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?
- 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, shifting 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?
- 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, meaning they are not allocated to the best interests of society.
What are the consequences of market failure?
Economic and social welfare is not maximised, and the economic problem is not answered as resources are misallocated.
What are the causes of market failure?
- Externalities, as costs and benefits of consumption and production are not considered by the market, so quantity sold is not the social optimum
- Under-provision of public goods, as no profit being can 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
- Inequalities in the distribution of income and wealth can lead to negative externalities such as social unrest
- Price instability, as 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?
- Non-excludable, so by consuming the good, someone else is not prevented from consuming it as well, and people cannot be prevented from using it
- Non-rival, so the benefit other people get from the good does not diminish as 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
- It is difficult to measure the value consumers get from public goods, so it is hard to put a price on it
- 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
- Funded using tax revenue, but the quantity provided will be less than the social optimum quantity
What are private goods?
- Goods supplied by the free market, as they are profitable for producers to make and sell
- They are rival and excludable
What are quasi (non-pure) public goods?
Goods with the characteristics of both public and private goods, partially provided by the free market.
What is an example of a quasi public good?
Roads, as they 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.
Why is technological change significant in changing excludability?
- For example, the introduction of subscriptions can make television broadcasting excludable, as it is only available to those willing and able to pay for them
- However, data sharing can decrease excludability
What is the tragedy of the commons?
- 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, leading to the negative externality of air pollution, resulting in market failure from common access
What is an externality?
- A cost or benefit a third party receives from an economic transaction outside of the market mechanism
- The spill-over effect of the production or consumption of a good or service
What does the supply curve represent when considering externalities?
Marginal private cost (MPC)
What does the demand curve represent when considering externalities?
Marginal private benefit (MPB)
What causes positive externalities?
Merit goods, causing information failure as consumers do not realise the long run benefits of consuming it.
What causes negative externalities?
Demerit goods, causing information failure as consumers are not aware of the long run implications of consuming it.
Why is the extent to which a market fails normative?
It involves a value judgement, so it is hard to determine what the monetary value of an externality is, such as the cost of pollution to society.
What are private costs?
- Private costs of production producers are concerned with, such as any factors of production, determining how much the producer will supply
- Could refer to the market price which the consumer pays for the good
What are social costs?
The total of private costs and external costs.
How are external costs shown on a diagram?
- The vertical distance between the marginal private cost and social cost curves
- The difference between private costs and social costs
What is private benefit?
- The benefit derived from the consumption of a good for a consumer, determined by the price the consumer is prepared to pay
- Could also be a firm’s revenue from selling a good
What is social benefit?
The total of private benefits and external benefits.
How is external benefit represented on a diagram?
The difference between the marginal private and social benefit curves.
What is the social optimum position?
The quantity/price at which MSC = MSB, and is the point of maximum welfare.
Describe a diagram showing a positive consumption externality.
- Qe where MPC/MSC (S) meets MPB (D), social optimum quantity Q1 where MPC/MSC (S) meets MSB to right of MPB
- Shows that product is underconsumed, creating a loss of economic welfare, deadweight loss
Describe a diagram showing a negative consumption externality.
- Qe where MPC/MSC (S) meets MPB (D), social optimum quantity Q1 where MPC/MSC (S) meets MSB to left of MPB
- Shows that product is overconsumed, creating a loss of welfare, deadweight loss
Describe a diagram showing a positive production externality.
- Qe where MPC (S) meets MPB/MSB (D), social optimum quantity Q1 where MPB/MSB (S) meets MSC to right of MPC
- Shows that good is underproduced, creating a loss of economic welfare, deadweight loss
Describe a diagram showing a negative production externality.
- Qe where MPC (S) meets MPB/MSB (D), social optimum quantity Q1 where MPB/MSB (S) meets MSC to left of MPC
- Shows that good is overproduced, creating a loss of welfare, deadweight loss
How is deadweight loss found on an externality diagram?
Find the point of private equilibrium, go vertically up/down depending on the externality, to the social benefit/cost.
What are the characteristics of demerit goods?
- Asymmetric information, as consumers are unaware of consequences of consumption
- Poor individual decision making, such as short termism
- Negative externalities of consumption
What are the characteristics of merit goods?
- Asymmetric information, as firms withhold information for short term profits
- Poor individual decision making, such as short termism
- Positive externalities of consumption
What are examples of demerit goods and what are their negative externalities?
- Alcohol, consequences of harmful addiction on others
- Cigarettes, second-hand smoke
What are examples of merit goods and what are their positive externalities?
- Education, higher skilled workforce
- Healthcare, such as vaccines resulting in herd immunity, more productive workforce
What does symmetric information mean?
Consumers and producers have perfect market information to make their decision, leading to an efficient allocation of resources
What does asymmetric information mean?
There is unequal knowledge between consumers and producers, leading to a misallocation of resources, therefore market failure
What does imperfect information mean?
Information is missing, so an informed decision cannot be made
What are examples of asymmetric information?
- A car dealer might know about a fault with the car that the consumer is unaware of
- Insider trading, where buyers have more information than the public, as they are not aware of the true value of the stock
- Adverse selection, such as where customers usually buy insurance when they have a greater need for it
What is the mobility of factors of production?
The ability of workers to change between jobs
What provides evidence that labour markets do not work efficiently?
Unemployment
What are examples of factor of production immobility?
Geographical immobility and occupational immobility, causing structural unemployment and possibly frictional unemployment
What is geographical immobility of factors of production?
The obstacles which prevent the factors of production moving between areas, such as labour finding it hard to find work due to family and social ties, the financial costs of moving, imperfect market knowledge on work and the regional variations in house prices and living costs
What is occupational immobility of factors of production?
- The obstacles which prevent factors of production changing their use, such as labour finding it difficult to change their occupation
- Occurred in the UK with the collapse of the mining industry, when workers did not have transferable skills to find other work
What are the causes of occupational immobility?
Insufficient education, training and skills, age and technological change
What is moral hazard?
- Risks that someone becomes more inclined to take as they have a reason to believe that an insurer will cover the costs of any damage, leading to a higher need for payouts, increasing the price of premiums, or under provision of the service
- For example, banks after the global financial crisis were bailed out by government funds, so were encouraged to make more risky loans
How can monopolies and monopoly power lead to market failure?
- Monopolies can exploit consumers by charging higher prices and underproducing as profit maximisers, leading to underconsumption of the product, causing a loss of allocative efficiency and therefore market failure
- However there can also be dynamic efficiency from supernormal profit, depending on how it is spent, and the market, such as a natural monopoly
What is the Competition and Market Authority (CMA)?
A department of the UK government aimed at strengthening business competition and reducing anti-competitive behaviour.
What is the role of the CMA?
- To reduce anti-competitive behaviour, such as monopoly and cartel exploitation, and price discrimination
- To increase contestability and competition within markets
- To oversee or control mergers
What is competition?
When rival firms in a market aim to increase their profits and market share.
What is contestability?
When incumbent firms are threatened by the entry of new firms.
How does the CMA reduce anti-competitive behaviour and increase competition and contestability?
- Break up cartels
- Regulate profit, such as windfall or excess profit taxes
- Price caps
- Fines for restrictive practices, including cutting quantity produced, buying up supply chains, dictating retailer behaviour and price discrimination
- Suggest nationalisation in certain markets
How has the UK government helped to increase competition in markets?
- By establishing the ‘Red Tape Challenge’
- Aiming to improve access to finance and reduce barriers to entry
What is the aim of the Red Tape Challenge?
To simplify regulation for small businesses, by making it cheaper and easier to meet environmental targets and create new jobs.
How has the Red Tape Challenge increased competition?
It aims to simplify regulation for SMEs, which are important for creating a competitive market, as they create jobs, stimulate innovation and investment, and promote a competitive environment.
What are SMEs?
Small and Medium Sized Enterprises.
What is deregulation?
The act of reducing how much an industry is regulated, reducing government power and enhancing competition.
What is nationalisation?
- When private sector assets are sold to the public sector
- The government gains control of an industry, so it is no longer in the hands of private firms
What are examples of nationalisation in the UK?
The railway industry in the UK was nationalised after 1945, along with the Bank of England and the coal industry in 1946.
What are arguments for the public ownership of firms and industries?
- Creation of natural monopolies, because, for example, it is inefficient to have multiple sets of water pipes, so only one firm provides water
- Natural monopolies have economies of scale, so produce at lower costs than if the industry was in the private sector
- Some nationalised industries yield strong positive externalities, such as public transport reducing pollution and congestion
- Nationalised industries have different objectives to privatised, which are mainly profit driven, so social welfare might be prioritised
- In the long term, sustainability and infrastructure is likely to be more improved
What is privatisation?
- When assets are transferred from the public sector to the private sector
- The government sells a firm so that it is no longer in their control, and the firm is left to the free market and private individuals
What are examples of privatisation in the UK?
The privatisation of British Airways, which now operates in the competitive market, as well as Royal Mail.
What are arguments for the privatisation of state-owned enterprises?
- The private sector gives firms incentives to operate efficiently, increasing economic welfare, due to firms operating on the free market having a profit incentive
- Firms have to produce goods and services consumers demand, increasing allocative efficiency, and can mean they are of a higher quality
- Competition might result in lower prices, as well as productive and X-efficiency
- Creative destruction is encouraged, allowing quicker development
- The public sector aims to protect workers’ jobs, which in the long term might lead to inefficiency, whereas the private sector prioritises efficiency, so will only keep efficient workers
- By selling the asset, government revenue is gained, but this is only a one-off payment
What are arguments against the public ownership of firms and industries?
- The government budget position is likely to worsen, as government revenue is needed to buy the business, as well as pay operating costs, which also creates an opportunity cost
- There is likely to be less flexibility and adaptability
- Less efficient due to lack of profit motive
What are arguments against the privatisation of state-owned enterprises?
- The level of quantity produced for merit and demerit goods will not be at the social optimum, as externalities are not taken into account by the free market
- Public goods will not be produced as there is no profit to be made
What are arguments for the regulation of markets?
- The government can make it illegal not to do something, such as the minimum school leaving age meaning young people have to be in school until 16, and in education or training until 18
- This has positive externalities in the form of a higher skilled workforce, therefore preventing market failure
- Regulation can prevent exploitation and support market stability, including enforcing competition
What are arguments against the regulation of markets?
- It could raise costs for firms, who might pass on the higher costs to consumers
- Enforcing regulation could entail high administrative costs for the government, creating an opportunity cost
- Bans on the consumption of goods might result in the creation of parallel markets, which cannot be regulated or taxed
- Excessive regulation is called ‘red tape’, which can limit the quantity of output a firm produces
- Government failure can occur due to information asymmetry or failure
What are arguments for the deregulation of markets?
By deregulating the public sector, firms can compete in a competitive market, which should help improve economic efficiency
What are examples of excessive regulation, also known as ‘red tape’?
- Environmental laws and taxes might result in firms only being able to produce a certain quantity before exceeding a pollution permit
- Excessive taxes, such as a high rate of corporation tax, might discourage firms earning above a certain level of profit, since they do not keep as much of it
- This could limit the size a firm chooses, or is able to, grow to
What is regulatory capture?
The risk that regulators start acting in the interests of the company, due to information asymmetry, rather than in consumer interests.
How might regulatory capture occur?
When the problem of asymmetric information makes it hard to determine what level a price cap should be imposed at.
What is the consequence of regulatory capture?
Without sufficient information, governments could make poor decisions and could lead to a waste of scarce resources.
What does market failure provide an argument for?
Government intervention
Why might governments intervene in a market?
To correct a market failure, such as the underprovision of healthcare and education
In what ways can governments intervene to influence the allocation of resources in a market?
Indirect taxes, subsidies, regulation and provision
What are the effects of indirect taxation on markets supplying demerit goods?
They increase production costs for producers, so supply decreases (shifts up) and demand contracts, increasing the price and decreasing the quantity produced, closer to the social optimum quantity where MSB = MSC
What does the impact of an indirect tax depend on?
- The extent of the tax needed is normative, due to the impact of the externality or information failure
- The size of the tax
- The price elasticity of demand and supply, as it determines by how much the resource allocation is changed, and the bearing of incidence
- The use of the tax revenue gained, so if it is hypothecated, meaning used to fix the negative externality or information failure
- The market structure, as monopolies can make consumers pay all the incidence
- The time the tax is enacted, as elasticity tends to increase over time
What is incidence?
Who becomes worse off from the introduction of a tax, so who pays more of the tax
What are the 2 different categories of indirect taxation and how do they differ when illustrated on a diagram?
- Ad valorem taxes, which are percentages, such as VAT which adds 20% of the unit price, and is the main indirect tax, shown on a diagram by a steeper (more inelastic) supply curve shifted upwards
- Specific/flat taxes, which are a set tax per unit, shown on a diagram by shifting the supply curve upwards with the same gradient
On a diagram showing an indirect tax, what price of the tax is paid by the consumer and what price of the tax is paid by the producer?
Consumers pay Pt-Pe of tax (above Pe), and producers pay Pe-Ps of tax (below Pe)
If Pt - Pe is greater than Pe - Ps, who bears more of the incidence?
The consumers
If Pt - Pe is less than Pe - Ps, who bears more of the incidence?
The producers
What is the relationship between the elasticity of supply and demand and incidence beared by producers and consumers as a result of an indirect tax?
The less elastic of supply and demand pays more of the incidence
What must be true if all incidence is paid by the consumers?
Supply is perfectly elastic
What must be true if all incidence is paid by the producers?
Demand is perfectly elastic
What is the relationship between the elasticity of supply and demand, and the impact of an indirect tax on resource allocation?
The less elastic either supply and demand are, the smaller the impact of the tax in resource allocation
What are the main concerns in analysing an indirect tax?
- If it internalises the externality, meaning if the externality cost is shifted from the third party to the producer, so they pay the cost of it instead of creating it
- If it shifts the quantity of price equilibrium to the social optimum quantity where MSB = MSC
What is a subsidy?
A payment from the government to a producer to lower their costs of production and encourage them to produce more
What is the aim of a subsidy?
To encourage the consumption of merit goods, by including the full social benefit in the market price of the good, therefore internalising the external benefit, and moving the quantity towards the social optimum where MSB = MSC
What are the effects of subsidising a market supplying a merit good?
The supply is increased (shifted down), extending demand and moving the price-quantity equilibrium towards the quantity where MSB = MSC
What does the impact of a subsidy depend on?
- The positive externality of the merit good, as its extent is normative
- Possible inefficiency from businesses depending on the subsidy
- The opportunity cost of the government spending
On a diagram showing a subsidy, what price of the subsidy is received by the producer and what price of the subsidy is received by the consumer?
P2 - Pe is received by the producer, Pe - Ps is received by the consumer
If P2 - Pe is greater than Pe - Ps, who gains more of the benefit?
The producers
If P2 - Pe is less than Pe - Ps, who gains more of the benefit?
The consumers
What is the relationship between the elasticity of supply and demand and benefit gained by producers and consumers as a result of a subsidy?
The greater benefit is gained by the less elastic of supply and demand
What is the relationship between the elasticity of supply and demand, and the impact of a subsidy on resource allocation?
If demand and supply are more elastic, the quantity increases by more
What is the relationship between the elasticity of supply and demand, and the cost of a subsidy?
The higher the PED/PES, the higher the cost of the subsidy
What is another term for a maximum price?
A price cap or ceiling
What is the purpose of a maximum price?
To encourage the consumption or production of a good, by making sure it does not become too expensive to produce or consume
Where do maximum prices have to be set?
Below the free market price
What are the impacts of a maximum price?
- A shortage of Qd - Qs, leading to rationing
- Welfare gains for consumers by keeping prices low
- Efficiency increases in firms as they have an incentive to keep their costs low and maintain their profit level
- Could reduce a firm’s profits, leading to less investment in the long run
- Firms could raise the prices of other goods, so consumers might have no net gain
- Could lead to government failure if the optimum market price is misjudged
What is an example of a maximum price?
New York City rent caps
What is another term for a minimum price?
A price floor
What is the purpose of a minimum price?
To discourage the consumption or production of a good, ensuring the good never falls below a certain price
Where do minimum prices have to be set?
Above the free market price
What is an example of a minimum price?
The National Minimum Wage
What are the effects of a minimum price?
- A surplus of Qs - Qd, resulting in wasted goods that the government may have to purchase to store or give away
- Can lead to parallel markets, as the high price encourages development of illegal markets where the good is sold at lower prices, such as alcohol
- Loss of consumer welfare due to higher price, but ensures income to producers in volatile markets, such as agriculture
What are pollution permits?
Licenses provided by the government for firms in polluting industries to allow them to pollute up to a certain amount, and can be traded between firms
What is an example of a pollution permit in the UK?
ETS, which provides a limit on the quantity of carbon dioxide emissions released by firms
How is the supply of pollution permits represented on a diagram?
A perfectly inelastic supply curve
Why is the supply of pollution permits perfectly inelastic?
The government provides a fixed number of them
What determines the price of a pollution permit?
Demand
Why might the demand for pollution permits increase?
As an economy experiences growth, the level of production will increase, meaning firms in polluting industries will need polluting permits to produce a higher quantity of goods
Why should the supply of pollution permits decrease over time?
As the economy develops and becomes more sustainable, there will be less need for pollution permits, so the government may decrease the number provided
What are the advantages of pollution permits?
- The environment should benefit in the long run, as firms are encouraged to use less polluting production methods to cut down costs from paying for the permit
- The government can raise revenue from permits, as they can sell them to firms, which could be reinvested into green technology
- If firms exceed their permit, they will have to purchase more permits from firms not using their whole permit, raising revenue for greener firms, who might then invest in green production methods
What are the disadvantages of pollution permits?
- Firms may relocate to where they can pollute without limits due to the higher production costs, meaning less domestic production and output
- Firms can pass the higher costs of production onto the consumer to retain profit
- If the permits create a barrier to entry for potential firms, competition is restricted in the market
- The cost for the government to monitor emissions may not justify the revenue received
What does the impact of pollution permits depend on?
- The extent of the pollution, which is normative
- Possible inefficiency from intervention, due to government failure
- If the level of pollution can be measured accurately and truthfully
What are arguments for the provision of public goods?
- Under-provided goods are provided in the free market, such as education and healthcare, which have external benefits
- It makes merit goods more accessible, which might increase their consumption and yield positive externalities
What are arguments against the provision of public goods?
It could be expensive for governments to provide education and healthcare, and the government will incur an opportunity cost of spending their revenue.
What are arguments for the provision of 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 the car, so consumers know exactly what they are buying
What are arguments against the provision of information?
It could be expensive to police, and creates an opportunity cost of government spending.
What are property rights?
They define the legal ownership of resources and the extent to which the owner can use them.
What are arguments for the extension of property rights?
- Addresses market failure by internalising externalities, such as limiting pollution emitted by a factory, or the preservation of green spaces, benefitting society with cleaner air, biodiversity and recreation opportunities
- Ownership creates an incentive to manage resources sustainably and efficiently as the owner can profit from their resource while protecting its value for the future
- Therefore eliminates the tragedy of the commons since resources are no longer shared but owned
What are arguments against the extension of property rights?
- Extending property rights can disproportionately benefit those with the resources to enforce or acquire them, potentially increasing inequality
- If poorly regulated, they can lead to new inefficiencies, such as monopolies or speculative behaviour
- Monitoring and enforcing them can be expensive for governments, as well as complex in the case of public goods such as the air and oceans
What is government failure?
When governments intervene in a market, worsening a market failure already present or creating a new one, resulting in a net welfare loss to society and a misallocation of resources.
How does government failure result in a net welfare loss to society?
From having ineffective intervention, to when harm is caused.
What are possible sources of government failure?
- Unintended consequences
- Regulatory capture
- Information gaps
- Distortion of price signals
- Corruption
- Excessive administrative costs
How is the distortion of price signals a possible source of government failure?
- Government subsidies could distort price signals by distorting the free market mechanism, which free market economists would argue would lead to government failure
- There could be an inefficient allocation of resources as the market mechanism is unable to act freely
- For example, an industry which is failing or has few prospects may be subsidised
What are unintended consequences?
When government intervention results in unexpected or unforseen outcomes.
What is an example of government intervention resulting in unintended consequences?
The prohibition of alcohol in the USA created parallel markets, in which low quality products were sold, resulting in a negative externality as people’s health decline, decreasing their productivity, as well as social unrest increasing.
Why might administrative costs be a source of government failure?
The social benefits of a policy might not be worth the financial cost of administering the policy, as it might cost more than the government anticipated, so it has to consider whether the policy is good value for money
Why might information gaps be a source of government failure?
- Some policies might be decided without perfect information
- This might require a full cost-benefit analysis, which is likely to be time consuming and expensive, as well as inaccurate
- However, it is impractical for governments to gain every bit of information they need, so assumption are made
What is an example of information gaps being a source of government failure?
Government housing policies are long term, and have failed several times in the past.
Why might corruption be a source of government failure?
- Politicians may take money from the private sector to promote their interests, leading to a misallocation of resources
- The political business cycle, such as the 5 year election cycle in the UK, resulting in instability, disrupting the economy and resource allocation
