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?