(a) Explain how the price mechanism allocates resources efficiently. [8]

Essay Plan
1) Define Price Mechanism
2) Define “efficient allocation of resources”
3) Explain the adjustment process that allows the market to reach equilibrium price and quantity, hence achieving efficient allocation of resources
i. Increase in dd (or decrease in ss) -> shortage -> price mechanism -> eqlb
ii. Decrease in dd (or increase in ss) -> surplus -> price mechanism -> eqlb

Price mechanism is the system through which producers and consumers interact to determine how scarce resources are allocated to competing uses. In a free market, price is determined by the demand and supply of the good. The efficient allocation of resources is where society’s welfare is maximised and any re-allocation of resources will make society worse off. To achieve allocative efficiency, price must be equal to marginal costs (P=MC), where consumers’ valuation of the good is exactly equal to the cost of producing the last unit of the good. Price mechanism can only help achieve efficient allocation of resources when there is perfect competition and externalities are absent.

In the case where there is a change in taste and preferences in favour of a good, like Iphone, there will be an increase in the demand for the good, shifting the demand curve to the right. This creates a shortage at the original price, P1. Recognising the shortage, consumers will signal to producers that they are willing and able to pay higher prices to acquire the good, imposing an upward pressure on the price. As price rises, quantity demanded will fall, as reflected in the graph as an upward movement along the demand curve.

At the same time, the higher prices will incentivise producers to increase the quantity supplied, as reflected by the upward movement along the supply curve. This process will continue until the shortage is resolved and a new equilibrium is established at E2. At any output level below equilibrium quantity, Q2, there is inefficient allocation of resources to the production of that good. This illustrates how the price mechanism helps to allocate resources efficiently by serving as a signal system which helps eliminate shortages in the free market, allowing society welfare to be maximised.

On the other hand, if there is an improvement in technology which reduces the cost of production for Iphones, there will be an increase in the supply for the good, shifting the supply curve to the right. This creates a surplus at the original price, P3. Recognising the surplus, producers will reduce prices in order to sell off excess stocks, imposing a downward pressure on prices. As prices fall, there will be a fall in the quantity supplied, as reflected in the graph as a downward movement along the supply curve.

At the same time, as prices fall, consumers will be willing and able to buy more of the good; the increase in quantity demanded is reflected as a downward movement along the demand curve. This process will continue until the surplus is resolved and a new equilibrium is established at E4. This again illustrates how the price mechanism helps to allocate resources efficiently by serving as a signal system which helps eliminate surpluses in the free market, allowing society welfare to be maximised.

It should be noted that price mechanism can only achieve efficient allocation of resources when there is perfect competition and absence of externalities. Market imperfections such as imperfect knowledge as well as positive/negative externalities would result in inefficient allocation of resources and welfare loss to the society.

(b) A government imposes taxes on a variety of goods and services which include alcohol, fuel and some imported goods. Discuss whether taxation would lead to a more efficient allocation of resources. [17]

Essay Plan
Introduction
1) Briefly state the use of taxes

Thesis:
2) Explain how demerit goods like alcohol leads to market failure
3) Explain how taxation leads to more efficient allocation of resources

Anti-thesis
4) Limitations of taxation
5) Taxation can lead less efficient allocation of resources

Evaluation
6) Combination of policies – taxation combined with moral-suasion

Market imperfections will lead to an inefficient allocation of resources, for example negative externalities arising from the consumption of demerit goods leads to an over-allocation of resources to the consumption of the good beyond the socially optimal level. To correct the market failure, government may impose taxes on certain demerit goods and services, which increases the marginal private costs borne by undertakers of the activity. If administered appropriately, the taxation should help to correct market failure. This essay will use alcohol as an example of a demerit good to illustrate how taxation is useful in leading to a more efficient allocation of resources.

Demerit goods are deemed to be socially undesirable by the government. Such goods generate negative externalities in consumption or production. In the case of alcohol, there will be an over-consumption of it when left to the market forces. The marginal private benefit (MPB) is the satisfaction enjoyed by the undertakers of the activity for every additional unit of alcohol consumed, while marginal private costs (MPC) involves costs to purchase the alcohol and adverse health effects on the consumers. The consumption of alcohol generates negative externalities as there are significant external costs to third parties. The marginal external costs (MEC) involve life danger to third parties due to drunk-driving, higher crime rates and lower labour productivity to the economy.

The marginal social costs (MSC) curve will always lie above the MPC curve since MEC causes a divergence between these two graphs; MSC = MPC + MEC. For simplicity’s sake, assume that there is no marginal external benefit (MEB) so MPB = MSB. In a free market driven by self interest, market equilibrium is at QF where MPB = MPC, as consumers ignore the MEC involved in the activity. The socially optimal quantity is at QS, where MSB=MSC. However, at QS, MSC is higher MSB due to the existence of MEC. There is over-consumption of alcohol beyond the socially optimal level, leading to welfare loss to the society. [draw graph]

To correct the market failure and bring about a more efficient allocation of resources, the government may choose to impose taxes. The taxes should be equal to the MEC at the socially optimal output level in order to completely eliminate the welfare loss. The tax levied will increase the MPC (MPC’ = MPC + taxes), increasing prices from PF to PS. The new market equilibrium will now be at QS, the socially optimal level, where MPC’=MPB, hence resolving the over-consumption problem. This illustrates how taxes can help lead to a more efficient allocation of resources.

However, there remain limitations to taxes which may limit the effectiveness of such policies in achieving a more efficient allocation of resources.

In practice, it is extremely difficult and costly to accurately determine the MEC at the socially optimal level. In the case where there is overestimation of the MEC leading to over-taxation, there may be under-consumption of alcohol, where inefficient allocation of resources persists. On the hand, if MEC is underestimated leading to under-taxation, there will still be an over-consumption of alcohol. Nonetheless, it is important to note that having some form of taxation policies to reduce the gap between QS and QF is better than having none. Though welfare loss may not be completely eliminated, having some form of taxes will still lead to a more efficient allocation of resources than in the absence of such policies.

There may be cases where taxes, imposed in the form of tariffs on imports, could worsen the efficiency in the allocation of resources instead. The countries from which goods are imported from are expected to possess comparative advantage in the production of such goods, associated with reasons like abundant factor endowment. This means that these countries face relatively lower (opportunity) costs in producing these goods and are expected to be more efficient producers in this case. When tariffs are implemented, price signals are distorted and imports prices are artificially increased.

Given that locally produced products are highly substitutable with these imported goods, the demand for imports and domestic goods is expected to be relatively price elastic. The increase in prices of imported goods will lead to a more than proportionate increase in the quantity demand for imports. At the same time, locally produced goods will appear relatively cheaper now, leading to a more than proportionate increase in the quantity demanded for domestically produced goods. This illustrates a situation where there is an over-consumption of domestic goods, produced by less efficient local producers. At the same time, there is an under-consumption of imported goods, produced by more efficient foreign producers. Hence on the overall, tariffs may hence lead to a less efficient allocation of resources instead.

In conclusion, whether taxes can help lead to a more efficient allocation of resources depends highly on the government’s ability to accurately determine the magnitude of the MEC involved. An over or under-taxation will fail to completely eliminate the welfare loss brought about by the consumption (or production) of demerit goods, like alcohol. However, some form of tax policies to reduce the gap between QS and QF is superior to having no correcting measures. It is also important that the government recognises the root cause of the problem and implement appropriate policies to address the issues.

The government should recognise that apart from taxes, there are other policies which may help lead to a more efficient allocation of resources. The government should hence adopt a combination of policies – taxation as well as educational and awareness campaign. Awareness campaigns can help to increase consumers’ knowledge on the costs to third parties brought about by their activities. For example, the government in some countries like Singapore has widely advertised on the harm and danger to third parties brought about by over-consumption of alcohol and related activities like drunk-driving. These campaigns, accompanied by moral-suasion, may help discourage the consumption of alcohol, correcting the over-consumption problem and leading to a more efficient allocation of resources. However, since the effects of these campaigns may take a long time to set in, the government should combine tax policies with these campaigns for a more lasting outcome and a more efficient allocation of resources on the overall.