Every society in the world, including Singapore faces the basic problem of scarcity. I.e Allocating resources occurs because there is unlimited human wants and limited resources, hence the problem of scarcity derives. There is three basic choices to be made: What, How, and for Whom to produce. Where the choice of what to produce is dependent on product prices, Product prices are determined by the market demand and supply conditions of the particular goods/services. Moreover How to produce will depend on the factor prices, where firms will adopt its least costly method to maximise revenue by minimising cost. In addition, the decision for Whom to produce, will depend on both factor and product prices, as the price mechanism rations out the good produced according to the consumers’ willingness and ability to pay.
Economic Efficiency is achieved when it is not possible to change the existing allocation of resources in a way that will make one person better off without making someone else worse off. For economic efficiency to exist, it is necessary to achieve both Allocative and productive efficiency.
In a free market system, there is laissez-faire and no government intervention. The recurring problem of how to allocate the scarce resources between alternative uses is solved through the price mechanism. This decision is made through the free interaction of the market forces of demand and supply. (i.e the price mechanism). In the free market, it gives private ownership over all factors. There are self-motives, where consumers are out to maximise satisfaction, producers are assumed to be profit motivated and resources owners would want to maximise return on resources. Thus they rely on the price mechanism to allocate resources.
The free market which uses the price mechanism may appear to be the most efficient way of allocating resources. As Allocative efficiency is achieved when the right amount of the right kind of goods is produced. Thus to achieve Allocative efficiency there must be a ‘right product mix’ which will then maximise the welfare of society. For private individual household and firms, when Marginal Private Benefit (MPB which is equal to Price [P])= Marginal Private Cost (MPC), i.e P=MC, Allocative efficiency is achieved. With regards to society, when Marginal Social Benefit (MSB) is equal to Marginal Social Cost (MSC), Allocative efficiency is achieved. At this output level, society’s welfare is maximised. Assuming there is the absence of externalities; Price (Demand) reflects both the marginal private benefit as well as the marginal social benefit. Similarly, the Marginal Cost (Supply) reflects both the marginal private cost and the marginal social cost.
From Diagram 1, If the output of good A is at 0Q1, where P>MC (Also MSB>MSC). This suggests that society values additional units of Good A more than the alternative goods that the resources are currently used for. Hence there is an under-allocation of resources to the production of good A. Consumer surplus of area ABEe is lost. Output of good A should be increased by reallocating some resources away from other industries to produce more of good A as to improve Allocative efficiency in the society. Conversely, if the output of good A is being produced at 0Q2, of where P<MC (also MSC<MSB), this suggests that society values additional units of good A less than what it is currently being used for. Thus there is an over-allocation of resources to the production of good A, hence the production of Good A should be decreased. Hence at the market equilibrium, 0Qe, P=MC and they are also equal to MSB=MSC. Consumer and producers’ surpluses are maximised and the market equilibrium output coincides with the socially optimum output of the industry....