3.1.5 The market mechanism, market failure and government intervention in markets

Question 1

What is the price mechanism?

Answer 1

Changes in supply and demand of a good/service leads to a change in its price and quantity bought or sold

Question 2

What does the price mechanism do?

Answer 2

The way in which the basic economic problem of scarcity is resolved in a market economy.

Allocates goods/services in an impersonal way as prices will change until equilibrium is reached so that supply = demand.

Question 3

What are the 3 functions of the price mechanism?

Answer 3

(1) signal - changes in price show changes in supply/demand which is a signal to producers and consumers

(2) Incentive - Higher prices encourage increased production and sales through high profit

(3) Ration - scarce resources used allocatively efficient.

Question 4

What are the advantages of the price mechanism?

Answer 4

Resources are used allocatively efficient to satisfy consumer wants and needs.

Not costly to regulate it

Prices are kept to a minimum as resources are being used efficiently

Question 5

What are the disadvantages of the price mechanism?

Answer 5

Inequality in wealth and income

under provision of merit costs and over provision of demerit goods - not at the socially optimum level

public goods won’t be produced

Question 6

What is consumer surplus and producer surplus?

Answer 6

Consumer surplus: . It’s the difference between the price that a consumer is willing to pay for a good/ service and the price they actually pay. Area below demand curve and above equilibrium price line.

Producer surplus: Difference between the price that a producer is willing to supply a good/ service and the price that they actually receive for it. Area above supply curve and below equilibrium price line.

Question 7

Define market failure

Answer 7

When the price mechanism fails to allocate scarce resources efficiently.
Not allocated to the best interests of society - allocatively inefficient
Only the PC and PB are considered not the EC or EB

Question 8

What is meant by a misallocation of resources?

Answer 8

Scarce resources are used allocatively inefficient. It is caused by an information gap - so more demerit goods and goods with negative externalities are consumed

Question 9

What is the difference between complete and partial market failure?

Answer 9

Complete: Missing market e.g. national defense

Partial: A market exists but contributes to resource misallocation by wrong pricing or quantity supplied e.g. healthcare

Question 10

Define positive externality

Answer 10

benefits to a third party by the action/ decision of others. They are usually under consumed / under produced

Question 11

Define externalities

Answer 11

Cost or benefit a third party receives from an economic transaction outside of the market mechanism.
They exist when there is a divergence between private and social costs and benefits

Question 12

Define negative externality

Answer 12

A cost imposed onto a third party by the action/ decision of others. Only the PC and PB are considered resulting in overconsumption / overproduction

Question 13

What is a social optimum?

Answer 13

True benefit is taken into consideration. MSC =MSB at p2,q2 where society wants us to be at

Question 14

What is a positive/negative externality in consumption?

Answer 14

Consumers impose a benefit/cost onto others when they consume goods/services

Question 15

What is a positive/negative externality in production?

Answer 15

When producers impose a benefit/cost onto others through their production processes

Question 16

Define merit good

Answer 16

Has more benefits then their consumers realize due to information failure and there is an underconsumption / underproduction
SB > PB
depends on value judgment

Question 17

Define de merit goods

Answer 17

Consumption is more harmful than consumers realize due to information failure there is overconsumption / overproduction
SC > PC
depends on value judgment

Question 18

What is a subsidy?

Answer 18

A payment from the government to a producer which lowers the cost of production which is used to encourage them to produce more so there is encouragement of consumption of merit goods

Question 19

What are some disadvantages of using subsidies?

Answer 19

(1) depends on if its an elastic good/service

(2) government may need to increase taxes to fund the subsidy - cost

(3) Opportunity cost - NHS, Education

(4) May not be used rightly - increase profits

Question 20

What is an indirect tax?

Answer 20

Taxes on specific goods to increase cost of production for producers so that they’re less willing and able to supply and can discourage consumption of demerit goods

Question 21

What are some disadvantages of using tax?

Answer 21

(1) Depends on elasticity of the good/service

(2) Inequitable - risk for people on low incomes

(3) Size of tax

Question 22

Define regulations

Answer 22

Government set laws to ban consumers from consuming goods (illegal)

Question 23

What are some disadvantages of using regulations?

Answer 23

(1) firms/ consumers may not comply with the law

(2) Difficult to police - costs

(3) Heavy fines - act as a disincentive to break the rule - size of the punishment

Question 24

define maximum price

Answer 24

The government set a maximum price where the consumption or production of a good is encouraged - set below the free market price

Question 25

define minimum price

Answer 25

The government set a minimum price where the consumption or production of a good is discouraged - set above the free market price

Question 26

Define pure public goods that are non - rival and non - excludable

Answer 26

Non - rival: One person benefitting from the good doesn’t stop others also benefitting e.g. flood defense scheme - 0 MC

Non - excludable: People cannot be stopped from consuming the good even if they haven’t paid for it e.g. benefits from the services of the armed forces

Question 27

What is the difference between a public and private good? (pure public goods)

Answer 27

Public good: Goods consumed collectively cannot be rejected or excluded

Private good: Excludable and exhibit rivalry - choice

Question 28

What is a quasi-public good?

Answer 28

When a public good may take on some of the characteristics of a private good e.g. tolls

Question 29

What is the significance of technological change to public goods?

Answer 29

The invention of digital technology has meant that channels can be encrypted so people have to pay for certain channels

Question 30

What is the free rider problem?

Answer 30

Once a public good is provided, it’s impossible to stop someone from benefitting from it, even if they haven’t paid for it. e.g. a firm providing street cleaning

Question 31

What is meant by the ‘state provision of public goods’?

Answer 31

The government providing public goods which are underprovided in the free market such as education and healthcare. Merit goods become more accessible for consumption

Question 32

What are the 2 types of indirect tax?

Answer 32

(1) Specific: fixed amount charged per unit of a particular good regardless of its price

(2) Ad valorem: Charged as a proportion of the price of a good

Question 33

Define government failure

Answer 33

Government intervention can lead to resources being misallocated and a net welfare loss (unintended consequence of intervening to correct market failure)

Question 34

Give examples of government intervention causing market distortions

Answer 34

(1) Income taxes can act as a disincentive to working hard

(2) Price fixing - min / max price leads to distortions of price signals.
Firms may overproduce when they will receive guaranteed min price

(3) Subsidies may encourage firms to be inefficient or e.g. subsidies for public transport may not increase demand that much as it’s viewed as an inferior good. You may prefer to go by car for convenience and privacy