4.1.8 Market Mechanism, Market Failure and Government Intervention in Markets Flashcards
rationing function of price
scarce resources, price rises due to excess demand, the price then discourages demand and rations resources
incentive function of price
encourages a change in behaviour from producer or consumer, a high price suggests firms should supply more as it is more profitable
signalling function of price
price acts as a signal to consumers and new producers, shows where resources are needed, high price encourages firms to supply more, but also signals consumers to ration demand
advantages of the price mechanism
- impersonal way of allocating resources
- consumer gains soveirgenty
disadvantages of price mechanism
- does not consider inequality
- underprovision of merit and public goods
when does market failure occur
when there’s a misallocation of resources
misallocation of resources
when resources are not allocated to the best interests of society
market failure- externality
cost or benefit a third party recieves from an economic transaction outside market mechanism
market failure- underprovision of public goods
Public goods are non-excludable and non-rival, and they are underprovided in
a free market because of the free-rider problem.
market failure- information gaps
It is assumed that consumers and producers have perfect information when
making economic decisions. However, this is rarely the case, and this
imperfect information leads to a misallocation of resources.
market failure- monopolies
consumer has very little choice where to buy the goods and services
offered by a monopoly, they are often overcharged. This leads to the underconsumption of the good or service, and therefore there is a misallocation of
resources, since consumer needs and wants are not fully met.
market failure- inequality
There is an unequitable distribution in income and wealth. This can lead to negative externalities, such as social unrest.
complete market failure
occurs when there is a missing market. The market does not
supply the products at all.
partial market failure
occurs when the market produces a good, but it is the wrong
quantity or the wrong price. Resources are misallocated where there is partial
market failure
public goods
missing from the free market, but offer benefits to society eg street lights
non excludable
non rival
non excludable
by consuming the good, someone else is not
prevented from consuming the good as well
non rival
benefit other people get from the good does not diminish if more people
consume the good.
free rider problem
people who do not pay for the good still receive benefits
from it, in the same way people who pay for the good do. This is why public
goods are underprovided by the private sector: they do not make a profit
from providing the good since consumers do not see a reason to pay for the
good, if they still receive the benefit without paying.
why are public goods underprovided
it is difficult to measure the
value consumers get from public goods, so it is hard to put a price on the
good. Consumers will undervalue the benefit, so they can pay less, whilst
producers will overvalue, so they can charge more.
private goods
rival
excludable
quasi public goods
characteristics of both public and private
goods. They are partially provided by the free market. For example, roads are
semi-excludable, through tolls and they are semi-non-rival, because
consumers can benefit from the road whilst other consumers are using it
(unless it is rush hour).
tragedy of the commons
The tragedy of the commons refers how individuals prioritise personal gain
over the well-being of society.
When resources are held in common, it means that no one owns the
resource, but everyone can access it.
For example, no one owns the air, but everyone can use it. This unlimited use
leads to the negative externality of air pollution. This is a market failure that
results from common access.
externality
the cost or benefit a third party receives from an economic
transaction outside of the market mechanism. In other words, it is the spillover effect of the production or consumption of a good or service.
negative externalities
caused by demerit goods. These are associated
with information failure, since consumers are not aware of the long run
implications of consuming the good, and they are usually overprovided. For
example, cigarettes and alcohol are demerit goods. The negative externality
to third parties of consuming cigarettes is second-hand smoke or passive
smoking.
positive externalities
Positive externalities are caused by merit goods. These are associated with
information failure too, because consumers do not realise the long run
benefits to consuming the good. They are underprovided in a free market.
For example, education and healthcare are merit goods. The positive
externality to third parties of education is a higher skilled workforce
private costs
Producers are concerned with private costs of production. For example, the rent, the
cost of machinery and labour, insurance, transport and paying for raw materials are
private costs.
This determines how much the producer will supply.
It could refer to the market price which the consumer pays for the good.
social costs
This is calculated by private costs plus external costs
private benefit
Consumers are concerned with the private benefit derived from the consumption of
a good. The price the consumer is prepared to pay determines this.
Private benefits could also be a firm’s revenue from selling a good.
social benefit
private benefits plus external benefits.
socially optimum position
This is where MSC = MSB and it is the point of maximum welfare.
The social costs made from producing the last unit of output is equal to the social
benefit derived from consuming the unit of output.
how do you show external costs on a diagram
vertical distance between MSC and MPC
where is their deadweight loss
output where social costs > private benefits
why does the absence of property rights lead to externalities
where their are no property rights free riders can have unlimited access leading to exploitation of the good
moral hazard assumes someone else will pay the consequences
demerit goods
cause negative externalities
information failure as consumers are not aware of the long term implications of consumption and they are overprovided
merit goods
cause positive externalities
information failure as consumers are not aware of the long term benefits from consuming them
underprovided in free market
why does information failure lead to misallocation of resources
Consumers might pay too much or too little, and firms might produce the incorrect amount
how can information failure be intervened in
advertising
importance of small and medium enterprises
important for creating a competitive
market. They create jobs, stimulate innovation and investment and promote a
competitive environment.
dergulation
the act of reducing how much an industry is regulated. It reduces
government power and enhances competition.
privatisation
assets are transferred from the public sector to the private
sector. In other words, the government sells a firm so that it is no longer in their
control. The firm is left to the free market and private individuals.
competitive tendering
When a project is put out to tender so that private sector firms can bid for the right to provide the service such as laundry services in hospitals, school meal services and tenders to build and maintain public roads.
arguments for nationalised industries
positive externalities
reduced costs
less profit driven
arguments for privatised industries
efficiency gains
innovation due to comp
raises revenue for gov by selling asset
for regulation
externalities
disincentives rule breaking
for deregulation
less costs for firm
less administratitive costs
regulation may disincentivise profit due to taxes
reguulatory capture
when regulators start acting in the
interests of the company, due to impartial information, rather than in consumer
interests. This information disadvantage is a problem for regulators.
why do government intervene
to correct market failure
indirect tax
They increase production costs for
producers, so producers supply less. This increases market price and demand
contracts. They could be used to discourage the production or consumption of a
demerit good or service
ad valorem tax
taxes are percentages, such as VAT, which adds 20% of the unit
price.
less efective if inelastic but gov gain more
specific taxes
set tax per unit, such as the 58p per litre fuel duty on
unleaded petrol.
The more inelastic the demand, the higher the tax burden for the consumer,
and the lower the burden of tax for the producer.
subsidy
payment from the government to a producer to lower their costs of
production and encourage them to produce more.
encourage consumption of merit goods
Consumers gain more from the subsidy when demand is price inelastic, whilst
producers supply more when demand is price elastic.
maximum price
consumption or production
of a good is to be encouraged. This is so the good does not become too expensive to
produce or consume.
Maximum prices have to be set below the free market price, otherwise they would
be ineffective.
minimum price
where the consumption or production
of a good is to be discouraged. This ensures the good never falls below a certain
price.
Minimum prices have to be set above the free market price, otherwise they would
be ineffective.
The minimum wage could be used as an example.
tradeable pollution permits
These could limit the amount of negative externalities, in the form of pollution,
created in industries. Firms will be allowed to pollute up to a certain amount, and
any surplus on their permit can be traded.
adavntages of tradeable pollution permits
This should benefit the environment in the long run, by encouraging firms to use
green production methods.
The government could raise revenue from the permits, because they can sell them to
firms. This revenue could then be reinvested in green technology.
If firms exceed their permit, they will have to purchase more permits from firms
which did not use their whole permit. This raises revenue for greener firms, who
might then invest in green production methods.
disadvantages of tradeable pollution permits
it could lead to some firms relocating to where they can pollute without
limits, which will reduce their production costs.
Firms might pass the higher costs of production onto the consumer.
Competition could be restricted in the market, if the permits create a barrier to entry
for potential firms.
It could be expensive for governments to monitor emissions
state provision of public goods
government could provide public goods which are underprovided in the free
market, such as education and healthcare. These have external benefits.
This makes merit goods more accessible, which might increase their consumption
and yield positive externalities.
It could be expensive for governments to provide education, and the government
will incur an opportunity cost of spending their revenue.
provision of information
By providing information, governments can ensure there is no information failure, so
consumers and firms can make informed economic decisions.
For example, governments might make it illegal for second-hand car dealers not to
reveal the entire history of a car, so consumers know exactly what they are buying.
This could be expensive to police.
regulation
The government could use laws to ban consumers from consuming a good. They
could also make it illegal not to do something
Firms which fail to follow regulations could face heavy fines, which acts as a
disincentive to break the rule.
It could raise costs of firms, who might pass on the higher costs to consumers
gov failure- distortion of price signals
Government subsidies could distort price signals by distorting the free market
mechanism. A free market economist would argue that this could lead to
government failure. There could be an inefficient allocation of resources because the
market mechanism is not able to act freely
gov failure- unintended consequences
actions of producers and consumers have unexpected, or
unintended, consequences.
With government policies, consumers react in unexpected ways. A policy could be
undermined, which could make government policies expensive to implement, since
it is harder to achieve their original goals.
gov failure- excessive administrative costs
The social benefits of a policy might not be worth the financial cost of administering
the policy. It might cost more than the government anticipated. The government has
to consider whether the policy is good value for money.
gov failure- info gaps
Some policies might be decided without perfect information. This might require a full
cost-benefit analysis, and it could be time-consuming and expensive.
However, it is impractical for governments to gain every bit of information they
need, so assumptions are made
