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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]

Preview Answer

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.

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