This essay question was adapted from an actual H2 A level economics examination question
This
economics essay evaluates whether the price mechanism in a market economy will
always allocate scarce resources efficiently for all goods and services. This essay argues that, on the one hand, the price mechanism working in a
free market economy will indeed allocate scarce resources efficiently, according
to standard economic theory, because of the price mechanism can achieve
productive and allocative efficiency. On the other hand, the allocation of
scarce resources may not always be efficient, especially when there are market
failures and resources are not allocated efficiently, leading to a situation of
allocative inefficiency, which distort the workings of the free market.
First, we
need to deal with the central problem of economics. Human wants are unlimited,
while the earth's factors of production of land, labour, capital, and entrepreneurship
are limited. Land refers to gifts of nature such as physical land, natural
resources, and oil and gas, among other examples. Labour refers to human
ingenuity, effort, time, and talent in the form of “human capital”. Capital in
economics often refers to goods that are used to produce yet other goods. And entrepreneurship
is the risk-taking, decision-making element that coordinates the other factors
of production in an economy. This situation of limited factors of production
that could potentially be allocated to different outputs, and the context of
unlimited human wants, results in a situation of scarcity. It is important to
note that economic scarcity necessitates choice, usually made between competing uses.
Tutor’s Question: What economics diagram do you think should be drawn here? And how would this diagram back up your arguments?
The price mechanism, through the
intersection of demand and supply, determines the optimal price and output and
it is from the rational choices of millions of suppliers, producers, and firms
meeting the requirements of millions of consumers, individuals, and households
that eventually leads to the free market determining what to produce, how to
produce, and for whom to produce. Demand is defined as the willingness and
ability to purchase a good or service, ceteris paribus, while supply is defined
as the willingness and ability to produce a good or service, also ceteris
paribus. Oftentimes, one major assumption for this economic theory to work is
the situation of perfect competition, where there are many buyers and sellers
in a market, selling a homogeneous and non-differentiated good or service, and
there are no (or very low) barriers to entry into the market.
Under
the market price, consumers seek to maximise utility, and will therefore only
consume if they are able to have a positive net benefit from the consumption of
these goods and services. Those who are willing and able to pay will obtain the
good and service. And the resources used to produce these goods and services will
also be efficiently allocated, as producers maximise their profits. As a
result, there is productive efficiency, since goods will be produced at the
lowest cost combination to ensure profits are maximised, and price will be
equal to marginal cost. On the whole, there is also allocative efficiency,
since society’s welfare is maximised, and the Pareto efficient situation is
reached, where we can only make some people better off by making others worse
off in such an economic situation.
On the
other hand, there are market failures in the real world, which may impede the
efficient allocation of scarce resources. Market failure is the situation where
the free market fails to allocate resources efficiently, and there is
allocative inefficiency and deadweight loss to society. There are many types of
market failure, such as the lack of provision of non-rival and non-excludable public
goods, under-consumption of merit goods but over-consumption of demerit goods,
externalities both positive and negative and also in consumption and
production, imperfect competition leading to excessive market power in a market,
imperfect information, factor immobility, and income and wealth inequality in a
free market.
One
major example is the under-consumption of merit goods. Because rational
consumers seek to maximise their own welfare, they do not account for the
positive externalities associated with the consumption of their good or
service, which could be a merit good. There are many definitions of a merit
good, but one definition is that a merit good is a good defined by society or
the government to be beneficial to society, often because they bestow positive
externalities on society when they are consumed. Externalities are defined as spillover
effects to third parties not involved in the production or consumption of the
good. Vaccinations provided by the National Health Service (NHS) are examples
of merit goods, because they confer positive externalities on society, as when
people who are vaccinated help by not infecting others and by making UK society
healthier as a whole. However, an individual consumer only considers his marginal
private benefit from getting vaccinated, and does not consider the positive
externalities his vaccination confers on society – he would not take the
positive externalities into account when making his economic decision. This decision
results in an under-consumption of the merit good of vaccination, if the
decision is left to the workings of the free market, and there is therefore
dead-weight loss, as society’s welfare has yet to be maximised due to this
under-consumption.
Tutor’s Question: What economics diagram
do you think should be drawn here to support the merit good argument, which
shows that markets do not always work efficiently?
Another
example is the failure of the free market to produce public goods if there is
no government intervention. A public good is one that is non-rival and
non-excludable. Non-rival in consumption means that one person’s consumption of
the good will not result in less of the good being available to others – or the
consumption of the good does nothing to reduce the quality or quantity of the
good for others, such as public lighting in the streets, where the amount of
light cannot be “used up”. As a result, the marginal cost of the next user is
theoretically zero, and if allocative efficiency means to produce where price
equals to the marginal cost, and the marginal cost of producing the good is
zero, then it follows that no private firm would produce the good only to charge zero dollars (at the allocative
efficiency level). And non-excludable means that non-payers cannot be excluded from
consuming the good, for example national defence – it defends everyone in the
country, including those who have not paid for it, such as foreigners or
travellers, such as tourists. Therefore a rational firm would not produce this
good because of the problem of free riders, where one who has not paid for the
good has the ability to consume it. The government is the only decision-making
body that has the willingness and ability to produce a public good, like street
lighting and defence, as it has the mandate to do so for the welfare of its
citizens (and therefore the willingness) and can raise the revenues to do so
from compulsory taxes (and therefore the ability to do so).
In
conclusion, while the price mechanism allocates scarce resources efficiently according
to economic theory, this may not always be the case in reality, as there are
market failures that challenge the assumptions upon which the efficiency of the
price mechanism is predicated. Some government intervention is required in the
free market to make it genuinely “free”, and to let the price mechanism work as
it should. In the real world, with market failures such as the failure of the
free market to produce public goods or the underconsumption of merit goods, or
imperfect competition in the market, there is a strong need for government
intervention in the free market to reduce or eliminate market failures so that
the free market can go a long way to produce the optimal outcomes that the free
market economists promise.
Economics Tutor's Comment - This
is a top-quality, excellently-argued, and very strong economics essay which
covers quite a few important points and arguments. The candidate's use of
economic theory for market failure is quite strong in this economics essay and
the anti-thesis arguments have been well-explained. Could more real-life examples
have been used to demonstrate the arguments or the strength of the points? What
else would make this economics essay even better than it is currently? Thank
you for reading, and cheers!
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