The price mechanism will always allocate scarce resources efficiently for all goods and services in a market economy. Assess the validity of this statement made by an economist. [15]

This economics paper assesses whether the price mechanism will always allocate scarce resources efficiently for all goods and services in a market economy. 

On the one hand, it will indeed allocate scarce resources efficiently in economic theory, because of the workings of the price mechanism to 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, which distort the workings of the free market.

On the one hand, the price mechanism allocates scarce resources efficiently in the market economy for goods and services through its signalling, rationing, allocating, and incentive functions. The signaling function is one where the price of a good allows for a re-calibration of the quantity demanded and quantity supplied, allowing goods to be efficiently allocated. 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. Those who are willing and able to pay will obtain the good. Correspondingly, the resources used to produce these goods will also be efficiently allocated, as producers maximise their profits by producing only if the cost of production is less than or equal to the prevailing market price. As a result, there is productive efficiency, since goods will be produced at the lowest cost combination to ensure profits are maximised. On the whole, there is also allocative efficiency, since society’s welfare is maximised, where only those who are able to consume and produce do so. 

Question: What economics diagram do you think should be drawn here? How would this diagram back up your arguments? 

On the other hand, there are market failures in the real world, which may impede the efficient allocation of scarce resources in a theoretical free market. Market failure is the situation where the free market fails to allocate resources effectively, and there is allocative inefficiency. There are many types of market failure, such as the lack of provision of public goods, under-consumption of merit goods but the over-consumption of demerit goods, externalities both positive and negative and also in consumption and production, imperfect competition, imperfect information, factor immobility, and inequality. 

Here, we focus on 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 the merit good. Externalities are defined as the spillover effects to third parties who are not involved in the production or consumption of the good. Vaccinations provided for example by the National Health Service (NHS) are examples of merit goods. However, an individual consumer only considers his private benefit from getting vaccinated, and does not consider the positive externalities his vaccination confers on society. This results in an under-consumption of the merit good of vaccination, and there is therefore dead-weight loss, as society’s welfare has yet to be maximized due to this under-consumption.

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?

In conclusion, while the price mechanism allocates scarce resources efficiently in theory, this may not be the case in reality, as there are market failures that challenge the assumptions upon which the efficiency of the price mechanism is predicated. In the real world, with market failures, there is the need for government intervention in the free market to reduce or eliminate market failures so that the free market can produce the optimal outcomes the economists promise. 

Economics Tutor's Comment - This is a rather strong economics essay which covers quite a few important points and arguments, but it could do so much more. The candidate's use of economic theory is quite strong in this economics essay. Could more examples have been used, or could the example of the NHS have been even better utilised to make the point? Perhaps another market failure - the lack of provision of national defence - would have also been brought in to buttress the arguments. What else would make this economics essay even better than it is currently? Thank you for reading and cheers!  

JC Economics Essays - This economics essays site helps economics students with the A-Levels Economics (Cambridge, A1/S, A2, H1/H2 levels), and the international AS level economics examinations. This blog provides a range of useful economics content, materials, tips and techniques, and model economics essays that students in the United Kingdom, and also in countries such as Malaysia and Singapore, can use to excel in their studies and examinations.

This model essay was contributed by WT, our resident expert who helps students understand the beauty of Economics and provides content on economic issues. WT has a wide-ranging interest in Econometrics, Economic History, International Trade, and Game Theory, especially applications to real life. And as always, S. S., the editor of JC Economics Essays, edited this economics essay. He also provided comments for this essay. 

“A monopolistic firm has market power whereas a perfectly competitive firm has no market power. Perfect competition is, therefore, clearly preferable to monopoly, say economists. Discuss this statement. [25]

Monopoly is a firm which is the only seller of a unique product which has no close substitutes. In a market of perfect competition, the level of competition is very high, and each firm is a small entity, a price taker. There are four assumptions for a monopoly to exist: there is only one seller but many buyers, high barriers to entry (both natural and artificial), a highly differentiated product such that it is difficult or impractical to copy the product, and imperfect information. There are four main assumptions for a perfectly competitive market, which are: there are many sellers and buyers, low barriers to entry, homogenous product and perfect information. This essay attempts to explain the reasons for the high market power of a monopoly, low market power for a perfectly competitive firm, and the limitations of monopoly and the choice between a monopoly and a perfectly competitive market. 

Yes, it is true that monopoly has very high barriers to entry while a perfectly competitive market has very low barriers to entry. Barriers to entry refer to the reasons which deter potential entrants from entering the market. There are two types of barriers, which are natural barriers and artificial barriers. Monopoly often has high barriers due to various reasons. Firstly, when there is very high economies of scale of the existing monopoly firm, the starting cost of potential entrants will be very high as a result, and this is often because of high fixed costs, such as massive initial capital outlay followed by declining LRAC. 

Secondly, when there is limited and small market size, localized monopoly might arguably be present because the demand from the consumers is very low due to say a small population, which cannot support more suppliers. For example, there will be only one hairdressing shop in a small town because of its small population. 

Thirdly, when there are network economies, it is very hard for potential entrants to enter the market because of existing networks among users. For instance, after Facebook, it is difficult to have any more of the same type of online social network websites because users have built up broad network on Facebook already. 

These are main natural barriers. There are also artificial barriers to entry set up by governments and the existing firms as well. For example, patents, licenses, and regulations restrict potential entrants from entering. Existing will have limit pricing and predatory pricing to deter potential entrants from entering. Firms also can control retailers and suppliers to prevent potential firms. For example, deBeers controls the diamond resources of the world and can restrict diamond production. Therefore, a monopoly has very high barriers to entry to limit the number of existing firms to a very low number, i.e. one firm. The monopoly has very significant market share hence strong market power to control the price while a perfectly competitive firm has many competitors in the market and therefore their market share is insignificant as a result of this very low market power. Hence, a perfectly competitive firm is a price taker, whereas a monopoly can set output and accept a price, or set the price and accept the resulting output. 

[Insert diagram on PC Industry and PC firm]

The perfectly competitive firm takes the price from the intersection of market demand and supply. To maximize profit, the firm will produce at MC = MR at price P. In the long run, a perfectly competitive firm will gain normal profits when LRAC = P at minimum efficient scale (MES). 

Therefore, a perfectly competitive firm is productive efficient because it always produces along LRAC curve and every firm in the industry tries to produce at MES for maximized profits and minimized costs for survival. A perfectly competitive firm is also allocative efficient because P = AC. It gains maximum social welfare. 

A perfectly competitive firm is also equitable because it gains normal profits in the long run. There are therefore good and solid reasons for the preference of a perfectly competitive firm than a monopoly. A monopoly is productive inefficient , allocative inefficient, and inequitable as explained below. 

[Insert diagram on Monopoly Firm showing Supernormal profit and Deadweight loss]

A monopoly is productive inefficient because the firm has great market power and it can be X-inefficient, which means that it does not act energetically to curb its costs, for instance costs from lobbying for government intervention. It can produce above the LRAC curve due to overpaying for workers, building ostentatious buildings, or unnecessary perks. 

A monopoly is allocative inefficient because of the deadweight loss resulting from monopoly power. At the profit maximizing point, MC = MR, and P > AC. Hence, there is a positive welfare to be achieved by promoting perfectly competitive firms.

A monopoly is not equitable to consumers because of its supernormal profits gained in the long run. 

However, a monopoly can be preferred to a perfectly competitive firm because it is dynamic efficient. It has the willingness and ability to innovate and create to do research and development (R&D) and to improve its product variety through product proliferation. This is because of its supernormal profits in the long run, leading to its ability to conduct R&D. It also aims to utilise product proliferation to fill the product gap, and thereby prevent potential entrants from finding a niche to exploit in its market that it dominates. A perfectly competitive firm is also not willing to innovate because of perfect information in its market, so other firms can easily copy from it, so a monopoly does have some strengths. 

[Insert diagram to compare PC firm and Monopoly]

A monopoly firm usually restricts output and set high price at maximized profit level, while a perfectly competitive firm has lower price and more output at the intersection point of its demand and supply. At this point in time, a perfectly competitive firm is preferred to a monopoly. However, in the long run, when a monopoly grows and exploits its economies of scale, it moves its (LR)MC curve downwards. It can then produce more output at a lower price. At this time, a monopoly is preferred to a perfectly competitive firm due to its dynamic efficiency. 

In conclusion, it is not always preferable to have a perfect competition than a monopoly. Ostensibly there are many good points that perfectly competitive firms have, such as productive efficiency and allocative efficiency, among other ideal points, whereas monopoly does appear or seem not ideal, due to its lack of productive and allocative efficiency. However, a monopoly has more dynamic efficiency than a perfectly competitive firm and has the potential to have lower prices than a perfectly competitive firm. In addition, a perfectly competitive market is ideal but does not exist in the real world. Hence, monopoly is sometimes preferable to a perfectly competitive firm. 

JC Economics Essays - H2 Economics essay on monopoly and perfect competition. Normally I would give detailed comments for essays and make some commentary or remarks on how good the essay is, or how it can be further improved by identifying particular points, arguments, or even sometimes, rarely, mistakes. Sometimes, I even ask difficult thinking questions about how the essay can be improved. However, for this particular essay done under timed examination conditions, I rather like its style and content, and so instead of giving my comments I will let you do most of the thinking: one simple question is - what can you learn from this economics essay? Thanks for reading and cheers. 

Discuss, using examples from the United Kingdom, whether high levels of research and innovation are best achieved in competitive compared to monopolistic markets. (25 marks)

This Economics paper argues that high levels of research and innovation are best achieved in monopolistic markets, compared to competitive markets, because dynamic efficiency is best achieved when companies have the willingness and ability to conduct costly research and development (R & D).

First, what is dynamic efficiency? Dynamic efficiency means that companies can invest in education, research, innovation, and other creative processes that help them increase their efficiency over time, and in the long run will help them earn supernormal profits above opportunity costs and explicit costs. Competitive markets are markets with low barriers to entry, and can be idealised using the model of perfect competition.

What is perfect competition? Perfect competition is the market structure where there are many buyers and sellers of a single homogeneous product with perfect substitutes, low barriers to entry, suggesting that they earn normal profits in the long run, and where there is perfect information.

This is in contrast with monopoly, which in theory is a firm that sells a product with few close substitutes, with high barriers to entry, and which thus earns supernormal profits in the long run.

It can be argued that competition might not lead to research and development. Taking perfect competition to benchmark competitive firms in the UK, because they earn normal profits in the long run, they have neither the incentive nor the willingness to invest in research and innovation. For instance, small shops along the streets of London, especially monopolistic competitive firms, will not engage in research. 

However, having said that, if these firms are able to borrow from capital markets or get funding, or perhaps even due to external events causing temporary supernormal profits due to changes in demand and supply, they could have the willingness to invest in innovation so that they can because more “monopolistic”, when they produce a highly differentiated product.

It can be argued that monopolistic markets have firms that earn supernormal profit, because of their high barriers to entry. They therefore have both the ability and willingness to innovate to keep their monopolistic position. First, they have the ability because they earn supernormal profits, and can allocate massive funds to R&D. Second, they have the willingness because if they are in monopolistic markets that could potentially be contested by more efficient firms that could displace them to take over their market, they need to innovate to maintain their long term dynamic efficiency. 

For instance, Rolls Royce which manufacturers engines and aeroplane systems is a dynamic company probably because it has incentive and ability to innovate. BAE Systems plc is also another such company, and in fact both Rolls Royce and BAE are multinational companies, companies that span international borders with their unique product chains that require high levels of research and development. In fact, it can be said that some monopolies are monopolies because they have developed a product that is unique, differentiated, and wanted by consumers.

However, having said that, on the other hand contestable markets are usually perfectly competitive or competitive in nature, and as such competitive markets could help dynamic efficiency better in that respect. Thus competition might also lead to research and innovation, but the level could be lower than that of monopolies that have incentive and ability to do research and innovation.

Also, there are problems with monopolies. It can be argued that monopolies sometimes have x-inefficiency, where they do not act energetically to curb costs, and they could therefore become slothful and inefficient firms. This is because they may preserve their position through the use of patents, laws, legislation, and other legal means that have nothing to do with their level of technology or the sophistication of their product.

In the final analysis, this paper argued that high levels of research and innovation are best achieved in monopolistic markets, compared to competitive markets, because dynamic efficiency is best achieved when companies have the willingness and ability to conduct costly research and development, even though there are indeed some limitations to monopolies such as x-inefficiency. Competitive markets may have the incentive to conduct some research, but their levels are lower, and most of the time they neither have willingness nor ability due to the lack of barriers to entry which ensure supernormal profit. 

JC Economics Essays (H2, H3 A levels): Economics Tutor's Comments - This Economics paper on research and development and comparison of monopolistic and competitive firms was crafted under model examination conditions and has a few good points that one can learn from, but also some problematic areas, such as simplistic analysis and lack of many other relevant examples from UK manufacturing or service industries. Do think: if you were an Economics tutor, what advice would you give this student to help him make the Economics essay better? Perhaps you could focus on an area of improvement, such as the structure or organisation of this essay. Think of how this Economics paper could be made better. Thanks for reading and cheers!

Compare and contrast the various types of economic efficiencies. [10]

Compare and contrast the various types of economic efficiencies. [10]

The fundamental economic problem is a problem of scarcity, necessitating choice. This is because human wants are potentially unlimited, but resources are limited, and hence choices have to be made, “efficiently”, between competing uses for the same resources. The scarce resources, or factors of production, are land, labour, capital, and entrepreneurship. Land refers to resources, gifts of nature, and other natural factors. Labour refers to human effort and work. Capital refers to any good that can be used to produced another good. Entrepreneurship refers to risk-taking, organisation, and business acumen, among other things. It can be said that efficiency is concerned with the optimal production and distribution of society’s scarce resources. This economics essay compares and contrasts the various main types of economic efficiencies – productive efficiency, allocative efficiency, dynamic and static efficiency, X-inefficiency, social efficiency, and Pareto efficiency.

Productive Efficiency

First, productive efficiency occurs when the maximum number of goods and services are produced with a given amount of inputs. This will occur on the production possibilities curve or production possibilities frontier (PPC or PPF), meaning that any point along the PPC will be productively efficient. On the PPC, it is impossible to produce more goods without producing fewer services. Productive efficiency will also occur at the lowest point on individual firms’ average cost curves (AC curves). This is because productive efficiency can be thought of as the method of least cost production, which means that production costs are minimised. Productive efficiency is not the same as the other types of efficiencies.

Think: how would you draw the PPC?

Allocative Efficiency

Second, allocative efficiency occurs when goods and services are distributed according to society’s preferences or when they are allocated in accordance with maximising society’s welfare. An economy could be productively efficient but produce goods that people that do not need, and this would be allocatively inefficient. In other words, allocative efficiency is a subset of productive efficiency, where productive efficiency is a necessary condition of allocative efficiency. (A necessary condition is a condition for some state of affairs that must be satisfied before the state of affairs can be obtained.) It should be noted that allocative efficiency occurs when the price of the good produced by a firm equals the marginal costs of production.

Dynamic Efficiency

Third, dynamic efficiency refers to efficiency over time, whereas static efficiency refers to efficiency at a particular point in time. The first concept has the element of time taken into consideration whereas the other does not consider time. Dynamic efficiency involves the introduction of new technology and working practices to reduce costs over time, whereas static means “at a fixed point in time”. Basically, this concept of dynamic means that there are changes over time whereas static means that time is held, as it were, frozen.

X-inefficiency

Fourth, X-inefficiency occurs when firms do not have incentives to cut costs. This is usually associated with monopolies, which usually pursue rent-seeking behaviour rather than think of how to lower costs. For instance, a monopoly which makes supernormal profits may have little incentive to get rid of surplus labour. Therefore, a monopolistic firm’s average costs may be higher than necessary.

Social Efficiency

Social efficiency occurs when externalities are taken into consideration and occurs at an output where the social cost of production (SMC) = the social benefit (SMB), or alternatively, the marginal social costs (MSC) = the marginal social benefits (MSB). This is closely related to both the concepts of allocative and Pareto efficiency, also known as Pareto optimality. Pareto efficiency or optimality is defined as a situation where it is not possible to make one party better off without making another party worse off. Hence, Pareto efficiency is socially efficient and also allocatively efficient, at society’s level.

Conclusion

In conclusion, there are many efficiency concepts in Economics and it is important to understand economic efficiency. Many of the concepts are related and can be understood in relation to each other.

JC Economics Essays – Tutor’s Commentary: This is a good introduction to the various “efficiencies” that Economics has to offer, not just at ‘A’ levels, but also at O, AS levels and introductory undergraduate Economics as well. ‘A’ level Economics can be quite esoteric, it is true, and this Economics material might seem difficult. Think positively instead: how could you make this Economics essay comprehensible and easily understood by you? Let’s do some counterfactual experiments here. Put yourself in the role of the Economic tutor, the examiner, or the lecturer, and you were marking this essay paper. If you were an Economics tutor, how would you judge this essay? What were its strengths and weaknesses, and why do you think – as a professional Economics tutor – those parts of the Economics essay were strengths or weaknesses? Thanks for reading, all the best and good luck!