from a wider choice of goods and services in the free market. Enterprise involves taking the risk of production, which exists in a free enterprise economy. Free market economies allow business owners to innovate new ideas, develop new products and offer new services. They can study consumer demands, research popular trends and meet the customer's needs through innovation.


Step ➌ : Discuss whether imperfect information in a free market is beneficial to consumers.

It can be argued that because of imperfect information, the factor enterprise and the free working of the price mechanism does not always ensure a satisfactory outcome for consumers.

3.1 In a market economy, merit goods will be under-produced and demerit goods will be overproduced due to information failure.

It is often argued that the market is unable to allocate resources efficiently due to market failures. For example, due to imperfect information to the consumer, merit goods and demerit goods are not produced in the right quantities. This arises because consumers do not perceive quite how good or bad a particular product is for them

There tends to be overconsumption and overproduction of demerit goods. A demerit good is a product that is worse for the individual consumer than the individual realises. Examples are alcohol, cigarettes and various drugs. There is also an under consumption and underproduction of merit goods.

Since entrepreneurs will only consider private costs and private benefits of production, they will not consider the welfare of consumers. The main aim of entrepreneurs is to make a profit and, for example, producers will supply cigarettes, even it is detrimental to the health of consumers. This is shown in the figure below.

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When consumers are not informed about the harmful effects of demerit goods, the equilibrium price and quantity demanded and supplied is at P1Q1 . If consumers were fully informed about the harmful effercts of demerit goods, the demand curve would shift inwards from D1 to D2. The new equilibrium price and quantity would fall to P2Q2. Thus there was previously an over-consumption of demerit goods from Q2 to Q1 in the free market.

A merit good is defined as a good that is better for a person than the person who may consume the good realises. Examples are education and healthcare. Merit goods tend to be under-consumed and under produced due to information failure. This is shown in the diagram below.

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With information failure, the equilibrium price and quantity demanded and supplied for merit goods is at P1Q1. If consumers were better educated about the benefits of merit goods , then the demand curve would shift outwards from D1 to D2 . The new equilibrium quantity increase to P2Q2 . Thus there was previously an under-consumption of merit goods from Q1 to Q2 in the free market.

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Step ➍ : Conclude.
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To conclude, the free market will lead to a satisfactory outcome for consumers only to an extent. The price mechanism and enterprise will ensure that the demands of consumers are met. However, due to information failure, they may not perceive how much a product is good or bad for them. Thus there might be the need for government intervention to discourage the consumption of demerit goods and encourage the consumption of merit goods.

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♕ Examiner's report
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In this question, it was expected that candidates would provide some analysis to explain how the factor enterprise and the free working of the price mechanism respond to consumers’ wishes and then go on to consider whether imperfect information might prevent a satisfactory outcome for consumers. This topic is indicated in section 1(g) of the syllabus. Imperfect information leads to over-consumption of demerit goods and under-consumption of merit goods so this is clearly not a satisfactory outcome for consumers. A large number of candidates did not recognise the focus of this question. Many provided answers with no reference to ‘imperfect information’. Many answers were provided that gave long descriptions of the price mechanism with no mention of demerit or merit goods. Some gave largely irrelevant answers on free market and centrally planned economies. Inevitably, a failure to answer the question set resulted in a low mark.

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♕ Marking scheme
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Please note that the new syllabus does not require candidates to have knowledge of the
technical framework formerly used to analyse merit and demerit goods. Analysis of these
concepts now focuses upon ‘imperfect information’. Reference to private and social costs
and benefits can be credited here, but is not necessary for full marks.

For analysis showing how the price mechanism and the factor enterprise respond to signals
from consumers to allocate resources in line with consumer preferences. (up to 2 marks)

and the impact of imperfect information in terms of merit goods (up to 4 marks)

and demerit goods. (up to 4 marks)
8 maximum

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