1. ) ‘The free market is the most efficient way of allocating resources in Singapore. ’ Do you agree? Every society in the world, including Singapore faces the basic problem of scarcity. I. e Allocating resources occurs because there is unlimited human wants and limited resources, hence the problem of scarcity derives. There is three basic choices to be made: What, How, and for Whom to produce. Where the choice of what to produce is dependent on product prices, Product prices are determined by the market demand and supply conditions of the particular goods/services.
Moreover How to produce will depend on the factor prices, where firms will adopt its least costly method to maximise revenue by minimising cost. In addition, the decision for Whom to produce, will depend on both factor and product prices, as the price mechanism rations out the good produced according to the consumers’ willingness and ability to pay. Economic Efficiency is achieved when it is not possible to change the existing allocation of resources in a way that will make one person better off without making someone else worse off. For economic efficiency to exist, it is necessary to achieve both Allocative and productive efficiency.
In a free market system, there is laissez-faire and no government intervention. The recurring problem of how to allocate the scarce resources between alternative uses is solved through the price mechanism. This decision is made through the free interaction of the market forces of demand and supply. (i. e the price mechanism). In the free market, it gives private ownership over all factors. There are self-motives, where consumers are out to maximise satisfaction, producers are assumed to be profit motivated and resources owners would want to maximise return on resources.
Thus they rely on the price mechanism to allocate resources. The free market which uses the price mechanism may appear to be the most efficient way of allocating resources. As Allocative efficiency is achieved when the right amount of the right kind of goods is produced. Thus to achieve Allocative efficiency there must be a ‘right product mix’ which will then maximise the welfare of society. For private individual household and firms, when Marginal Private Benefit (MPB which is equal to Price [P])= Marginal Private Cost (MPC), i. P=MC, Allocative efficiency is achieved. With regards to society, when Marginal Social Benefit (MSB) is equal to Marginal Social Cost (MSC), Allocative efficiency is achieved. At this output level, society’s welfare is maximised. Assuming there is the absence of externalities; Price (Demand) reflects both the marginal private benefit as well as the marginal social benefit. Similarly, the Marginal Cost (Supply) reflects both the marginal private cost and the marginal social cost. From Diagram 1, If the output of good A is at 0Q1, where P>MC (Also MSB>MSC).
This suggests that society values additional units of Good A more than the alternative goods that the resources are currently used for. Hence there is an under-allocation of resources to the production of good A. Consumer surplus of area ABEe is lost. Output of good A should be increased by reallocating some resources away from other industries to produce more of good A as to improve Allocative efficiency in the society. Conversely, if the output of good A is being produced at 0Q2, of where P<MC (also MSC<MSB), this suggests that society values additional units of good A less than what it is currently being used for.
Thus there is an over-allocation of resources to the production of good A, hence the production of Good A should be decreased. Hence at the market equilibrium, 0Qe, P=MC and they are also equal to MSB=MSC. Consumer and producers’ surpluses are maximised and the market equilibrium output coincides with the socially optimum output of the industry. Thus through the price mechanism, the free market is the most efficient way to allocate resources. However, this may not always be the case as there are some types of goods/services, which the price mechanism fails to allocate resources efficiently; hence it results in market failure.
Market failure refers to a situation when the price mechanism fails to allocate resources efficiently. There are two forms of market failure. The first form: total market failure, this refers to a situation where there is a total collapse of the price mechanism due to the missing demand curve. The second form is called partial market failure, which refers to a situation where the price mechanism is unable to allocate resources efficiently resulting in overproduction (in the case of Demerit goods) or underproduction (as in the case of merit goods). There is a situation where there is total market failure.
The collapse of the price mechanism is due to the missing demand curve. This occurs in the case of public goods. A pure public good has features of non-excludability, which means it is not economically feasible to exclude anyone from using the good once it is provided and non-rivalry in consumption which refers to the situation where the consumption of the good/service by a individuals does not diminish another person’s ability to consume the same good/service. The property of non-excludability give rise to the problem of ’free rider-ship’ where it is possible for a person to consume a public good without having to pay for it.
From the demand side of the market, the desire to be a free rider weakens the incentive for consumers to offer to pay for public goods. Hence it is impossible to charge a market price for a public good. If such goods, For example, Street lamps, were to be left to the free market (private enterprise) they would not be provided at all. Moreover the feature of non-rivalry also means the opportunity cost or MC of producing one more of the good is Zero. Since MC is zero for a public good, at socially optimum output which occurs when P (MSB) = MC (MPC), the socially ideal price will be zero market price.
Therefore at zero market price, zero amount will be supplied to the market since producers in the free market are assumed to be profit motivated. Hence, because of the characteristics and nature of public goods, this results in complete market failure as no resources are allocated to these goods that are beneficial and essential to the society. i. e resources not allocated efficiently. In addition to the factors that contribute to market failure, partial market failure refers to cases that largely derived from market imperfection. A factor that contributed to partial market failure is market dominance.
In this essay I will use the example of monopoly to illustrate market failure from market dominance as monopoly is assumed to have high market dominance due to the high empirical evidence in the real world that monopoly holds the most market share. Misallocation of resources may result due to the increased market power of the firm which can possibly lead to consumer exploitation. Allocative efficiency is achieved and consumers’ welfare is maximised when the firm produces where P=MC. However, As Monopolies is assumed to have profit maximisation as their main objective.
The monopolist would produce where MC is equal to MR where MC is rising, i. e. output 0Qm at price 0Pm. Thus the monopoly is allocatively inefficient when it produces at 0Qm because P is greater than MC. This means that, for the last unit of good produced, consumers are willing to pay more than the additional cost that is needed to produce it. At this output level, the consumer surplus is ABPm and the producer surplus is PmBDE. This means that there is a loss of consumer surplus and producer surplus of area BCD, which is also known as the deadweight loss.
As there is an under-allocation of resources at 0Qm, there is deadweight loss results. Hence society welfare is not maximised. Thus the free market is unable to allocate resources efficiently. Moreover, The greater the dominance of the firm, suggests that the demand for the good is more inelastic, hence greater is the gap between price and Marginal Cost. Thus there is greater inefficiency. Lastly, there is the problem of externalities. The price mechanism depends on the interaction of the demand and supply curves. The market demand curve reflects the consumers’ Marginal Private Benefit (MPB) from the consumption of the good.
The market supply curve reflects the producers’ marginal private cost (MPC) at the intersection of the demand and the supply curves, equilibrium price is determined. However, at equilibrium, prices may not reflect the true value of the product to society or the true costs of producing the product to society when externalities are involved. Since societal Allocative efficiency is achieved when marginal social cost equals marginal social benefit. i. e MSC=MSB, a market failure occurs when there is a divergence between private benefit and social benefit, or private cost and ocial cost. An example would be the external cost from production. Where a firm dumps its production waste into the river and pollutes the available drinking water to the nearby community. Hence with the presence of external cost of production, the marginal social cost will be greater than marginal private cost. MSC=MPC+ External cost. In the diagram above, D=MPB=MSB because there is no externality in consumption. Due to the negative externality in production, MSC is higher than MPC. The market equilibrium is at E where MPC = MPB. This will give an equilibrium quantity 0Qe.
At this output, MSC>MPC because external Cost is not taken account by producers. More importantly, MSB is less than MSC. Society values an extra unit of good less than what it would cost society to produce it. Therefore the price mechanism over-allocates resources to the production of the good. The good is ‘’underpriced’’ resulting in greater quantity demanded of the good demanded and produced. Area ECD represents the deadweight loss to society as a result of the over-allocation of resources. The socially efficient level should be where MSC=MSB, i. e at output 0Qs.
Therefore, the existence of a negative externality will lead to market failure because of Allocative inefficiency in the price mechanism (free market). In conclusion, the price mechanism in the free market is the centrepiece of allocating resources, however if might fail when there is market failure. But nevertheless though it may not always satisfy the condition of allocating resources efficiently, the alternatives of government intervention may not be ideal either because of their high tendency to be complacent and x-inefficient due to the problem of bureaucracy. Hence most societies, including Singapore, adopts a mixed economy.