‘Government economic policy is based on the idea that people cannot be trusted to choose what is good
for them but instead sometimes choose things that are harmful to themselves or detrimental to the
environment (or both). Therefore a free market cannot allocate resources efficiently.’ Do you support this
argument? [25] (May/June16/42/02)
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A free market system is where the forces of demand and supply allocate the economy’s scarce resources and
determine the equilibrium price. It is characterized by consumer sovereignty, competition, low prices and a wide
choice for consumers. The producers are deemed as ‘servants’ to the consumers and must have to produce
exactly what is demanded by the consumers.
Economic efficiency refers to a situation where the best combination of resource is being used to produce the right
types of goods in the right quantity. Economic efficiency has two aspects, productive allocative (PE) and allocative
efficiency (AE). PE occurs when the best possible resources are being used to produce maximum possible outputs.
On an economy level, PE can be shown by any point on the Production Possibility Curve (PPC).
For a firm, PE has two criteria, production on the lowest average cost curve and also on the lowest point of lowest
average cost curve (Technical efficiency – TE).
The point X on ATC is where both PE and AE occur. AE is when the right combination of products is being
produced and consumer welfare is being maximised. AE for country is on the PPC but the exact combination is
unknown. A firm however is said to be allocatively efficient if the P=MC i.e. the value attached by the producer to
a good is equal to the value attached by the consumer.
Firms in perfectly competitive markets are both productively and allocatively efficient. This is also known as Pareto
optimality i.e. it is not possible to make someone better off without making someone else worse.
The point X is where P=MC and it is the lowest point of the ATC. Therefore economic efficiency in this case does
exist in a free market. However, the market fails to allocate resources efficiently in the real world. Perfect
competition is a theoretical extreme which does not exist in reality.
Market failure occurs due to imperfection in the markets. Firms are price makers and have control over the price.
They use their power to exploit consumers. A monopoly, for example, in order to maximise profits will restrict
output, produce at MC=MR and charge a very high price which earn a profit. Thus it is not being efficient as it does
not meet the criteria of economic efficiency.
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