October/ November 2020: paper 43

2(a) Explain what is meant by ‘Pareto optimality’ and whether it is correct to say that an optimal
allocation of resources would result if a good’s price equalled its marginal cost. [12]

Italian economist, Vilfredo Pareto, defined pareto optimality as a situation where no one can be
made better off without making someone else worst off. This concept can be explained using a
production possibility curve. A possibility production curve shows the maximum possible
combinations of two goods that an economy can produce with a given set of resource and a given
state of technology over a period of time.

When a country produces on its production possibility curve, for example at point A or B on the
above diagram, there exists pareto optimality as it is impossible to produce more of a good or
service without reducing the output of the other good or service. For example, as shown in the
above diagram, if a country decide to move from point A to point B, it will need to forsake ( Y-Y1) of
healthcare to produce (X1-X) more of education. As such, those initially benefitting from Y of
healthcare will be rendered worst off for the betterment of those now enjoying X1 of education.
However if the country was to move from point C to point B on the production possibility curve, then
this allocation of resources would not pareto optimal as more of both services can produced.

It is important to point out that there is an optimal allocation of resources would result ‘only’ when
the marginal social benefit of a good or service is equal to its marginal social cost. That is the total
benefits to the society from consuming and producing a good or service must equal to the total costs
to the society from consuming and producing the good or service. Allocative efficiency is achieved
when the value consumers place on a good or service equals to the cost of resources used to
produce it. As such, when the price of a good is equal to its marginal cost, allocative efficiency rather
than an optimal allocation of resources is achieved.

As shown in the above diagram, if we consider the market for healthcare services, then allocative
efficiency will be achieved at point e, where marginal private cost is equal to marginal private cost
because consumers and producers are primarily concerned with their private costs and benefits.
However, since healthcare is a merit good and it exerts positive externalities to the society at large,
as shown by the distance ab, an optimal allocation of resources would result at point e1, where the
marginal social benefit of healthcare is equal its marginal social cost.

Likewise, if we consider the market for alcohol, allocative efficiency would be achieved at point c.
Nonetheless, since alcohol is a demerit good and its consumption and production exert negative
externalities on the society, the optimal allocation of resources would be achieved at point d, where
all costs and benefits to the society are taken into consideration.

In conclusion, pareto optimality will exist when nobody can be made better off without making
someone else worst off while an optimal allocation of resources would result when the marginal
social benefit of a good or service is equal to its marginal social cost. As such, it can be said that the
socially optimal output would be achieved at the point where the price of a good or service is equal
to its marginal social cost and not its marginal cost as the former takes into all account externalities
that may arise from the production and consumption of the good and service at large.
(b) Discuss why an optimal allocation of resources might fail to occur in practice and consider what
could be done about this failure. [13] ;Note add info on diagrams m and d

An optimal allocation of resources might fail to occur in practice due to the existence of market
failures. According to neoclassical economics, market failure occurs when the market fails to
produce the goods and services consumers want, in the right quantities and at the lowest cost
possible.

To begin with, the markets fail to deliver an optimal allocation of resources since they do not provide
for public goods such as defence and street lightning which are important in an economy. Public
goods share the characteristics of non-rivalry, non-excludability and non-rejectability. That is,
consumption by one additional consumer do not affect the amount left for others, consumers
cannot be excluded from consuming the good if they do not want to pay and consumers cannot
reject the consumption of these goods. Due to these particular characteristics, a price cannot be
charged for public goods. Hence, private firms being profit-motivated, will not provide for such
goods in an economy. Resultantly, the market fails to ensure an optimal allocation of resources

Also, it can also be pointed out that in a market economies especially, merit goods such as education
and healthcare are likely to be under-produced and under-consumed due to information failure. A
merit good is a good whose consumption leads to an improvement in the quality of life of individuals
in an economy. The consumption of such goods generate positive externalities and are likely to
benefit the society at large. For example, if the population of a country is healthy, then productivity
is likely to improve, which in turn may boost economic growth. Nonetheless, since consumers are
unaware of the potential benefits that could accrue to them and the society at large from the
consumption of merit goods, they tend to demand and consume less of these goods and resultantly
producers also produce less of such goods. As shown in the above diagram, consumers will consume
at the point e, where their marginal private cost is equal to their marginal private benefit. However,
the optimal point of consumption and production will be at point e1, where the marginal social
benefit of education equals to its marginal social cost. As such, it is worth pointing out due to
imperfect failure, merit goods are often under-consumed and under-produced in a market economy.

On the other hand, demerit goods such as cigarettes and alcohol, whose consumption leads to a
deterioration in living standards in an economy, tend to be over-produced and over-consumed if left
to market forces due to information failure. People often fail to acknowledge the potential
disadvantages of consuming such goods to themselves and the society at large. For example, by
consuming cigarettes, smokers not only endanger their health by becoming more susceptible to
deadly diseases but they also impose a burden on the National Health Service [NHS] of their country.
As shown in the above diagram, cigarettes will be over produced and over consumed by in a market
economy due to imperfect information.

It can also be added that the existence of monopolies in a market may lead to increased consumer
exploitation and thus cause the market to fail. A practical monopoly is a firm which has at least 25
percent of the market share while a pure monopoly is a single seller in a market. For example, the
CWA in Mauritius. When a firm enjoys monopoly power, it may have no incentives to cut back on its
costs as it can simply pass on any increase in their costs of production to consumers in the form of
higher prices, especially if the goods and services that they are producing have an inelastic demand;
that is a proportionate change in price will lead to a less than proportionate change in quantity
demanded. If firms producing basic necessities such as foodstuffs enjoy monopoly powers,
consumers can be highly exploited through higher prices. This means that some people may even
have to reduce their consumption of essential goods which will eventually lead to lower living
standards in the economy.

As shown in the diagram above, if we assume that the producer of rice is a monopoly, then we can
see that the latter charges a price of p, which is higher than its marginal cost, leading to allocative
inefficiency, consumer exploitation and eventually market failure.

Whenever the market fails to allocate resources efficiently, the government can intervene and adopt
certain policies to address the issues. For example, since there is no market for public goods, the
government can step in and provide for goods itself through general taxation. Moreover, since merit
goods are under-provided and under-consumed in a market economy, the government can
encourage production by subsidising such producers or even provide the good itself so that
consumption does not depend primarily on one’s ability to pay for the goods. It can also attempt to
overcome market failure by educating people about the importance of consuming such goods
through awareness campaigns. In order to discourage the consumption and production of demerit
goods the state can impose taxes on them. The state can cap the prices of basic necessities and also
adopt anti-monopoly regulations to prevent consumer exploitation by monopolies.

In conclusion, in practice an optimal allocation of resources might not necessarily always occur due
to market failure in the light of no provision of public goods, under- provision and under
consumption of merit goods, over provision and consumption of demerit goods and high prices
charged by monopolies in a market economy. Nonetheless, to improve the allocation of resources,
the government can step in and regulate the market by subsidising some goods and by providing for
some goods and services that it deems to be important for collective consumption through general
taxation. Also, it can impose taxes, price controls or even adopt anti-monopoly policies to discourage
the consumption and production of certain harmful goods and to prevent consumer exploitation
respectively.

4(b) Discuss why an industry might experience falling long-run average costs and comment on
whether consumers might benefit from such a situation. [13]