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The Efficiency of Free Markets in Resource Allocation
‘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?
Market Structures and Competition
[CIE A level November 2019]
Step ➊ : Define the free market in the introduction.
In a free market, most decisions are taken through the market mechanism. This means that the price and quantity of a product is determined on the basis of demand and supply. There are no government restrictions in a free market. This gives rise to competition as producers work to satisfy consumer demand and aim to gain an advantage over their competitors. In order to achieve this, they must operate as efficiently as possible. However, it will also be seen that the free market can cause market failures. Thus, for an economy to be successful, there may be a need for government intervention.
Step ➋ : Discuss how the market achieves economic efficiency.
Economic efficiency occurs when resources are allocated optimally in such a way that each person is served in the best possible way. The profit motive encourages firms in the free market to be more efficient in order to produce at the lowest price and to minimise wastage. These firms may thus achieve productive efficiency and allocative efficiency.
➤ 2.1 Competition and the profit motive in a free market may encourage firms to achieve productive efficiency
Productive efficiency occurs at the lowest point on the firm’s average costs curve. This means that the maximum number of goods and services are produced with a given amount of inputs. Productive efficiency can be achieved by using advanced technology such as robots. In a free market, if the firm cannot remain competitive, they will be forced out of the market. It is thus in the interest of firms operating in the free market to achieve productive efficiency. This can be done through innovation and the development of more advanced technology in the production process.
➤ 2.2 Allocative efficiency can also be achieved in a free market as firms will distribute goods and services to consumers in an optimal way.
Allocative efficiency will occur at an output level where Price equals the Marginal Cost of production. At this point, there is no wastage and both producers and consumers are satisfied with what is produced. This is because the price that consumers are willing to pay is equivalent to the marginal utility that they get. Therefore the optimal distribution is achieved when the marginal utility of the good equals the marginal cost.
➤ 2.3 Firms in perfect competition in a free market are able to achieve both productive and allocative efficiency.
Perfectly competitive firms will maximize their profits by producing the quantity where the price is equal to marginal cost (P=MC) in both the long run and the short run. The diagram below shows a perfectly competitive market in the long run. At the ruling price P1, consumer and producer surplus are maximised. There will be allocative efficiency. Productive efficiency occurs when the equilibrium output (Q) is supplied at a minimum average cost (AVC).
Step ➌ : Discuss why market failure occurs in a free market (For this question, choose at least 2 types of market failure )
It is argued that the free market may fail to achieve allocative efficiency and productive efficiency because of market failure. Market failure exists whenever a free market, left to its own devices and totally free from any form of government intervention, fails to make the optimum use of scarce resources. There are various reasons why market failure occurs.
➤ 3.1 There may be are externalities present in the market. The market may fail to achieve social efficiency.
The free market may give rise to negative production externalities and negative consumption externalities. Externalities lead to an inappropriate amount of goods and services being produced: there may be the overproduction or underproduction of certain goods in the market. There will be an inefficient use of resources.
Negative production externality occurs when producing a good causes a harmful effect to a third party.
For example, a chemical firm producing chemical toxic waste will only consider the private costs of producing and distributing the chemical. The external costs, which are the costs born by society, will not be taken into account. Negative production externalities can be shown in the diagram below.
In the diagram above, the social marginal cost (SMC) is greater than the private marginal cost (PMC). This is because in the free market, producers ignore the external costs to others. Therefore in a free market, the output will be determined at Q1 , where the private marginal cost is equal to the private marginal benefit, that is where PMC=PMB. This is socially inefficient because at Q1, the social marginal cost (SMC) is greater than the social marginal benefit (SMB). Social efficiency occurs at Q2, where SMC = SMB. The shaded area shows the social welfare loss.
➤ 3.2 Monopoly firms may fail to achieve both productive and allocative efficiency.
Assuming an absence of economies of scale, monopoly equilibrium is both productively and allocatively inefficient.
The diagram below compares the efficiency between perfect competition and monopoly. The monopolist's level of output is productively inefficient. The figure below shows that at the profit maximising level of output MQ , the monopolist is productively inefficient, producing less than the optimum output in the search for extra profit. The monopoly firm is also allocatively inefficient. The monopolist's profit maximising price MP d, is considerably above marginal cost. In monopoly p>mc, which means that compared to the whole perfectly competitive market, the monopoly produces too low an output which it sells at too a high price
➤ 3.3 The market may fail to provide the correct amount of merit goods and demerit goods. The free market may not be able to allocate resources efficiently due to information failure.
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 under-consumed. 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. For example, when a person makes a decision 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.
➤ 3.4 The free market fails to provide public goods
The free market may also not be able to produce public goods because of the free-rider problem. Public goods are non-excludable, which implies that once one consumer has purchased the product, all other consumers cannot be prevented from benefiting from that product.
Step ➍ : Conclude
To conclude, the free market does not always make the most efficient use of resources and does not always ensure the success of an economy. It is true that firms in the free market, motivated by profit, will aim to meet consumer demands. In order to reduce costs, firms in the free market will innovate and develop new technology in order to be more efficient. The perfectly competitive market is theoretically able to achieve efficient resource allocation, however, in imperfect markets, there will be market failure. Market failure can take the form of externalities, monopoly power and imperfect information. In order for an economy to be successful, there will be a need for government intervention. For example, the government could impose taxes on goods-producing negative externalities, such as tobacco. The government could issue pollution permits to reduce pollution. The government can also subsidise merit goods such as education and directly provide public goods. Thus, both the free market and government intervention is required for an economy to be successful. A mixed economy is required.
♕ Marking scheme
A definition of a free market and the concepts of productive and allocative efficiency. Discussion of reasons for market failure, Imperfect knowledge, inequality, friction within a market, externalities. Note: All types of efficiency together to be regarded as one type of market failure.
L4 (18–25 marks): For a thorough discussion which covers a good understanding of productive and allocative efficiency produced by markets. A good explanation of 2 forms of market failure which consider the impact on efficiency. A conclusion will be drawn that refers to a successful economy. (Max. 21 no conclusion).
L3 (14–17 marks): For a competent discussion of productive and allocative efficiency produced by perfect markets. A limited explanation of 2 forms of market failure.
L2 (10–13 marks): For an accurate though undeveloped explanation of efficiencies or market failures.
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.