Marginal social costs comprise private and external costs whilst marginal social benefits comprise private and external benefits. Externalities could be positive or negative; for instance, when social benefits greater than private benefits, it is a positive externalities. External costs will steer level of production and consumption above the socially efficient level; or vice versa. ‘In perfect free market system the market forces of supply and demand would lead to the optimal allocation of resources whereas social marginal benefit equals the social marginal cost and community surplus is maximised. ’ (Gillespie, 2007, p102)
Price mechanism, the salient feature of a free market economy, acts as the signalling and incentive function as well as rationing device on resource allocation, which is corresponding to Mankiw’s 4th principle: ‘People respond to incentives’ (Mankiw, 2008, p7). Price enables ‘transmission of preferences’ that assists the information flow between entrepreneurs and consumers (Tutor2u, n. d. ). However, resource allocation will only be efficient if the price accurately reflect marginal social costs and benefits of consumption and production; whilst having good levels of information flow and resources mobility in the market economy.
Thus, market failure will occur when the ‘signalling and incentive function of the price mechanism fails to operate optimally leading to a loss of economic and social welfare’ (ibid, n. d. ) Social efficiency and equity are the two major objectives of government intervention (Sloman, 2007, p190). Social efficiency occurs when marginal social benefits identical marginal social costs. If marginal social benefits have exceeded marginal social costs, it will be socially efficient to increase production; or vice versa. Equity is ‘fair distribution of resources’, which free market economy claimed as fail to lead both (ibid, p190).
Government intervention can be conducted in various ways, such as legislation, taxation and subsidies; however, is claimed may lead to several issues. Price control is a pricing system determined by the government that dictates the prices of a commodity. It could be demonstrate in Figure 7-8. image06. pngPrice ceiling is conducted to make consumers better off. If it is below the equilibrium, (P0 in Figure 8), a shortage will be formed (Q2>Q1), which then lead to welfare loss as in free market economy, price would rise and reach equilibrium at PE. image07. png Price floor, is conducted to make entrepreneurs better off.
If it is above equilibrium, (P0 in Figure 9), surplus will be formed (Q2>Q1) which then lead to welfare loss as in free market economy, price would fall to reach equilibrium at PE. However, if government require complete control on a business, it may use nationalisation, which means transferred private company’s ownership into public sector. Government intervention may also lead to issues such as valuation problems, Bureaucracy and lack of incentive. Bureaucracy, for instance, decision-makings may be time-consuming and lack of accuracy as it involved various groups.
Moreover, it may virtually encourage the criminal and corrupted activities, such as the ‘black markets’, namely, illegal free markets. Taking everything into consideration, certain conclusions can be drawn. In free markets economy, price and allocation of resources are determined by demand and supply conditions, which their alterations would steer to new equilibrium price and quantity. In addition, government may intervenes the markets in terms of price controls as attempting to remedy market failures and imperfections which however may lead to corruption and inefficiency of allocation and production.
Tutor2u. (n.d.) AS Markets & Market Systems: Price Mechanism. Retrieved, November 18, 2010 from http://www.tutor2u.net