4.1.8 The market mechanism, market failure and government intervention in markets Flashcards
What is the purpose of price mechanism?
It determines the market price and allocates resources in a free market economy, solving the economic problem of scarce resources.
What functions does price mechanism use to allocate resource?
Rationing mechanism, incentive and signalling function
How does the rationing mechanism work?
When there are scarce resources, price increases due to the excess of demand, discouraging demand and consequently rationing resources.
How does incentive work?
It encourages a change in behaviour of a consumer or producer. For example, a high price encourages firms to supply more to the market, as it is more profitable to do so.
How does signalling work?
The price acts as a signal to consumers and new firms entering a market, and price changes show where resources are needed in the market. For example, a high price signals firms to enter the market because it is profitable. It therefore shifts the demand and supply curves.
What are the advantages of the price mechanism?
- Can signal what the cost of purchasing a good is to a consumer, and acts as a signal to producers to tell them what revenue they will receive
- Allows consumers to gain sovereignty in the market, as they have ‘spending votes’ in the market, enabling them to choose what is bought and sold
What are the disadvantages of the price mechanism?
- There may be inequality in income and wealth with it, not considering what the distribution of income is, as those with money have buying power over those that do not
- The price mechanism and free market ignore inequality, it can be argued that inequality exists, but the degree of inequality may vary between capitalistic societies
- In a free market there is under-provision of public and merit goods, requiring government intervention
When does market failure occur?
Whenever a market leads to a misallocation of resources (not allocated to the best interests of society).
What are the consequences of market failure?
Economic and social welfare is not maximised, and economic problem is not answered as resources are misallocated.
What are the causes of market failure?
- Externalities, as there exists costs and benefits of consumption and production not considered by the market, so quantity sold on market is not the social optimum
- The under-provision of public goods, due to no profit being able to be made from their provision, so the market does not supply it
- Monopolies restricting output, leading to under-consumption of a good or service
- Information gaps leads to a misallocation of resources
- Inequalities in the distribution of income and wealth can lead to negative externalities such as social unrest
- Instability, such as price, where inflation/deflation can deter investment leading to no growth
When does complete market failure occur?
When there is a missing market, so the market does not supply the products at all.
When does partial market failure occur?
When the market produces a good at the wrong quantity or price, leading to misallocation of resources.
What are public goods?
Goods and services missing from the free market, that offer benefits to society, such as flood defences and street lights.
What are the characteristics of public goods?
They are non-excludable, so by consuming the good, someone else is not prevented from consuming the good as well, and people cannot be prevented from using it.
They are non-rival, so the benefit other people get from the good does not diminish if more people consume the good.
How does the free-rider problem occur?
Due to the non-excludable nature of public goods, people who do not pay for the good still receive benefits from it, in the same way people who pay for it do.
Why are public goods underprovided by the private sector?
Due to the free-rider problem, they do not make a profit form providing the good since consumers do not see a reason to pay for the good, if they still receive the benefit without paying.
Also, 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 the producers will overvalue, so they can charge more.
How are public goods provided?
By the government, by estimating what the social benefit of the public good is when deciding what output of it to provide. They are funded using tax revenue, but the quantity provided will be less than the socially optimum quantity.
