RVHS H1 ECONS P1 Essay Q3 Soln

Rational decision making involves the consideration of the marginal costs and marginal benefits of the choices available. (a) Using demand and supply analysis, explain how c onsumers and firms make rational decisions in the free market. [10] (b) Discuss the view that the free market inevitable fails and government intervention always leads to an improvement in resource allocation. [15] Suggested answer for part (a) In economics, the rational decision-making is a pro cess based on the marginalist principle. That is, it is based on a comparison of the marginal benefits and marginal costs of a particular activity, which in this case, refers to the consumption and production. Consumers decide how much to consume by comparing the private benefits which they derive with the opportunity cost for each unit of the good. The private benefits can be depicted by the demand curve as the curve shows the maximum price that consumers are willing and able to pay. In Figure 1 below, the private benefit is P 1 for the Q 1th unit. The opportunity cost is the benefits of the next best alternative forgone which can be depicted by the price that he has to pay, which is P e based on Figure 1. Rational consumers will buy the unit as long as the marginal benefits surpass the marginal costs. Since P 1 surpasses P e, consumers will buy this unit, Q 1. In fact, consumers will buy up to the point Q e since for all units before Q e, the additional benefits surpass the additional costs. However, it is irrational to consume beyond this un it as the additional costs surpass the additional benefits. For example, for the Q 2th unit, the costs, P e, will surpass the benefit, P 2, thus it is better for the consumers to forgo this u nit. As such, the quantity that consumers eventually buy is given by the equilibrium quantity, Q e. Likewise for producers, they decide how much to pro duce by comparing the private benefits which they can derive with the opportunity costs for each unit of the good they produce, so as

to maximise their profits. With reference to Figure 1, the private benefits can be depicted by P e, which is the payment they would receive for each unit produced. For Q 1th unit, the private benefits is P e. The opportunity costs for the producers are given by the supply curve. Like the consumers, rational producers will produce the unit so long as the additional benefits surpass the additional costs. Using Figure 1, for Q 1th unit, the opportunity costs to producers is P 2. Since P e surpasses P 2, producers will produce this unit. In fact, the pr oducers will produce up to Q e since for all units before Q e, the additional benefits surpass the additional costs. However, it is to be noted that it is irrati onal to produce beyond Q e as the additional costs surpass the additional benefits. For example, for the Q 2th unit, the costs, P 1, will surpass the benefit, P e, thus it is better for the producers to forgo this unit. As such, the quantity that suppliers eventually produce is given by the equilibrium quantity, Q e. In conclusion, the use of marginalist principle doe s help consumers and firms make rational decisions. Level of Response Marking Scheme (LORMS) L3 Developed explanation of how consumers and firms use margina list principle to make rational decisions. Graphs are pr operly drawn and explained. 8 – 10m L2 Undeveloped explanation of why consumers and firms make rational decisions. OR Developed explanation of why consumers or firms make rational decisions (cap at 6m) 5 – 7m L1 Smattering of valid points 1 – 4m Suggested answer for part (b) Allocative efficiency is achieved when the current combination of goods and services produced and consumed maximizes societal welfare. It occurs at the point where marginal social benefit (MSB) = marginal social cost (MSC) at Q e as shown in Figure 2. The free market will be able to achieve allocative efficiency if the following criteria are satisfied. Firstly, there is the absence of externalities. Secondly, there is perfect information present and thirdly the good is not a public good. Assuming in a free market where the 3 criteria are satisfied, the equilibrium price and quantity is determined by the intersection between demand and supply. With reference to figure 2, at a price above P e e.g. P 1, quantity supplied is more than quantity demanded. This creates a surplus in the free market. Producers will respond to the surplus by reducing price. When price decreases, quantity supp lied falls while quantity demanded increases. This continues until the equilibrium price P e and equilibrium quantity Q e where the surplus is eliminated. Similarly at a price below P e e.g. P 2, quantity demanded is more than quantity supplied. This creates a shortage in the free market. Consumers wi ll respond to the shortage by offering a higher price. When price increases, quantity demanded falls while quantity supplied increases. This continues until the equilibrium price P e and equilibrium quantity Q e where the shortage is eliminated.

Thus when the 3 criteria are satisfied, the free ma rket will adjust itself to achieve allocative efficiency at Q e through the price mechanism and that government in tervention is not necessary. However, if any of these criteria is not satisfied, the free market will fail to achieve allocative efficiency and this necessitates government intervention. Using merit good as an example. A merit good is a good that is deemed socially desirable by the government and yet perceived by the government to be under-consumed. This under- consumption can be attributed to individuals disregarding positive externalities and/ or under- estimating their private benefits of consuming the good. One example of a merit good is immunization. Some consumers may ignore the externa l benefits of immunization. External benefits are beneficial side-effects of producing / consuming a good on third parties who are not involved in the production / consumption of the good. Third parties like the family members and the co-workers enjoy the external benefits of i mmunization even though are not immunised. They are less likely to catch contagious disease from the person who was inoculated. When external benefits are ignored by consumers, under-consumption results. With reference to Figure 3. The existence of external benefits cause the marginal social benefit (MSB) to be higher than the marginal private benefi t (MPB). The market output of the merit surplus shortage Figure 3 MPC subsidy = MPC = MSC = MPB = MSB Figure 2

good is Qm, given by the intersection of demand and supply (or marginal private benefit MPB, and marginal private cost MPC). The external benefits on third parties (i.e., marginal external benefits, MEB) are not considered when consumers decide how much of the good to consume. However, the socially optimal level of the good is Qs, given by the intersection of marginal social benefit (MSB) and marginal social cost (MSC) , since society’s welfare is maximised when MSB=MSC. Since Qm < Qs, there is under-consumption of the good. The welfare loss to society (i.e. deadweight loss) is given by Area ABC. Society’s welfare can be increased by increasing Qm towards Qs. One method to move towards a position of greater ec onomic welfare is for government to provide subsidies to producers of healthcare like s ubsidizing doctors’ training costs or hospitals operation cost. This will lower MPC to MP C subsidy in Figure 3, making healthcare available at a lower price and thereby encouraging consumption. This increase the consumption of healthcare and move equilibriu