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 p