Q.1 price-mechanism-and-market-failure

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Q.1 price-mechanism-and-market-failure

  1. 1. The function of the price mechanism is to allocate factor inputs to satisfy human wants. Discuss whether the price mechanism will carry out this function efficiently? [25] The price mechanism, or the price system, is the process whereby the decisions of consumers, which are the market force of demand, and the decisions of firms, which are the market force of supply, interact to determine the allocation of factor inputs. The question on whether the price mechanism will allocate factor inputs efficiently can be discussed with reference to the concepts of price signal, externalities, imperfect information, market imperfections and public goods. Under the market system, the allocation of factor inputs is determined by the price mechanism. Consumers indicate to firms the types and amounts of goods that they want by the prices that they are able and willing to pay for them. Firms that seek to maximise profit will only produce the types and amounts of goods that consumers are able and willing to pay for. Therefore, prices signal the types and amounts of goods that are in demand and hence, the profitability of producing these goods. This signalling role of prices is the essence of the price mechanism. For instance, when consumers demand more of a good, the price will rise which will induce firms to produce more of the good. When this happens, more factor inputs will be allocated to the market. Conversely, when consumers demand less of a good, the price will fall which will induce firms to produce less of the good. When this happens, less factor inputs will be allocated to the market. In this way, the decisions of consumers and the decisions of firms interact to determine what and how much to produce and hence the allocation of factor inputs. In the above diagram, when the demand rises and hence the demand curve (D) shifts to the right from D0 to D1, the equilibrium price (P) rises from P0 to P1. As a result, the equilibrium output level (Q) where quantity demanded is equal to quantity supplied increases from Q0 to Q1. © 2011 Economics Cafe All rights reserved. Written by: Edmund Quek
  2. 2. In the above diagram, when the demand falls and hence the demand curve (D) shifts to the left from D0 to D1, the equilibrium price (P) falls from P0 to P1. As a result, the equilibrium output level (Q) where quantity demanded is equal to quantity supplied decreases from Q0 to Q1. The socially efficient output level is the output level where marginal social cost (MSC) is equal to marginal social benefit (MSB). MSC is the sum of marginal private cost (MPC) and marginal external cost (MEC) and MSB is the sum of marginal private benefit (MPB) and marginal external benefit (MEB). External costs and benefits, or simply externalities, are costs and benefits of consumption or production experienced by society other than the producers or the consumers. In the absence of externalities, the price mechanism will allocate factor inputs efficiently, assuming no market imperfections, imperfect information, public goods and immobility of factor inputs. Firms and consumers consider only private costs and benefits. In other words, the demand curve is the MPB curve and the supply curve is the MPC curve. © 2011 Economics Cafe All rights reserved. Written by: Edmund Quek
  3. 3. In the above diagram, due to the absence of external benefits, the MSB is equal to the MPB, and due to the absence of external costs, the MSC is equal to the MPC. As a result, the equilibrium output level (QE) where MPB is equal to MPC is equal to the socially efficient output level (QS) where MSB is equal to MSC. The price mechanism may fail to allocate factor inputs efficiently due to externalities. Positive externalities, or external benefits, lead to a divergence between MSB and MPB resulting in under-consumption or under-production and this is a matter of concern particularly if the goods are merit goods. Merit goods are goods that society deems desirable and the government thinks people should be encouraged to consume. Examples of merit goods include education and healthcare. © 2011 Economics Cafe All rights reserved. Written by: Edmund Quek
  4. 4. In the above diagram, due to external benefits, the MSB is higher than the MPB. For example, the consumption of education produces external benefits such as a more innovative labour force. Therefore, QE is lower than QS. The deadweight loss, which is the loss of surplus due to market failure or government intervention, is represented by the shaded area. In the case of negative externalities, or external costs, such as tobacco and alcohol, MSC and MPC will diverge which will result in over-consumption or overproduction. The price mechanism may fail to allocate factor inputs efficiently due to imperfect information. Imperfect information about beneficial effects causes perceived MPB to be lower than true MPB resulting in under-consumption and this is a matter of concern particularly if the goods are merit goods. In the above diagram, the perceived MPB (MPBP) is lower than the true MPB (MPB). For example, the perceived MPB of education is lower than the true MPB as many people do not fully realise the beneficial effects. Therefore, QE is lower than QS. The deadweight loss is represented by the shaded area. In the case of imperfect information about detrimental effects, such as tobacco and alcohol, the perceived MPB is higher than the true MPB which will result in over-consumption. The price mechanism may fail to allocate factor inputs efficiently due to market imperfections. Market imperfections are deviations from the assumptions of perfect competition that lead to under-production and this is a matter of concern particularly if the market is monopolistic. A monopolistic market is a market where there is a single large firm selling a unique product that has no close substitutes. Due to lack of competition in the market, a monopoly is a price-setter in the sense that it is able to set its price by setting its output level. The presence of barriers to entry in a monopolistic market allows a monopoly to make supernormal profit in the long run. A monopoly has substantial market power which it can use to restrict output and charge a higher price to make more profit resulting in under-production. © 2011 Economics Cafe All rights reserved. Written by: Edmund Quek
  5. 5. In the above diagram, the socially efficient output level where MSB is equal to MSC is QS. However, if the monopoly increases its output level above QM where its MPC is equal to its MR, the increase in its total cost will be greater than the increase in its total revenue as its MPC will be higher than its MR. If the happens, its profit will fall. Therefore, the monopoly will restrict its output level to QM which is lower than QS. The deadweight loss is represented by the shaded area. The price mechanism may fail to allocate factor inputs efficiently due to public goods. Public goods will not be produced in the absence of government intervention. Public goods are goods that are non-rivalrous and non-excludable such as national defence and street lighting. A good is non-rivalrous when the consumption of the good by a consumer will not reduce the amount available to other consumers. In other words, an extension of the good to one more consumer will not reduce the amount available to current consumers. A good is non-excludable when the person who pays for the good cannot prevent those who do not from consuming it. Since people can consume public goods without paying for them, they are unwilling to pay for them. Therefore, non-excludability leads to the free-rider problem resulting in the non-provision of public goods. In the final analysis, in the event that the price mechanism fails to allocate factor inputs efficiently, the government can intervene in the markets, and this is necessary particularly if it involves merit goods, demerit goods or public goods. However, with government intervention, government failures may occur due to factors such as the difficulty in precisely determining the external costs and benefits and hence the amount of tax or subsidy needed to correct a market failure. In addition to efficiency, the government should also be concerned with income equity as a large income gap may result in some goods and services not being allocated to the people who need them more. © 2011 Economics Cafe All rights reserved. Written by: Edmund Quek
  6. 6. In the absence of government intervention, the price mechanism may lead to gross income inequity. © 2011 Economics Cafe All rights reserved. Written by: Edmund Quek

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