A level and O level ECONOMICS
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For A level, AS level, GCSEs and O level.
Role of Government in Controlling Free Market
A free market economy operates to the benefit of both consumer and producer to achieve the most efficient outcome, and therefore there is no role for a government to play in controlling the market. Consider the extent to which this statement is correct. 
Market Structures and Competition
[CIE A level June 2018]
Step ➊ : Describe ‘the free market’ and ‘efficiency’ in the introduction.
It is often debated to what extent the free market economy operates to the benefit of consumers and producers. A free market is a type of economic system where most decisions are taken on the basis of demand and supply. There are no government restrictions in a free market. The free market is also able to achieve efficiency. Economic efficiency occurs where scarce resources are used in the most efficient way to produce maximum output. However, the free market does not always achieve efficiency and can cause market failures, there may be a need for government intervention.
Step ➋ : Explain how the free market benefits consumers and producers.
➤ 2.1 In a free market, there is consumer and producer sovereignty.
The free market benefits consumers as, with competition, producers are encouraged to produce what consumers want at a reasonable and affordable price. Consumers can enjoy a wider choice of goods and services.
The free market benefits producers as there is the absence of bureaucracy. Because free markets reduce cost and minimize red tape, they lead to more innovation via research and development.
Competitive firms in a free market will work to satisfy consumer demand and aim to gain an advantage over their competitors. To achieve this, they must operate as efficiently as possible
Step ➌ : Explain how the free market achieves economic efficiency
The free market can achieve economic efficiency. Economic efficiency occurs when resources are allocated optimally in such a way that each person is served in the best possible way.
Competition and the profit motive in a free market may encourage firms to achieve productive efficiency. Productive efficiency can be shown through a firm’s average cost curve. Productive efficiency at the lowest point on the firm’s average costs curve.
Allocative efficiency can also be achieved in a free market as firms will distribute goods and services to consumers in an optimal way. There is no wastage and both producers and consumers are satisfied with what is produced.
Perfectly competitive firms can achieve both productive and allocative efficiency as shown in the diagram below. Perfect competition is a market structure where many firms offer a homogeneous product.
Firms in perfect competition are able to achieve both productive and allocative efficiency. Perfectly competitive firms will maximize their profits by producing the quantity where price is equal to marginal cost (P=MC) as shown in the figure above. At the ruling price P1, consumer and producer surplus are maximised. There will be allocative efficiency.
Productive efficiency occurs when the equilibrium output is supplied at minimum average cost .This is attained in the long run for a perfectly competitive market as shown in the diagram above. Productive efficiency is achieved at the lowest point on the firm’s average costs curve (ATC) at an output of Q.
Step ➍ : Explain how information failure in the free market does not benefit consumers.
It is argued that the free market can give rise to market failure. This is because there may be an inefficient distribution of goods and services in the market. Because of the profit motive, firms will consider only their private costs and benefits. They will not consider externalities and may produce goods that are undesirable for consumers. Monopoly firms may also abuse of their power and reduce consumer surplus. In this case, the free market will not benefit consumers. Information failure occurs where people do not have full or complete information and this may lead to the overconsumption or underproduction of certain goods.
➤ 4.1 The free market may fail to provide merit goods and demerit goods in correct quantities.
A merit good is defined as a good that is better for a person than the person who may consume the good realises. Due to information failure, merit goods tend to be underproduced and overproduced in the free market. For example, people underestimate the benefits of getting an inoculation against a contagious disease. Not only will they benefit a personal protection against the disease, but also there will be external benefits to the rest of society because it will help reduce the spread of the disease.
Demerit goods, on the other hand, are those products that are worse for the individual consumer than the individual realises. Due to information failure, there may be overproduction and overconsumption of demerit goods in the free market. For example, when a person decides to smoke, he is not fully in possession of all of the information concerning the harmful effects of smoking. Passive smoking can also cause negative externalities. This causes costs to non-smokers in the form of discomfort and respiratory problems where there is extensive exposure.
Figure 1 merit goods : Since people will only consider their marginal private costs and benefits, they will consume at Q1. This is where the marginal private cost is equal to the private marginal benefit (MPB=MPC). Since the consumption of merit goods leads to external benefits, the optimum output from society's point is at Q2. The most socially efficient allocation of resources to the production of a merit good would occur at the quantity which equates marginal social benefit (MSB) with marginal social cost (MSC). There will be a net welfare loss, as shown by the shaded area.
Figure 2 demerit goods: In this diagram , the social benefit is less than the private benefit. In a free market, output will be determined at Q1, At this output, the social marginal cost is greater than the social marginal benefit. Social efficiency occurs at a lower output (Q2) - where social marginal benefit(MSB) = social marginal cost(MSC). The welfare loss associated with 'over-consumption' of a demerit good is the excess of Social Marginal Cost above Social Marginal Benefit, which is the quantity Q1 to Q2 in the above diagram. The welfare loss is represented by the shaded area.
Step ➎ : Explain how abuse of monopoly power may be a disadvantage to producers and consumers.
The presence of monopolies in the free market may be a disadvantage to both consumers and other producers.
A pure monopoly is defined as a single seller of a product. Firms with monopoly power can set higher prices than in a competitive market. Abuse of monopoly power could also involve setting higher prices or limiting output and lead to less choice for consumers.
A monopoly can also set artificial barriers to prevent other producers from entering the market. For example, it can limit production and access to technical developments. There may also be an unfair treatment of competitors. The firm may give preferential treatment to certain parties, placing others at a disadvantage. This does not benefit other producers.
A measure of the resulting loss of economic welfare is given by the shaded triangle in the diagram above. This indicates the loss of net consumer and producer surplus due to the monopoly. This is also called the deadweight loss under monopoly. For consumers, the reduction in consumer surplus amounts to a reduction in real income
A competitive firm would produce at Q1 and at price P1. This represents the optimum production and consumption position. However, under monopoly firms will set price P2 and produce a quantity of Q2. Too few resources are used in the production of this good because the price is too high.
Step ➏ : how the government can intervene to control the market.
Since a free market economy does not always operate to the benefit of both consumers and producers to achieve the most efficient outcome, there is the need for government intervention.
➤ 6.1 The government can provide subsidies.
The government can subsidie products with positive consumption externalities. For example, merit goods such as education.
It can be seen in the figure below that after the imposition of a subsidy, the optimal amount of goods is sold by the market at the lower price of P3, which is beneficial to consumers.
As shown in the diagram above, the equilibrium without government intervention is at point F where MPC = MPB or D1 = S1. The marginal external benefit (MEB) is added to the MPB curve to give the MSB, the marginal social benefit. The MSB represents society’s demand curve for the product. If the government subsidises production of this product, then the supply curve shifts to the right from S1, which equals MPC, to S2, which equals MPC plus the subsidy. The marginal cost of supplying the good is reduced by the amount of subsidy and the vertical distance GH is equal to the value of the subsidy. Thus the equilibrium after the subsidy is at point H, which is where D1 crosses S2 and the optimal amount of goods Q2 is sold by the market at the lower price of P3. This is clearly more beneficial for consumers.
➤6.2 The government can impose taxes.
The government can impose indirect taxes on goods producing negative consumption externalities. For example, demerit goods such as cigarettes. In can be seen in the figure below that after the imposition of a tax, allocative efficiency is achieved.
As shown in the diagram above, because of the external costs, MSB is below MPB. The market equilibrium, however, is at P1 and Q1 where MPB = MPC. The social optimum is below this at Q0, where MSB and MPC intersect. Market failure can be corrected by imposing an indirect tax on those who have caused the negative consumption externality. The supply curve shifts to the left ; if the tax is the same as the external cost, then the quantity traded will fall to Q0. Allocative efficiency will now be achieved.
➤ 6.3 The government can impose legislations.
The government might intervene by setting standards that restrict the amount of pollution that can be legally dumped. In the case of education, legislation is used in some countries to make state-funded education compulsory up to a certain age.
➤ 6.4 The government can make use of the nudge theory.
Nudge theory suggests consumer behaviour can be influenced by small suggestions and positive reinforcements.The basis of nudge theory lies in the provision of information. Presenting choices in a better way, people make wiser decisions. . Nudge theory therefore is a way of achieving beneficial economic and social outcomes without the need for regulations In the case of market failure, it can be applied through letters, emails or personal communications.
For example people can be targeted by a sending a letter that makes them fully aware of the benefits of having an innoculation against a contagious disease and how they can get one.
Step ➐ : Explain why government failure occurs.
It can be argued that government intervention to correct market failures may not always be successful.
➤ 7.1 There may be bureaucracy
Excessive bureaucracy can cause failure. Government intervention can prove costly to administer and enforce. The estimated social benefits of a particular policy might be less than the administrative costs of introducing it.
➤ 7.2 There may be tax avoidance, tax evasion, and the development of grey markets.
Raising taxes on de-merit goods such as alcohol and cigarettes might lead to an increase in tax avoidance, tax evasion, and the development of grey markets. Trade will take place between consumers and suppliers without paying tax
➤ 7.3 There may be lack of information
There is a lack of information about the true value of a negative externality. It may be difficult to give an accurate figure for the value of a negative externality such as pollution. Furthermore the government may not really know the true revealed preferences of so many people. There is a lack of information about the level of consumer demand for a product.
Step 8 : Conclude
To conclude , the free market does not always operate to the benefit of both consumer and producer to achieve the most efficient outcome. Market failures such as externalities, imperfect information and abuse of monopoly power may occur. For example, consumers may not always recognise how much a product or service is good or bad for them and there may be overconsumption and underconsumption of certain products or service. Monopoly power does not benefit both producers and consumers. Consequently, government intervention may be required to correct these market failures. For example, the government can impose legislation and apply nudge theory. However, there are also limitations for the government in controlling the market. Thus, the government must set policies in a way what will most benefit both consumers and producers.
♕ Marking scheme
An explanation of productive and allocative efficiency. A discussion of the free market economy and its limitations. The role and limitations of government in controlling the market.
L4 (18–25 marks) For a discussion of both efficiencies which considers the effects of competition in achieving them. Two or more alternative forms of market failure and the application of government policies to reduce them. Maximum 21, if no conclusions.
L3 (14–17 marks) For a discussion of efficiency with a single form of market failure. A brief reference to the need for government.
L2 (10–13 marks) For an accurate though undeveloped explanation of efficiencies, market failure and/or government intervention.
L1 (1–9 marks) For an answer which shows some knowledge but does not indicate that the question has been fully grasped, or where the answer contains irrelevancies and errors of theory.