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

Question 1

Explain the function of the Price Mechanism.

Answer 1

The function of the price mechanism is to allocate resources.
This can be done in 3 ways:
* rationing
* incentive
* signalling

Question 2

Explain the roles of the different Economic Incentives.

Answer 2

• Economic incentives provide the reasons for economic agents to provide goods + services.
• Based on the price mechanism; method by which prices for goods + services are achieved.
• Rationing function: occurs because increase demand/reduced supply of a product will lead to a price rise, due to scarcity of the product (more scarce a product,higher the price). Leads to reduction in QD- rationing of product as its use is restricted. Movement along D curve showing a decrease in QD + in P.
• Signalling function occurs: because changing prices give a signal to consumers + producers as to whether to leave or enter a market, e.g. higher P suggests consumers should reduce D, increase in P gives indication to producers that she should decrease S.
• Incentive function: occurs because a consumer/producer is motivated to a course of action, e.g. higher prices incentivise a producer to supply more of a good/service; due to greater contribution per unit (difference between the selling price of a product + the VC). As prices rise so does revenue + profit- there’ll be a movement along the S curve showing an increase in QS + a decrease in P

Question 3

Explain the effectiveness of markets. in Allocating Resources.

Answer 3

• Allocative efficiency is difficult to identify, as we need to match consumer preferences to producer output, i.e. need to match D + S
• Markets don’t always operate at the market clearing price due to: excess demand (D > S) or excess supply (S > D)
• Market forces do push prices towards equilibrium where QD will equal QS.
• Therefore, likely that competitive markets help in achieving allocative efficiency.

Question 4

State + explain what firms compete on, other than price.

Answer 4

• Customisation: customers increasingly wish to purchase products modified to their preferences.
• Advertising: increasing brand recognition + brand loyalty
• New products: anticipating trends in markets by developing new products
• Location/Convenience: for some services, being in the right location is the most important.
• Online reviews: firms may seek to gain better online reviews.
• Pay for best workers: firms may want to employ top chef, best footballers, e.t.c.

Question 5

Define Market Failure.

Answer 5

• Market Failure: when the free market fails to allocate scarce resources at the socially optimum level of output.

Question 6

Define Market Failure.

Answer 6

• Market Failure: when the free market fails to allocate scarce resources at the socially optimum level of output.

Question 7

State + explain some of the different types of Market Failure.

Answer 7

• Negative/Positive Externalities: negative/positive impacts on 3rd parties, as a result of production or consumption. Not accounted for in the free market mechanism- as firms are profit maximisers, only consider their private costs, + consumers are utility maximisers + only consider their private benefits. Thus, the consumers + producers are self-interested.
• Merit + De-Merit Goods: Imperfect information/information failure, therefore consumers may make irrational decisions when they consume. Could lead to the allocation of scarce resources being too high or too low.
• Public Goods: Free rider problem + the notion that firms are profit maximisers, thus there’ll be no supply of public goods in the end.
• Common Access Resources: often over-consumed + over-produced, due to negative externalities in production. Private producers ignore external costs when it comes to producing- self-interest.
• Income Inequality: inequity- when income inequality becomes so high that it’s deemed to be unfair, it can be argued to be a source of market failure.
• Monopoly Power: one dominant seller + high barriers to entry- give rise to monopoly power, consumers are exploited with high prices (higher than socially optimum) and lower than socially optimum quantities.

Question 8

Define a Public Good.

Answer 8

• Public Good: one where its use by an individual doesn’t stop others from using it whilst its consumption doesn’t reduce the amount available for consumption by others.

Question 9

State + explain the characteristics of a Public Good.

Answer 9

• Non-Excludable: no price can be charged for the good (this is because the benefits of consuming the good can’t be confined to the individual whom paid, + maybe no price can be charged as there’s not an efficient way to price the good).
• Non-Rival: quantity available of good doesn’t diminish upon consumption

Question 10

Give an example of a Public Good.

Answer 10

• Street Lights: as soon as someone’s paid, the benefits can’t be confined to that person everybody else can also consume that streetlight, non-rival as when they are consumed the quantity available doesn’t diminish for everybody else

Question 11

Define a Pure Public Good.

Answer 11

• Pure Public Good: it’s impossible to exclude someone from consuming it if they are unwilling to pay for its use
* Example: the air we breathe

Question 12

Define + explain the Free-Rider Problem.

Answer 12

• Free-Rider Problem: where individuals have the incentive not to contribute anything at all to the provision of the public good, as they’ll wait for others to contribute, then free-ride of their contributions.
  • Individuals can ‘free-ride’ as they know the benefits can’t be confined to the person who paid, they also know that if the person whom paid consumed, the same amount would be available for them to consume as well.
  • If everybody has this incentive, no body will pay towards the provision of public goods-no contributions, therefore no private motive to supply them. Thus, no supply in the free-market, therefore there’ll be a missing market- complete market failure.

Question 13

Define a Private Good.

Answer 13

• Private Good: where its use by an individual stops others from using it whilst its consumption reduces the amount available for consumption by others.
* Examples: clothing, cars

Question 14

State + explain the characteristics of a Private Good.

Answer 14

• Rival Goods: consumption of good reduces amount available for consumption by others.
• Excludable Goods: where, once provided, possible to stop other individuals from using them.
* Can have either positive or negative externalities.

Question 15

Define a Quasi-Public Good.

Answer 15

• Quasi-Public Goods: a private good that is similar to a pure public good but there’s an ability to stop non-paying consumers from using it.
• Consumers can be stopped from using a product that is normally free.
• Example: Roads (can be excludable through toll roads, also can be rival during peak times where road space does diminish upon consumption)

Question 16

Explain how Technological Change leads to markets providing Private Goods.

Answer 16

• Technological Change: Process of innovation, invention + the widespread use of technology in society.
• Tech change can lead to markets efficiently producing goods previously regarded as non-excludable + non-rival.
• Therefore public goods can become private goods over time.
  This can be achieved by:
• Intellectual Property Rights (IPR): granting patents, copyright, e.t.c. Becomes protected/excludable.
• Monitoring + Control Systems: restricting use of good by monitoring usage (e.g. congestion charging)
• Technology tends to be non-rival but can be excludable.
• Its use can create tangible goods, generally recognised to be rival + therefore excludable.
• Thus, tech change can lead to public goods becoming private goods.

Question 17

Define Positive Externalities.

Answer 17

• Positive Externalities: Benefits to a third party that aren’t included in the price of the economic activity.

Question 18

Define Private Benefits + Social Benefits.

Answer 18

• Private Benefits: benefits of consuming/producing goods/services that are received by an economic agent (i.e. individual or firm). These benefits are paid for by the economic agent.
• Social Benefits: benefits of consuming/producing goods/services that are received by society. Social benefits include private benefits, but the difference between them is unpaid for, creating the free-rider problem.
* When Social Benefits (SB) > Private Benefits (PB) we have positive externalities.

Question 19

Analyse Positive Externalities in Consumption.

Answer 19

MSB > MPB
* Self-Interest: individual consumers are ignoring the full SB of their actions, only considering their own PB.
* Under-Consumption/Under-Production
* Misallocation of Resources: too few resources being allocated to this market. Thus, there’s a welfare loss.

Question 20

State an example of Positive Externalities in Consumption.

Answer 20

• Healthcare: being vaccinated against the flu- other people in society benefit as there’s less chance of them contracting the flu.
• Education: rest of society benefits if individuals are well educated, as they’re more productive, earn higher incomes, pay greater taxes to gov- used to provide socially desirable things, e.g. infrastructure

Question 21

Analyse Positive Externalities in Production.

Answer 21

MSC < MPC
* Self-Interest: firms only consider their PB, don’t consider any SB- therefore they ignore any external benefits to external firms. Thus, resources are allocated at their private optimum (P1,Q1), rather than their social optimum (P,Q)
* Under-Consumption/Production taking place
* Misallocation of Resources: allocative inefficiency + a welfare loss.

Question 22

State an example of Positive Externalities in Production.

Answer 22

• producers may offer high quality in-work training schemes: 3rd party that’ll benefit is other firms who are able to poach workers whom have benefited from the training schemes, without having to pay to train them themselves- lower CoPs.

Question 23

Define Negative Externalities.

Answer 23

• Negative Externalities: Costs to a third party that aren’t included in the price of the economic activity.

Question 24

Define Private Costs + Social Costs.

Answer 24

• Private Costs: those costs of consuming/producing goods/service that have to be paid for by the parties to the transaction (e.g. individual or firm)
• Social Costs: those costs of consuming/producing goods/services that are paid for by society (e.g. social Costs include Private Costs)
• When Social Costs (SC) > Private Costs (PC) we have negative externalities

Question 25

Analyse Negative Externalities in Production.

Answer 25

MSC > MPC
* Self-Interest: firms are ignoring full SC due to self-interest, only consider their PC
* Over-Production/Consumption
* Price too low: as it’s at P1 not P*- only accounting for the PC, not the full SC.
* Misallocation of Resources: allocative inefficiency + welfare loss.

Question 26

State examples of Negative Externalities in Production.

Answer 26

• Air Pollution: firms producing metals, chemicals which produce air pollution. 3rd party could be local residents- suffer from respiratory problems, greater risk of lung cancer.
• Deforestation: 3rd party: villagers whom live near the forest, use it for food sources, water sources, e.t.c

Question 27

Analyse Negative Externalities in Consumption.

Answer 27

MSB < MPB
* Self-Interest: consumers ignore full SB of their actions, only consider their PB.
* Over-Consumption + Over-Production
* Misallocation of Resources: too many resources allocated to this market, than are socially desirable- resulting in allocative efficiency + welfare loss to society.

Question 28

State examples of Negative Externalities in Consumption.

Answer 28

• Smoking: bi-standers who inhale the smoke- greater risk of luck cancer + respiratory issues
• Those who consume excess alcohol: 3rd parties: health-services- deal with treating them, + police services- deal with crime associated.

Question 29

Define Merit Goods.

Answer 29

• Merit Goods: goods for which social benefits on consumption > private benefits (i.e. good has positive externalities)
• Deemed to be more beneficial to consumers than they realness.
• There’s a value judgement when deciding if a good is a merit good.
• Examples: health care, education, museums.

Question 30

State + explain the characteristics of Merit Goods.

Answer 30

• Deemed to be socially desirable- good for society
• Have positive externalities in consumption
• Have information failures associated with consumption
• Would be under-consumed if left to the free market; therefore, gov intervenes in the arrest + attempts to increase/encourage greater consumption.

Question 31

Explain Information Failures, with regard to Merit Goods.

Answer 31

• Information Failures where Merit Goods are concerned: consumer will consumer too little of a merit good compared to what they would consume if they fully understood the benefits to themselves + to society.
• In these circumstances, consumers themselves lose out on the benefits, as well as society missing out on the benefits.
  Information Failures can occur:
• Information can be too little, too much, inaccurate, too complex.
• Present Bias: occurs when individuals place greater value on goods/income achieved in the present moment- rather than receiving the same goods/income in the future. (Present bias suggests that given a choice between a pay-off today + a pay-off in the future,we will choose today, also suggests people can be time-inconsistent- they may make decisions their future self may regret)

Question 32

Define Demerit Goods.

Answer 32

• Demerit Goods: goods for which the private benefits of consumption > social benefits
• Deemed to be more harmful to consumers than they realise.
• There’s a value judgement when deciding if a good/service is a demerit good
• Good must have negative impacts that go to a wider society (i.e. negative externalities)

Question 33

State + explain the characteristics of a Demerit Good.

Answer 33

• Deemed to be socially undesirable- bad for society
• Have negative externalities in consumption
• Have information failures associated with consumption
• Demerit Goods will be over-consumer if left to the free market; therefore, govs will intervene in market + attempt to decrease/discourage consumption.

Question 34

Explain Information Failures, with regards to Demerit Goods.

Answer 34

• Consumer will consume too much of a demerit good compared to what they’d consume if they fully understood the full cost of consuming good.
  Information Failures can occur:
• Information too little/too much/inaccurate/too complex.
• Present Bias.
• Asymmetric Information:** producers may have information but are deciding not to share it perfectly with consumers.
• Can also be addictive/ influence by social norms leading to overconsumption.

Question 35

Define Symmetric Information.

Answer 35

• Consumers + producers have perfect market information to make their decisions.
• Leads to an efficient allocation of resources.

Question 36

Explain what Asymmetric Information is.

Answer 36

• Unequal knowledge between consumers + producers; leads to market failure.
• Example: car dealer might know about a fault with the car that the consumer is unaware of.
• Could also lead to a misallocation of resources.
• Consumers can also know more information than the producer (e.g. when purchasing insurance policies)
• Could also be imperfect information, where information is missing, so an informed decision can’t be made- leads to a misallocation of resources.
• Consumers may pay too much/too little, + firms might produce the incorrect amount (e.g. monopolies might exploit the consumer by charging them more than consumers really need to pay)
• Asymmetric information can be linked with the principal-agent problem- when the agent makes decision for the principal, but the agent is inclined to act in their own interests, rather than those of the principal.
• Information could be made more widely available through advertising or government intervention (e.g. harmful effects of smoking could be made public through adverts + messages on cigarette boxes)

Question 37

Explain why the Immobility of FoPs can lead to Market Failure.

Answer 37

• Mobility of labour is the ability of workers to change between jobs.
• Unemployment is evidence that labour markets don’t work efficiently.
• Geographical immobility: refers to the obstacles which prevent the FoPs moving between areas (e.g. labour might find it hard to find work due to family + social ties, the financial costs involved with moving, imperfect market knowledge on work, e.t.c.)
• Occupational immobility: refers to the obstacles which prevent the FoPs changing their use (e.g. labour might find it difficult to change occupation- occurred in the UK with the collapse of mining industry, when workers didn’t have transferable skills to find other work- causes of this include insufficient education, training + skills.)

Question 38

Explain why the existence of Monopoly + Monopoly Power can lead to Market Failure.

Answer 38

• Basic model of monopoly suggests higher prices, profits + inefficiency may result in a misallocation of resources compared to the outcome in a competitive market.
• Monopolies could exploit consumers by charging them higher prices- means the good is under-consumed, so consumer needs + wants aren’t fully met- this loss of allocative efficiency is a form of market failure.
• Monopolies have no incentive to become more efficient, as they have few/no competitors, so production costs are higher.
• There’s a loss of consumer surplus + gain of producer surplus

Question 39

Explain how inequitable distribution of income + wealth can lead to a Market Failure.

Answer 39

• In absence of gov intervention, the market mechanism is likely to result in a very unequal + inequitable distribution of income + wealth.
• In market economies, an individual’s ability to consumer goods depends upon their income, inequitable distribution of income likely leads to misallocation of resources, hence market failure.

Question 40

Define Government Intervention.

Answer 40

• Government Intervention: when the state (gov) intervenes in a market, to change the behaviour of those in the market + to change the market outcomes.
• In Neo-Classical (Free Market) economics there’s said to be a case for gov intervention in a market when the market fails to achieve an efficient/equitable allocation of resources

Question 41

State + explain the reasons for Government Intervention in Markets.

Answer 41

1) To correct market failures + improve the allocation of resources
Why?
* To provide public goods that wouldn’t be provided at all, or would be underprovided by the market
* Reduce negative externalities +/or maximise positive externalities
* Increase consumption of merit goods +/or reduce the consumption of demerit goods
* Correct/reduce market imperfections (e.g. information failures, monopoly power, factor immobility)
* Change the distribution of income/reduce inequality
Other reasons for Gov Intervention:
2) Achieive macroeconomic objectives + improve economic performance
3) Economic growth
4) Low unemployment
5) Low + Stable inflation (2% target)
6) Satisfactory current account of the BoPs
7) Equity (fairness)- achieve a fairer outcome for citizens, reduce poverty + its impact
8) Improve economic well-being of citizens

Question 42

State + explain the ways in which the Government Intervenes to correct Market Failure.

Answer 42

• Indirect Taxation: specific duties, VAT
• Subsidies: provision of payments to suppliers
• Price Controls: minimum price (price floor), maximum price (price ceiling)
• Direct Provision: provision of goods + services (e.g. education so they are free at the point of consumption)
• Regulation: rules/laws to restrict behaviour of firms/consumers + encourage competition
• Provision of Information: reduce information failures

Question 43

State + explain how Indirect Taxation is used to correct Market Failures.

Answer 43

• Internalise the Externality (polluter pays principle): if tax can be set at value of negative externality, effectively makes producers + consumers pay for the negative externality (full social cost). However, very difficult to estimate actual value of externality- so as long as it moves the market closer to the socially optimal level of output, likely to be seen as beneficial.
• Creates Revenue for Gov: revenue can be used for clearing up the externality, provision of services, enforcement costs, e.t.c.
• Impact of Tax depends on PED: if tax is used to reduce consumption of a good with a negative externality such as a demerit good- less effective if demand is price inelastic.
• Indirect Taxes often Regressive: regressive tax is a tax which takes a higher % of tax revenue from those on low incomes. As income increases, proportion of your income paid in tax falls.
  Example: if there’s a council tax of £2,000, a household earning £20,000 is paying 10% of their income in tax, a household earning £40,000 is paying 5% of their income in tax, + a household earning £100,000 would pay just 2% of their income in tax.

Question 44

State + explain how Indirect Taxation is used to correct Market Failures.

Answer 44

• Internalise the Externality (polluter pays principle): if tax can be set at value of negative externality, effectively makes producers + consumers pay for the negative externality (full social cost). However, very difficult to estimate actual value of externality- so as long as it moves the market closer to the socially optimal level of output, likely to be seen as beneficial.
• Creates Revenue for Gov: revenue can be used for clearing up the externality, provision of services, enforcement costs, e.t.c.
• Impact of Tax depends on PED: if tax is used to reduce consumption of a good with a negative externality such as a demerit good- less effective if demand is price inelastic.
• Indirect Taxes often Regressive: regressive tax is a tax which takes a higher % of tax revenue from those on low incomes. As income increases, proportion of your income paid in tax falls.
  Example: if there’s a council tax of £2,000, a household earning £20,000 is paying 10% of their income in tax, a household earning £40,000 is paying 5% of their income in tax, + a household earning £100,000 would pay just 2% of their income in tax.

Question 45

State + explain how Subsidies are used to correct Market Failures.

Answer 45

• Subsidies:Any form of gov support- financial or otherwise- offered to producers + (occasionally) consumers.
• Subsidies to producers reduce the marginal cost (MC) of supply (i.e. the subsidy has the effect of reducing the costs of production)
• Subsidy usually leads to an increase in the output sold of a good/service at a lower market price.
• The subsidy reduces the costs of production, consequently there’s the potential for additional profit for the firms- thus creating the incentive for firm to increase supply- shifts S right- leads to an increase in QS + a decrease in P, causing a movement along the demand curve + a new equilibrium quantity + price.

Question 46

State examples of Subsidies for Consumers.

Answer 46

• Subsidies for people buying electric cars
• Food + energy subsides- often used in emerging/developing countries
• Free television listeners for the over 75s
• Scotland- new legal duty in 2021 on local authorities to ensure that free items such as sanity products are available to ‘anyone who needs them’

Question 47

Explain when Subsidies may be justified as a method by which the government intervenes in a market.

Answer 47

• Helping poorer families with food + childcare costs particularly during an economic crisis
• Encourage output + investment in fledgling sectors, e.g. life science + renewable energy
• Protect jobs in loss-making industries hit by recession + by external economic shocks
• Improve housing + transport affordability to improve geographical mobility of labour
• Reduce the cost of training + employing workers.

Question 48

Explain the Disadvantages of using Subsidies in attempt of correcting a Market Failure.

Answer 48

• Producers can become ‘subsidy dependent’
• Subsidies can lead to excess production/surpluses
• Subsidies can distort resource allocation
• Environmental risks from extensive production
• Subsidies can be very expensive- taxpayers bear the costs

Question 49

State + explain how State Provision is used to correct Market Failures.

Answer 49

• State Provision: Direct provision of goods/services by the gov free at the point of consumption.
• Merit goods (under-consumed/production inequity)- state provision for healthcare/education
• Public goods: state provision solves free rider problem
  How state provision works:
• Gov considers full SC + SB, allocating resources at Q*
• Free at point of consumption
• Solve UC/UP + inequity issues
• Solve missing market issues
• Allocative efficiency + Welfare max.

Question 50

State + explain the Issues when using State Provision, in an attempt to correct Market Failures.

Answer 50

• Long-run excess demand: Q* not at Q1- in a private market, excess demand is likely to be an issue.
• Cost of state provision: taking over whole market- greatly expensive
• Gov doesn’t have perfect information: Q isn’t going to be at Q*- gov failure risks
• State run organisations tend to be highly inefficient due to lacking a profit motive

Question 51

Define a Price Control.

Answer 51

Price Control: when the gov sets a legal maximum or minimum price for a good/service.

Question 52

Define a Minimum Price (Price Floor)

Answer 52

A fixed price (price floor) enacted by the gov usually set above the equilibrium market price.
* Gov is saying the equilibrium market price is simply too low, + it needs to be rise by implementing a minimum price.
* Legally prices cannot fall below this level

Question 53

Explain why the government may implement a Minimum Price.

Answer 53

• Protect producers from price volatility: in particular farmers, or producers of primary commodities, as these goods are highly volatile. Minimum price protects producers from price falls in particular + keeps an industry going- by providing producers with a guaranteed income.
• Solve Market Failure: raising price to discourage consumption + production of goods/services which do a lot of harm to society (e.g. minimum price on alcohol).

Question 54

Explain the effects using a Price Floor, in an attempt to correct a Market Failure.

Answer 54

• The imposition of a minimum price means prices can’t legally go below this set price floor.
• If minimum price is set at Pmin (i.e. above the equilibrium), this leads to higher prices for producers selling the good.
• Demand contracts along the D curve so that quantity sold is now at QD
• However, at the new higher price, there’ll be excess supply of QDQS, as firms will wish to supply more at a higher price.

Question 55

Define a Minimum Price (Price Ceiling).

Answer 55

A fixed price (price ceiling) enacted by the gov usually set below the equilibrium market price.
* Gov is saying the equilibrium market price is too high, needs to be lowered
* Legally prices can’t be set any higher.

Question 56

Explain why the government may implement a Maximum Price.

Answer 56

• To increase affordability of necessity goods + services: allow more consumers to access the market. (e.g. renting accommodation market- renting controls).

Question 57

Explain the effects of using a Maximum Price, in an attempt to correct a Market Failure.

Answer 57

• Imposition of a max price at Pmax, below the market price, restricts prices charged by producers to Pmax.
• Reduces supply; there’s a contraction down the supply curve.
• Also leads to excess demand of Q2Q3, as consumers wish to demand more at a lower price.
• Gov may wish to impose a max price to prevent the consumer from being exploited

Question 58

Explain how Regulations are used to correct Market Failures.

Answer 58

• Regulation is undertaken by gov to tackle market failures, + improve efficiency + competitiveness in markets.
• Very wide range of regulations in UK economy that affect activities of firms + consumers. Significant regulations on industries such as telecoms, water + energy.
• Regulations can often be seen as restricting firms’ activities in the free market (e.g. rules on quality standards or employee rights)
• However, many regulations are designed to improve the operation of the market by increasing competing such as regulations on predatory pricing + collusion.
• If a regulation’s effective, it should: prevent consumers being exploited, improve efficiency in the market, lead to greater choice + lower prices for consumers.