1.8 The market mechanism, market failure, and government intervention in markets Flashcards
Market mechanism
the process through which changes in prices allocate resources
Price mechanism
changes in price in response to changes in demand and supply have the effect of making demand equal to supply
Functions of the price mechanism (4)
- allocative
- Rationing
- signalling
- incentive
allocative function of price
changing relative prices allocate scarce resources away from markets exhibiting excess supply and into markets in which there is excess demand
rationing function of prices
rising prices ration demand for a product
signalling function of price
Prices provide information to buyers and sellers
Incentive function of prices
Prices create incentives for people to alter their economic behaviour; for example, a higher price creates an incentive for firms to supply more of a good or service.
allocative efficiency
occurs when the available economic resources are used to produce the combination of goods and services that best matches people’s tastes and preferences
market failure
occurs when the price mechanism fails to allocate scarce resources in a productively efficient way and when the operation of market forces leads to an allocatively inefficient outcome
Partial market failure
a market does function, but it delivers the ‘wrong’ quantity of a good or service, which results in resource misallocation
productive efficiency
The production of a good in the least costly way; occurs when production takes place at the output at which average total cost is a minimum
shortage
excess demand in a market which is in disequilibrium
surplus
excess supply in a market which is in disequilibrium
equilibrium price
price where quantity supplied equals quantity demanded; at this price there is no shortage or surplus
black market
anywhere where buyers and sellers come together, a price is agreed and an illegal transaction takes place
minimum price (price floor)
a legal limit on how low a price can be charged for a particular good, in a particular market
Effects on a minimum price below equilibrium
no effect on price or quantity sold
Effects of minimum price above equilibrium
price increases, excess supply
Maximum price (Price ceiling)
a legal limit on how high a price can be charged for a particular good, or in a particular market
Effects of Maximum price below equilibrium
price falls, excess demand
Effects of maximum price above equilibrium
no effect on price or quantity
Missing market
the absence of a market for a good or service, most commonly in the case of public goods and externalities
non-excludable + example
when it is impossible or very costly to prevent non-paying consumers from benefiting from it.
National defense, Clean air
non-rivalrous + example
one person’s consumption does not reduce the amount available for others.
National defense
private good
a good which has excludability and rivalry
public good
a good which has non-excludability and non-rivalry
property right
the exclusive authority to determine how a resource is used (e.g. the owner of a chocolate bar has the right to prevent others from consuming the bar unless they are prepared to pay the owner a price)
free rider problem
Consumers have no incentive to pay because they can benefit for free (e.g., street lighting, national defense).
This results in under-provision by private markets.
quasi-public good + example
a good that has some characteristics of both public and private goods, but not all.
Key Features:
Partially Non-Rival – One person’s use does not fully reduce availability for others (up to a point).
Partially Excludable – It is possible to exclude non-payers, but not perfectly.
E.g Public Parks Free to enter (non-excludable), but can get crowded (rivalrous at peak times).
Public goods examples
-National Defence
-Lighthouses
Example: Street Lighting
Non-Rivalrous: One person’s use doesn’t dim the light for others.
Non-Excludable: Pedestrians benefit even if they don’t pay taxes.
Market Failure: Private firms won’t provide it (free-rider problem).
Government Role: Funded by taxation.
Tragedy of the commons
a market failure where individuals overuse a shared, rivalrous resource (a “common-pool resource”), leading to its depletion. This occurs because:
No one owns the resource (non-excludable).
Users act in self-interest, ignoring long-term sustainability.
Real-World Examples
Resource- Problem -Consequence
Fish Stocks -Overfishing by trawlers. -Collapse of cod fisheries (e.g., Canada, 1992).
Clean Air -Pollution from factories/cars.- Climate change; health costs.
Why must public goods be free?
Because public goods are non-rivalrous, when an extra person benefits from the good the benefits available to other people are not reduced. This means the marginal cost of providing the good to an extra customer is zero. In order to achieve allocative efficiency the price must also be this.
externality
an economic side effect of a good or service that generates benefits or costs to someone other than the person deciding how much to produce or consume
socially optimal output
output where marginal social benefit = marginal social cost; also known as allocatively efficient level of output; if output occurs at any other level, a market failure exists
social cost =
private cost + external cost
social benefit =
private benefit + external benefit
third party
someone not directly involved in a transaction, separate from the seller (first party) and the buyer (second party)
negative externality
a cost that is suffered by a third party as a result of an economic transaction
positive externality
a benefit that is enjoyed by a third-party as a result of an economic transaction
production externality
when production of a good or a service imposes external costs or benefits on third parties outside of the market without these being reflected in market prices.
Consumption externality
When consumption of a good or service imposes external costs or benefits on third parties outside of the market without these being reflected in market prices
Describe a positive production externality diagram
MSC<MPC
Describe a Negative Production Externality diagram
MSC>MPC
Describe a Positive Consumption Externality diagram
MSB>MPB
describe a negative consumption externality diagram
MSB<MPB
imperfect information
where economic agents are not completely and immediately aware of costs, benefits, or prices that are relevant to their decisions, such as the extent of external costs and benefits
information gap
when one party in an economic transaction has more or better knowledge than the other, leading to market failure.
merit good
demerit good
asymmetric information
one party in a transaction has more/better information than the other, distorting outcomes.
Adverse selection
AQA-Aligned Examples
Health Insurance Market
Problem: Sick people (who know their health risks) are more likely to buy insurance than healthy people.
Outcome: Insurers raise premiums for all → healthy people drop out → market collapses.
factors of production
Inputs into the productive process; land, labour, capital, enterprise
factor immobility
when factors of production cannot move between different markets
unemployment
occurs when a person who is actively searching for employment is unable to find work
geographical immobility of labour
when workers are unwilling or unable to move from one area to another in search of work
occupational immobility of labour
occurs when workers find it difficult or impossible to move between jobs because they lack or cannot develop the skills required for new jobs
income
the flow of money a person or household receives in a particular time period
wealth
the stock of everything which has value that a person or household owns at a particular point in time
equality
everyone is treated the same; a completely equal distribution of income means that everybody has the same income
equity
everyone is treated fairly
progressive taxation
a tax for which, as income rises, a greater proportion of income is paid
income tax threshold
the level of income above which people pay income tax
means-tested benefits
benefits claimable depending on the person’s income
universal benefits
benefits claimable of right and not dependent on a person’s income
absolute poverty
the state of being deprived of basic human needs
relative poverty
the state of having an income below a specified proportion of average income
national minimum wage
A minimum wage or wage rate that must by law be paid to employees, though in many labour markets the wage rate paid by employers is above the national minimum wage.
distribution of income
how income is divided between rich and poor, or between different groups in society
distribution of wealth
how wealth is divided between rich and poor, or between different groups in society
resource misallocation
when resources are allocated in a way which does not maximise economic welfare
complete market failure
the absence of a market for a good or a service
monopoly power
the power of a firm to act as a price maker rather than a price taker
indirect taxation
a tax which can be shifted by the person legally liable to pay the tax onto someone else, for example through raising the price of the good being sold to the taxpayer. they are normally levied on spending
subsidy
a payment made by the government to a producer
state provision
the government providing a good
regulation
imposition of rules, controls, and constraints, which restrict freedom of economic action in the market place
provision of information
providing missing information (e.g. TV adverts on the dangers of drinking)
monopoly policy
policy regarding markets with a high firm concentration ratio
government failure
occurs when government intervention leads to a net welfare loss compared to the free market solution
5 sources of government failure
- regulatory capture
- imperfect information
- conflicting objectives
- administration costs
- unintended consequences
regulatory capture
occurs when regulatory agencies act in the interest of regulated firms rather on behalf of the consumers they are supposed to protect.
conflicting objectives
in attempting to achieve one outcome, another is sacrificed
administration costs
expenses associated with the management and execution of a policy
unintended consequences
outcomes that are not the ones foreseen and intended by a purposeful action
intellectual property right
the exclusive authority to determine how an intangible resource that is the result of creativity is used. These rights include copyrights, patents, and trademarks
Patent
gives its owner the right to exclude others from making, using, selling, and importing an invention for a limited period of time, usually twenty years
Copyright
the exclusive authority to determine how creatuve works are used
trademark
the exclusive authority to determine how symbols or words legally representing a firm or product are used
Royalty
a sum paid to a patentee for the use of a patent or to a copyright holder for each copy of a work sold and/or publicly performed
Moral hazard
Command-and-control
a regulatory approach whereby the government “commands” pollution reductions (e.g. by setting emissions standards) and controls how these reductions are achieved (e.g. through the installation of specific pollution control strategies)
Tradable pollution permits
each firm is given a permit to produce a given level of pollution. If less than the permitted amount is produced, the firm is given a credit. This can then be sold to another firm, allowing it to exceed its original limit.
The competition and markets authority (CMA)
government agency responsible for advising on and implementing UK competition policy
Competition policy
the part of the government’s microeconomic policy and industrial policy which aims to make goods markets more competitive. It comprises policy toward monopoly. mergers and restrictive trading practices.
merger policy
policy regarding the joining together of firms which may create markets with a high firm concentration ratio
restrictive trading policy
policy regarding choices firms make to restrict competition
consumer inertia
the tendency of some consumers to buy or continue buying a good, even when superior options exist
State franchise
the government sells the right to provide a good or service, periodically issuing a license to a firm to operate for a fixed period of time. After this period of time, there is a competitive bidding process for the license. The government can renew the license, or grant it to a new firm.
Advantages of privatisation (3)
- If the firm is loss-making, privatisation will reduce the size of the Public Sector Net Cash Requirement (PSNCR)
- forces down average cost due to competitive pressure - economies of scale
- selling assets raises revenue for the government
Disadvantages of privatisation (2)
- changes objective to profit maximisation, increasing the prices charged
- short-term profit maximising neglects long-term growth
Nationalisation
the transfer of industries, firms or other assets from private ownership to public ownership
privatisation
the transfer of industries, firms, or other assets by public ownership to private ownership
Alternative approaches to the problem of monopoly (7)
- compulsory breaking up on monopolies
- use of price controls to restrict monopoly abuse
- taxing monopoly profits
- rate of return regulation
- state ownership of natural monopolies
- privatising monopolies
- deregulation and the removal of barriers to entry
Private good example
Example: A Chocolate Bar
Rivalrous: If you eat it, no one else can.
Excludable: Only those who pay can consume it.
Market Provision: Supplied efficiently by private firms (e.g., Cadbury).
price floor
unintended consequences E.g black market
price ceiling
