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Revision and Consolidation
Microeconomics
Price mechanism
and
resource allocation
Mkt Mechanism
Scarcity
Significance of resource allocation
Govt intervention
[limited resources, unlimited wants]
[How can society’s welfare be maximised?]
Merits / Demerits of each mechanism
How it works
Market Mechanism
Market failure
Market forces of dd & ss price changes guide movement of resources
Sources of market failureMethods to resolve
Market efficiency
Show how it can be efficient
JJC 2006a. Explain why the LCD TV market has expanded
so rapidly in recent years. (10)
Demand + Supply
Expansion of market
3 reasons
Demand Factors
1. Rising Y (underlying assumption?)
2. Improved functions
3. Advertising
Supply Factors
1. Increase in number of suppliers (rising dd, rising profits)
2. Improvement in production methods
Graph to illustrate effect on eqlm qty with both DD & SS increasing
???
PJC 2006Economic theory stresses the importance of efficiency in the allocation of resources.a. Explain how, in theory, output and price should
be determined in an industry to achieve efficient resource allocation. (10)
Which theory?
Demand-supplyWhat makes efficient resource allocation?
Social welfare is maximised
Price-output determination
Price
D0 = MPB0
S = MPC
Q0
P0
D1 = MPB1
New MPB
MPC
Net benefit
Q1
P1
= MSC
= MSB
New eqlm where MPB = MPCalso where MSB = MSC
Pte eqlm coincides with the socially optimum outcome
Resource allocation by px mechanism:
Individuals, by pursuing their self-interests, maximises the welfare of the society
i.e. MPB = MPC and MSB = MSC adjusting the level of output produces no net
addition / reduction to welfare point where welfare is maximised
Above analysis rests on the assumptions of• perfect competition• perfect information• absence of external costs / benefits
PJC 2006b. Discuss the difficulties of achieving an efficient
allocation of resources by both the market and government. (15)
Market Failure
1. Market power
2. Externalities
3. Public & merit (demerit) goods
Government failure1. Problems of pure
command economy2. Weakens competition3. Political pressure / self-
interest4. Policy decisions based
on imperfect information
Resource allocation by px mechanism:
Maximise social welfare only if:• perfect competition• perfect information• absence of external costs / benefits
When these conditions are not satisfied, resource allocation by px mechanism fails to maximise social welfare and market failure is said to have occurred.
Market Failure
Definition and examples of each type of mkt failure
Why each type of mkt failure leads to welfare loss
Graphs to illustrate welfare loss
Definition and examples of market power
Why market power leads to welfare lossMkt power in pdt mkt: firms raise prices and sell a lower quantity
Graph to illustrate welfare loss
Market Power
Externalities
Definition and examples of externalities
Why externalities leads to welfare lossNegative externalities:Crs/prs in deciding how much of a good to buy / produce consider only their private benefits and costs, ignoring the external cost borne by the 3rd party.
Graph to illustrate
Public goods
Definition and examples of public goods
Why public goods leads to welfare lossNon-excludability free riders absence of paying customersNon-rivalry MC = 0 inefficient to charge a priceTogetherpte prs unable to ss the good non-provision if left to the market
Govt Failure
Definition• When government intervention in resource
allocation leads to a deepening of existing market failure or the creation of a new failure
Some sources of government failure• Problems of pure command economy• Weakens competition• Political pressure / self-interest• Policy decisions based on imperfect information
Resource Allocation through Central Planning
Central Planning
Government collects data, estimates how much of each good people need and issues instructions to managers of factories.
The problem with central planning
No price mechanism to signal the changes in cr preferences and demand
No way for govt officials to keep track of all the thousands of local conditions and millions of individual desires within a country
Outcome
Resource misallocation – too
much of a good is produced while
acute shortages appear in others
Resource Allocation through Central Planning
Other problems with central planning
In the absence of competition:• little incentive for firms & workers to raise productivity• limited innovation and poor quality control
Nationalised industries in mixed economies also suffer from these same problems
Political Pressure / Self-interest
Govt reluctance to raise taxes on fossil fuels / subsidies on oil• Effects of extracting and burning fossil fuels on
the environment and health
Agricultural subsidies + tariffs on imported products in many developed countries• Distorts price signals• High price for consumers, over-production• Cheaper to import from developing countries
which enjoy CA in agricultural production
Decisions based on imperfect information
Pigovian taxes / subsidies
• correcting externalities require a tax (subsidy) equivalent to the marginal external cost (benefit) to get prs/crs will internalise this external cost (benefit)
• in reality, it is difficult to estimate the actual value of external costs (benefits) – e.g.?
VJC 2006“Scarcity is a problem faced by all economies.” In the context of the Singapore economy, comment on how efficiently the price mechanism allocates resources and how well it resolves the problem of scarcity.” (25)
Scarcity and allocation of resources
What is scarcity?
What has it got to do with resource allocation?
VJC 2006“Scarcity is a problem faced by all economies.” In the context of the Singapore economy, comment on how efficiently the price mechanism allocates resources and how well it resolves the problem of scarcity.” (25)
Price Mechanism
Based on dd- ss
Motivated by self-interest
Decides what, how and for whom to produce?
VJC 2006“Scarcity is a problem faced by all economies.” In the context of the Singapore economy, comment on how efficiently the price mechanism allocates resources and how well it resolves the problem of scarcity.” (25)
What makes efficient resource allocation?
Social welfare is maximised
Thesis: cr sovereignty
Anti-thesis: Mkt failure
Does it solve the scarcity problem?
How efficiently the price mechanism allocates
resources
Resource allocation in a single industry
Price
Coffee outlets
D0 = MPB0
S = MPC
Q0
P0
D1 = MPB1
New MPB
MPC
Net benefit
Q1
P1
= MSC
= MSB
New eqlm where MPB = MPCalso where MSB = MSC
Resource allocation across industries
Consumer sovereignty: Consumers, through their money “votes”, dictate what goods should be produced.E.g. Demand for coffee increases px of coffee ___ , profits of firms _____ forms the incentive for firms to ____ production increased competition for workers, retail space
and other fops bids up px of these factor i/p rising costs (e.g. rental) force bubble tea joints
which face falling dd to ___ production and ___ their claim on the resources
resources move into the coffee retail industry
Individual prs & crs, whose
actions are guided only by
their self-interests, help to
maximise society’s welfare.
Resources, guided by the
invisible hand, are channelled
to the production of g&s
which are desired by society.
Total satisfaction is
maximised
Resource allocationPrice
Quantity
Price
Quantity
Price
Quantity
Coffee joints Bubble Tea
Retail space
Resources channelled away
from declining industries to
produce goods which are
desired by society.
Resource allocation by px mechanism:
Individuals, by pursuing their self-interests, maximises the welfare of the society. No coordination is required!
i.e. MPB = MPC and MSB = MSC adjusting the level of output produces no net
addition / reduction to welfare point where welfare is maximised
Above analysis rests on the assumptions of• perfect competition• perfect information• absence of external costs / benefits
How efficiently the price mechanism allocates resources
Market Failure
Definition and examples of each type of mkt failure
Why each type of mkt failure leads to welfare loss
Graphs to illustrate welfare loss
Note:Choose examples in the Singapore context
How well price mechanism resolves the problem of
scarcity
How well it resolves the scarcity problem:
Reliance on price mechanismProfit-motive spurs adoption of more efficient methods of production and other cost-cutting measuresFirms more responsive to changes in dd and cost conditions, producing g&s in dd• more o/p can be produced with a given amount
of resources• outward shift of PPC• reduce scarcity BUT can’t eliminate it• Graph?
How well it resolves the scarcity problem:
How to produce
An increase in the price of labour relative to capital firms adopt more capital-intensive method of
production to minimise their cost cost-minimising behaviour guides firms to
substitute relative less scarce resources for scarcer resources.
How well it resolves the scarcity problem:
For whom to produce
The goods will be distributed to the people who are willing to pay the highest price
determined by availability of income
helps to reduce scarcity problem for high income groups but does little to help the low income groups
How well it resolves the scarcity problem:
Reliance on price mechanismProfit-motive spurs adoption of more efficient methods of production and other cost-cutting measuresFirms more responsive to changes in dd and cost conditions, producing g&s in dd• more o/p can be produced with a given amount
of resources• outward shift of PPC• reduce scarcity BUT can’t eliminate it• Graph?