2013 IJC H1 Econs Q3 Answer

1    3(a) Explain how the price mechanism may allocate resources efficiently. [10] Suggested Detail Essay Outline Step 1: Explain the price mechanism - Define price mechanism, demand and supply The price mechanism is a system where demand and supply interacts with each other to determine the equilibrium price and quantity of goods and services sold in markets. The demand shows the willingness and ability of consumers to purchase a particular good/service at various prices. The supply shows the willingness and ability of producers to produce a particular good/service at various prices. - Explain the role of price mechanism in a free market In a free market, economic agents such as producers and consumers are assumed to act rationally and governed by their self-interest. Pr oducers would aim to maximise profits while consumers would aim to maximise satisfaction. The price mechanism uses price to act as a signal to producers and consumers on how to allocate their resources in order to maximise their own satisfaction. Step 2: Explain how the price mechanism allow producers and consumers to make decision on the allocation of their resource - Explain how the price mechanism address the 3 basic questions on resource allocation what and how to produce and for whom to produce - Basic concept: price mechanism  use price as signalling (what to produce & how to produce) and rationing role (for whom to produce What and How much to produce? In the price mechanism, consumers decide what is to be produced (consumer sovereignty) by exercising their ‘dollar votes’. Producers then respond to the desire of the consumers by producing those goods and services that the consumers demand to maximise their profits. As such, producers then address how much to produce by looking at the prices consumers are willing and able to pay. How to produce? In order to maximise profits, firms will use the least cost method of production to produce the goods for the consumers. For whom to produce? The price mechanism also plays a rationing role in the sense that only consumers who are willing and able to pay for the good/service get to consume it eventually. As such, only consumers with the highest dollar vote get to enjoy these goods/services.

2    Step 3: Explain how the price mechanism always try to reach equilibrium and why the equilibrium is allocative efficient - Explain how the price mechanism allocates resources to achieve equilibrium when there is a shortage or surplus. [Using the case of shortage]: The price mechanism in, using price as a signalling and rationing role in the market economy, will automatically adjust to reach equilibrium. For example, if the price of a good is current ly too low such that quantity demanded exceeds quantity supplied, resulting in a shortage, consumers and producers will begin to respond to the shortage. Due to the shortage, consumers will begin to bid up the price so that they can get the good/service. As the price increase, some consumers will not be willing or able to pay for it and hence quantity demanded falls. Concurrently, as the price rises, producers find it more profitable and will increase their quantity supplied. The price will continue to rise until quantity demanded equals quantity supplied. This is where equilibrium quantity and price is attained. At this point, consumer and producer surpluses are maximised and hence it is allocative efficient. L3 Clear and well developed explanation on t he processes in which price mechanism allocates resources and how that equilibrium reached is efficient. There was diagrammatic analysis of the price mechanism. Concepts and economic terms were used accurately. 7-10 L2 There was underdeveloped explanation of the price me chanism in terms of how resources are being allocated due to lack of explanation on how the three basic allocation questions were being addressed. There is largely accurate usage of terms and concepts. 5-6 L1 There was a lack of coherence in the explanation and instead a list of unconnected points was given. There were some under standing of the price mechanism but the allocation process was inadequately explained. 1-4 (b) Discuss the view that government intervention in situations when the market fails will always result in more efficient outcomes. [15] INTRODUCTION - Define market failure in relation to allocative efficiency. - Explain briefly the various situations in which the markets may fail (in the case of public good, merit good or demerit good, externalities) and hence it is allocative inefficient Market failure occurs when the price mechanism is unable to allocate resources efficiently on its own; as such government intervention is necessary to improve the allocation of resources. In situation such as public good, merit and demerit goods or when the production or consumption of goods and services causes positive or negative externalities, the price mechanism will allocate resources inefficiently on its own, resulting in market failure. BODY

3    - By giving two situations (question said situation s), explain how government intervention may result in an outcome in the market that is more allocative efficient or less efficient outcomes as compared to free market outcomes due to government failures. The explanation should be linked to general limitations of government intervention as well as limitations of specific government measures used. - The quality of the examples would depend on the appropriateness of the examples, whether students use real life examples on why market fails to show application skills and the quality of the explanation coupled with economic analysis. You should choose two from either public good; merit good or positive externality; demerit good or negative externality. The examples should be connected in both thesis and anti-thesis. Market Failure Situation 1: - Explain the market failure, the thesis, anti-thesis then mini-conclusion One situation of market failure would be education where it is deemed as a merit good by our society due to its positive externality. Positi ve externality refers to external benefits on third parties not involved in the consumption of the service. In the case of education, the positive externalities would be the external benefits in terms of a more educated and productive workforce driving our economic growth as well as a more civilised and refined society. When consumption of education has positive exter nality, this will cause its marginal social benefits (MSB) to be higher than the marginal private benefit (MPB). Since there are no negative externalities, marginal private (MPC) = marginal social cost (MSC). Individuals will consume education up to MPC/MSC = MPB. However, the society will prefers consumption to be at MSB = MSC/MPC where it is allocative efficient. Since MSB is higher than MPB, from the society's point of view, there is under consumption of education which results in deadweight loss. Thesis: Government intervention in market failure will result in more efficient outcomes. In Singapore, a large part of our education is provided by the government directly. Primary school education is free while the rest are heavily subsidized. C onsumers receiving the subsidies will internalise the benefits. This increases their MPB of consuming education which leads to greater consumption of education. Consuming more education towards the socially optimal consumption will allows us to tap more of the positive externalities. The deadweight loss will be smaller. Anti-thesis: Government intervention in market failure may not result in more efficient outcomes. One limitation is that the provision of fr ee and subsidized education would require large funds which may implies higher income tax on our workforce. This may also drain resources away from other areas of developmen