Question

What are the roles of market and government in our economic decisions to efficiently allocate our scarce resources (money, time...)?

Answer 1

Producers in market will produce the profit maximizing quantity. This is the equilibrium quantity where Qd=Qs . This is WHAT WE GET.

Society wants the allocatively efficient quantity. This is the quantity where MSB=MSC . This is WHAT WE WANT.

there are no negative externalities (spillover or external costs) the S = MSC, and if there are no positive externalities (spillover or external benefits) the D = MSB, Therefore: WHAT WE GET = WHAT WE WANT and self-interested, profit maximizing, businesses will end up doing what is best for society - achieving allocative efficiency - as if there is some "invisible hand " guiding their decisions.

• Businesses will produce the profit maximizing or market equilibrium quantity - the quantity where Qd=Qs; (this is WHAT WE GET)

• Society wants the allocatively efficient quantity - the quantity where MSB=MSC ; (this is WHAT WE WANT)

• WHAT WE GET = WHAT WE WANT if:
  • Market Demand = Marginal Social Benefits (D=MSB)
    (and this is true if there are no positive externalities (spillover or external benefits))
  • Market Supply = Marginal Social Costs (S=MSC)
    (and this is true if there are no negative externalities (spillover or external costs))

THEREFORE if there are no negative externalities (spillover or external costs) and no positive externalities (spillover or external benefits) competitive markets (capitalism) achieves allocative efficiency.

WHAT WE GET = WHAT WE WANT

and profit maximizing businesses in market economies will produce the allocatively efficient quantity.

This is the "invisible hand" of capitalism.

So, pure market economies usually achieve allocative efficiency and therefore there is only a limited role for government - why do we need the government if the market is already maximizing our satisfaction? If you think about it, in the United States the government does not do very much. The government does not produce our food. It does not build our homes. It does not provide us with electricity, nor heat, nor clothes, nor most of the important things in our lives. But the government DOES provide public education, public parks, public libraries, military/defense, streets and highways, US mail, etc.

The main reason why the government chooses to intervene in the market is to ensure that scarce resources are distributed optimally among all the parties and to improve the social and economic status.

All governments of all political affiliation get involved in the economy to manipulate the allocation of limited resources among all the users. The main reasons for policy interventions are: to correct market failures, to achieve a more equitable distribution of income and wealth, and to improve the performance of the macro-economy domestically and internationally.

The government can intervene in the market through many ways, for instance, it can impose a competition policy, employment laws, price controls, indirect taxes, subsidies, and tax relief. Most of the commonly used technique is indirect taxes and subsidies. An indirect tax increases the price of a commodity and reduces the quantity consumed whereas a subsidy reduces the price and increases the quantity consumed.

However, both methods are influenced by the price elasticity of the demand curve. The purpose of this paper is to discuss the role of price mechanism in allocation of scarce resource in a free market economy and in a mixed economy where the government takes control. It gives the role and importance of government intervention in the allocation of scarce resources through the use of indirect taxes and subsidies.

Price mechanism is an imperative phrase used in economics to depict how decisions from customers and business interrelate in the distribution of resources which are limited. Price mechanism plays three crucial roles in the market; signaling, transmission of preference, and rationing function.

The price mechanism acts as an allocative mechanism for allocating scarce resources in a free market. However, most economies are not free and are composed of two sectors: the market and non-market sector. The non-market sector (government) intervenes in the allocation of scarce resources through the planning mechanism. It uses subsidies and taxes to determine the relative price to be charged in the market. When the government charges an indirect tax, the relative price of a commodity rises resulting in a reduction in its demand.

The government intervenes in the market so as to correct negative externalities and to ensure that neither the producers nor the consumers are exploited. The use of a government subsidy to consumers results in a reduction of relative prices thereby increasing the demand .