2013 AJC H1 Econs Essays

H1 Prelim 2013 Essays Suggested answers © Anderson Junior College Economics Department Page 1 Question 3 a. Explain how the price mechanism allocates scarce resources in an efficient manner. [10] b. Discuss the difficulties of achieving this in practice. [15] Scarcity is the situation that exists when there is insufficient amount of resources to produce all goods needed to satisfy unlimited wants. Most economies seek to address three basic economic questions – ‘What to produce’, ‘How to produce’ and ‘For whom to produce’. In a market where the government does not intervene at all, the price mechanism seeks to address the above basic economic questions by determining the prices of goods and services and factors of production through the interaction of the forces of demand and supply. Demand refers to the willingness and ability of consumers to purchase a particular good or service at various prices per period of time, ceteris paribus. The supply of a good is the amount of the good that producer s are willing and able to offer for sale at various prices per period of time, ceteris paribus. The basic principle underlying the price mechanism is that goods and services are provided through the market and that consumers and producers act in their self-interest. On the supply side are profit -maximising producers who will provide a certain good or service if the revenue they receive is equal to the cost of producing an additional unit of that good or servi ce (i.e. MR = MC) . On the demand side are consumers who will acquire a certain good or service to maximise their satisfaction if the price they have to pay is equal to the utility or benefit derived from consuming an additional unit of that good or service (i.e P = MU). The price thus acts as a signal which consumers send to producers indicating their demand for a good and producers will allocate resources among competing needs to the production of these goods most desired by consumers, backed by their ability to pay. In this way, the price mechanism plays the allocative and rationing function. Prices perform a signalling function. Market prices will adjust to reflect where resources are required and where they are not. In deciding on what to produce, consider crops such as corn which could be used to produce either biofuel or breakfast cereals. Biofuel and food are goods in competitive supply. Demand for biofuel has been growing in recent years due to greater acceptance of it as a viable s ource of fuel in place of oil. Referring to Figure 1(a), the increase in demand for biofuel causes the demand curve D1 to shift to D2. Without a change in supply, the increase in demand results in a shortage and the price of biofuel rises from P1 to P2. Explain scarcity and its implications Define demand and supply Price acting as a signal from consumers to producers

H1 Prelim 2013 Essays Suggested answers © Anderson Junior College Economics Department Page 2 The rise in price of biofuel is a signal to the producers to expand their production to meet the higher demand. Producers begin to shift resources, in this case corn, away from the production of breakfast cereal s to the production of biofuel. The quantity supplied of biofuel increases and more resources are used to produce biofuel and fewer resources are now available to produce food. As seen in Figure 1(b), the supply of breakfast food falls as shown by a leftward shift of the supply curve to S2. This causes price of breakfast food to rise to a new price P2. Therefore through prices, consumers are able to signal to producers about their changing needs and wants. When demand is strong, higher market prices act as an incentive to raise production because the producer stands to make a higher profit and will be willing to supply more, causing quantity supplied to increase. In this way, the price mechanism performs the rationing function by rationing scarce resources to the production of goods which consumers are willing and able to pay for (effective demand). The price mechanism also answers the question of ‘How to produce’. It does so based on the prices of factors of production which are determined by the demand and supply of these factors. Different combinations of factors of production will lead to different costs of production. In seeking to minimi se costs, producers may choose the lowest-priced factors to produce a given product at the least -cost. For example farmers may choose to use the least -cost fertilizer for their crops. Thus, the price mechanism also ensures productive efficiency. In allocating resources to the production of goods backed by consumers’ willingness and ability to pay, the price mechanism a nswers the question of ‘For whom to produce’. Those consumers who value a good more would be willing to pay a higher price for it. Therefore, more resources will be allocated to produce goods for these consumers than others. In conclusion, prices place a value on a good or service, which helps to sieve out consumers’ wants that are backed by the ability to pay. Use example to explain how the price mechanism performs the allocating function – ‘What to produce’  Link to allocative efficiency Price mechanism performs the rationing function ‘How to produce’  Link to productive efficiency ‘For whom to produce’  Link to allocative efficiency Conclusion

H1 Prelim 2013 Essays Suggested answers © Anderson Junior College Economics Department Page 3 Mark scheme Knowledge, Application, Understanding and Analysis L3 For an answer that explains the workings of the price mechanism well and address the three basic economic questions with the use of examples. 7 – 10m L2 For an answer that attempts to explains how the price mechanism addresses the three basic economic questions. 5 – 6m L1 For an answer that contains conceptual errors and some irrelevant points. 1 – 4m (b) Discuss the difficulties of achieving this in practice. [15] Price mechanism helps to allocate resources efficiently. However, in real world , the assumptions of free markets, such as homogenous product, perfect information, perfect factor mobility and marketable products do not hold true. Due to the above, market failure arises. The price mechanism in free unregulated markets (i.e. markets that are not subject to government intervention) fails to achieve an efficient allocation of scarce resources so as to maximise welfare. Market failure can either be complete or partial. Perspective 1: A d ifficulty of the price mechanism in allocating scarce resources efficiently is due to non-marketability of certain goods The reason why price mechanism cannot allocate resources efficiently is due to the characteristics of non -excludability and non -rivalry in consumption, hence leading to complete market failure. Complete market failure occurs when the price mechanism does not allocate any resources to the production of the good. Public goods exhibit the characteristics of non -excludability and non -rivalry in consumption. An example of a public good is street lighting. Non-excludability means that it is technically impossible or extremely costly to exclude any indiv