3.1.5 - Market Mechanism, Market Failure, Gov. Intervention Flashcards
Define price mechanism
a system where forces of demand and supply determines the prices or commodities and their changes
(Way that basic economic problem is resolved in a market economy)
Coined the ‘invisible hand of the market’ by Adam Smith
What 3 functions does the price mechanism use
- Rationing;
When there are scarce resources, price increases which discourages demand - Incentive;
Encourages change in behaviour of a consumer or a producer
High prices encourage firms to supply more to a market - Signalling;
Price acts as a signal to consumers and new firms entering the market
HIGH PRICE signifies PROFITABILITY which encourages reduced demand — consumers leave markwr
Define market failure
Occurs whenever market leads to a misallocation of resources in the economy
2 types:
- Complete
Market doesn’t exist, missing - Partial
Market exists but contributes to resource misallocation
Define misallocation of resources
When resources aren’t allocated to the best interests of society
Define missing market
No market as functions of prices have broken down
What is a public good?
Commodity / service made available to all members of society
Characteristics include:
- non-excludability:
Free riders - non-rival consumption:
Each parties consumption of the food doesn’t compromise others enjoyment - non-rejectable:
Collective supply of a pure public good where it can’t be rejected by people
Examples include flood defence, public service broadcasting, sanitation infrastructure
What is a quasi-public good?
Near public good
Characteristics include:
- semi non-rival
Up to an extent, more consumers using a park, beach, road etc do not not reduce space available for others (eventually things get crowded) - semi non-excludable
It is possible but not easy or cheap to exclude non-paying customers
Define free rider
Person who benefits from provision of public goods without paying
How has technology changed the nature of public goods?
- advances in technology are causing a blurring of the distinction between public and private goods
- encryption allows suppliers to exclude non-payers
Why should the government provide public goods? (What may happen if they don’t)
Why should they?
State provision may help to prevent under provision and under consumption of public goods so that social welfare is improved
What is an externality? + provide some examples
Type of external benefit (public good) or external cost (public bad) which is dumped on third parties outside the market
Positive:
- early years education
- free school
- museums / galleries
Negative:
- noise pollution
- air pollution from smokers
They exist when there is a divergence between private and social costs / benefits
What are private costs?
Producers are concerned with private costs of production
I.e rent, cost of machinery
Formula for social costs?
Private + external costs = social costs
costs
What are private benefits
Consumers are concerned with the private benefit derived from the consumption of a good
The price a consumer is prepared to pay determines this
Formula for social benefit
Private + external = social
benefits benefits benefits
When do external costs occur?
When a good is being produced / consumed
Define free market
Prices of goods are self regulated by buyers / sellers negotiating in an open market
What is allocative efficiency?
In a market which involves comparing the full social cost of producing an extra unit (MSC) with the full social benefit from its consumption (MSB)
Achieved when consumer satisfaction is maximised
What are the 8 causes of market failure?
- Market power
- Positive externalities
- Negative externalities
- Demerit foods
- Merit goods
- Information failure
- Public goods
- Immobility of factor inputs
Define a merit good, provide 2 of its characteristics and give an example
Goods for which the social benefits of consumption exceed the private benefits
Characteristics:
- excludable
- rivalrous
Governments believe these will be under-consumed and so should be subsidised or provide free at the point of use
i.e educations, vaccinations
Under provision may result from imperfect info
What is a demerit good?
Goods for which the social costs of consumption exceed the private costs (goods are subject to negative externalities in consumption)
Over provision of demerit goods may result from imperfect information
i.e tobacco, alcohol
Why would geographical and occupational immobility lead to market failure?
Geographical immobility:
When workers find it impossible or difficult to move to other parts of the country / countries
Occupational immobility:
When workers find it impossible or difficult to move between jobs because they lack skills required for new jobs
Both could lead to unemployment and a waste of scarce resources
Contributes to market failure
Why would imperfect information lead to market failure?
Asymmetric information means one party has better or more information than the other when making decisions or transactions
This can cause an imbalance in power
Can lead to market failure
Simply define income, and state what could occur within the market mechanism if there is no Gov intervention regarding income — what can this lead to
Flow of money
In absence of gov intervention, the market mechanism is likely to generate unequal distribution of wealth.
Can lead to negative externalities
Define wealth
Stock of assets
In absence of gov intervention the market mechanism is likely to lead to the unequal distribution of wealth.
Can lead to negative externalities
What ways can wealth inequality be reduced?
- Progressive taxes
- Gov spending
- welfare payments
What is a pro-free market economist?
Believes market mechanism works through incentives via price signals
What is an interventionist economist?
Believes that markets are often uncompetitive, prone to monopoly power and producer sovereignty corrected through gov intervention
In what ways can methods of gov intervention be assessed?
- impact of alternative policies on different groups
I.e producers and consumers - financial and opportunity cost of alternative policies
- effects of intervention on equity and efficiency
- significance of elasticity on the method
2 types of taxation?
- Indirect:
Tax levied on goods and service I.e VAT - Direct:
Tax levied on incomes of firms and people I.e income tax
(Gov intervention) Advantages and disadvantages of taxation?
Advantages:
- reduces production and consumption of demerit goods and those with negative externalities
- raises revenue to fund merit and public goods
- market orientated solution
Disadvantages:
- ineffective if PED for product / service is inelastic
- inefficiencies may occur — costs to collect tax
- tax evasion
Simply define subsidy, and who can they be for?
Payment from government
to:
- Producers:
For each unit of good they produce
I.e bus payments - Consumers
I.e over 60s winter fuel
(Gov intervention) Advantages and disadvantages of subsidies
Advantages:
- encourages consumption and production of merit goods with positive externalities
- purpose is to increase real income of consumers by keeping prices below market equilibrium
Disadvantages:
- inefficiency
- cost and opportunity cost
(Gov intervention) Advantages and disadvantages of regulation, standards and legal control
Advantages:
- forces consumers to consume more merit goods
- can be cheap and easy to impose
- backed by fines
Disadvantages:
- cost of enforcement
- opportunity cost
- black markets can develop
(Gov intervention) advantages and disadvantages of information provision
Advantages:
- move towards free market approach
- provides info needed to maximise welfare
Disadvantages:
- cost and opportunity cost
- may be ineffective, often ignored
- may not reach target audience
Define price ceiling
Maximum price laws set, illegal to sell below the price i.e rent prices
Define price floor
Minimum legal prices where it’s illegal to sell below it when trading i.e EU agricultural prices
What does Polluter Pays Principle mean?
Producer is responsible for paying for damage done to the environment
Underpins environmental policy
Traceable pollution permits allow owners to emit certain amounts of pollution
What is the state provision of goods?
Governments provide public goods which are under provided in the free market i.e education, healthcare
These make merit goods more accessible, might increase their consumption and yield positive externalities
Could be expensive
What is a private good?
A private good is a product that must be purchased to be consumed, and consumption by one individual prevents another individual from consuming it.
I.e dinner at a restaurant
How can public goods lead to market failure?
If some consumers decide not to pay but use the good anyway — leads to underfunding
How can externalities lead to market failure?
When the good / services price equilibrium doesn’t accurately reflect the true costs and benefits of that product / service
The market will fail by not supplying the socially optimal amount of the good. The imbalance causes allocative inefficiency, which is the over- or under-consumption of the good.
How can merit goods lead to market failure?
In the free market they are provided at a quantity below the socially optimum level thus creating market failure as there is a misallocation of resources
How can demerit goods lead to market failure?
In the free market these goods are over consumed — prices rise to in theory to deter buyers
How can a monopoly cause market failure?
Because not enough of a good / service is available or the price gets too high
How can income inequality lead to market failure?
Only products and activities that create profits are manufactured or pursued. This causes a large portion of consumers to be excluded from the market because they lack the income to purchase these products
How can governments influence the allocation of resources?
- public expenditure
- taxation
- regulation
When does government failure occur?
When gov intervention in the economy leads to a misallocation of resources
Potential sources include:
- inadequate information
- conflicting objectives
- administrative costs
Gov intervention can lead to unintended consequences
What are the types of market failure?
- externalities
Negative externalities are caused by consumption of demerit goods, i.e cigarettes - under provision of public goods
Public goods are non-excludable and non-rival. They are under-provided in a free market because of the free-rider problem - information gaps
Imperfect / asymmetric info leads to a misallocation of resources - monopolies
Consumers are often overcharged leading to underconsumption of the good / service (therefore needs and wants aren’t fully met) - inequalities in the distribution of income and wealth
Can lead to negative externalities I.e social unrest
Define symmetric information
Consumers and producers have perfect market information to make their decision leading to an efficient allocation of resources
Define asymmetric information
Unequal knowledge between consumers and producers leading to a misallocation of resources, hence market failure
What is the principal-agent problem?
When the agent makes decisions for the principal, but the agent is inclined to act in their own interest rather than those of the principal I.e shareholders and managers having different objectives
Define mobility of Labour
The ability of workers to change between jobs
> unemployment is evidence that labour markets don’t work efficiently
What is frictional unemployment?
When people are in-between jobs and are in search of a new one
What is structural unemployment?
Occurs when there is a decline in an industry, meaning worker skills don’t match the location and skills required for the job
What does geographical immobility of FOP refer to?
Obstacles which prevent FOP moving between areas I.e Labour finding it hard to find work due to family ties etc
What does occupational immobility of FOP refer to?
Obstacles which prevent FOP changing their use i.e Labour finding it hard to change their occupation m
Why would the government impose taxes i.e ad valorem tax on demerit goods like cigarettes?
To discourage consumption of the demerit good and reduce negative externalities.
For price inelastic goods like cigarettes most of the burden of tax is placed on the consumer
What are specific taxes?
Set taxes per unit
What does it mean for a firm to internalise an externality?
The polluter pays for the damage.
Increased prices of goods, whereby tax is equal to the external cost of each unit, then the supply curve becomes MSC rather than MPC, therefore the free market equilibrium becomes the socially optimum equilibrium
Do consumers gain more or less from price elastic or inelastic subsidies?
Consumers gain more when demand is price inelastic, whilst producers supply more when demand is price elastic
What is a maximum price?
Where the consumption or production of a good is to be encouraged — so the good doesn’t become too expensive to produce or consumer
>have to be set below free market price
SAME AS PRICE CEILING
What are price ceilings good for consumers?
It prevents monopolies exploiting consumers i.e price caps on roaming charges in the EU
Could lead to welfare gains for consumers by keeping prices low
Could increase efficiency in firms
What is a minimum price?
Where consumption or production of a good is discouraged. It ensures the good never falls below a certain price I.e alcohol
> makes goods less affordable hence reducing negative externalities from consumption
Have to be set above the free market price otherwise they would be ineffective
What does a tradeable pollution permit do?
- limits the amount of negative externalities, in the form of pollution, created in industries
> firms can buy and sell surplus allowances among themselves
Advantages of a tradeable pollution permit?
- should be a benefit in the long run by encouraging firms to use green production methods
- Gov can raise revenue from permits
- greener firms can raise revenue
Disadvantages of a tradeable pollution permit?
- could lead to some firms relocating to where they can pollute without limits, which will reduce their production costs
- firms might pass higher costs onto consumers
- competition could be restricted in the market (barrier to entry)
- could be expensive for governments to monitor emissions
Why would governments want to implement information provision?
To ensure there is no information failure and so consumers and firms can make informed economic decisions
What are 4 causes of government failure?
- Distortion of price signals
- Gov subsidies could distort price signals by distorting the free market mechanism. - Unintended consequences
- When actions of producers and consumers have unexpected or unintended consequences - Excessive administrative costs
- The social benefits of a policy might not be worth the financial cost of administering the policy. - Information gaps
- Some policies might be decided without perfect information I.e gov housing policies which failed
What is a public bad?
Opposite of a public good
> provides dis utility or dissatisfaction to people when consumed
> reduces welfare
