4.1.8 The Market Mechanism, Market Failure And Government Intervention Flashcards
Rationing functions
When there are scarce resources, price increases due to excess demand.
Incentive functions
This encourages a change in behaviour of a consumer or producer. E.g a high price would encourage firms to supply more to the market
Signalling function
The price acts as a signal to consumers and new firms entering the market. Price changes show where new resources are needed in the market
Price mechanism
Determines the market price, ‘the invisible hand of the market’
Advantages of the price mechanism
- impersonal method of allocating resources
- it acts as a signal to show the cost of purchasing a good to the consumer
- it signals to producers the revenue they will receive
- allows consumers to gain sovereignty in the market
- efficient allocation of resources
Disadvantages of price mechanism
- may be inequality in wealth as it doesn’t consider distribution of wealth
- ignores equality
- under provision of public goods and merit goods
Externality
The cost or benefit a third party receives from an economic transaction outside of the market mechanism
Public goods
Non excludable and non rival, they are underprovided in a feee market because of the free rider problem
Monopolies
Consumer has very little choice where to buy goods from so they are often over charged and under consumed
Non excludable
By consuming the good, someone else is not prevented from consuming the good as well
Non rival
The benefit other people get from the good does not diminish if more people consume the good
Quasi public good
Have characteristics of both private and public goods, semi excludable and semi rival
Tragedy of commons
Individuals priorities personal gain over the well being of society
Private good
Rival and excludable e.g chocolate bar
Social costs
Social costs=private costs+external costs
Who is Interested in benefits of a good or service?
The consumer so it is on the demand curve
Who is interested in the costs of a good or service?
Producers so it’s on the supply curve
Describe the negative production externality graph
- MSC is greater than MPC
* the welfare loss triangle points left to social optimum as it is over produced
Describe the positive production externality graph
- MPC is greater than MSC
* welfare loss triangle points right to SOE as it is underproduced
Describe the negative consumption externality graph
- MPB is greater than MSB
* welfare triangle points to the left to SOE as it’s over consumed
Describe the positive consumption externality graph
- MSB is greater than MPB
* welfare triangle points right to SOE as it’s under consumed
Symmetric information
Consumers and producers have perfect market information
Asymmetric information
Leads to market failure, where there is unequal knowledge between consumers and producers
Agent principal problem
When the agent makes decisions for the principal but the agent is inclined to act in their own interests
Market failure
A free market with a misallocation of resources
Merit good
Underconsumed in the free market and has a positive affect on the third party
Demerit good
Over provided in the free market, has negative affects on the third party
Free market
Where resources are allocated by supply and demand without government intervention
Social optimum
Where Marginal Social Cost (MSC) meets Marginal Social Benefits (MSB)
Consumer surplus
The difference between what someone is willing to pay and what they will pay
Welfare loss
The consumer surplus
Types of market failure
- externality
- under provision of public goods
- information gaps
- monopolies
- Inequality
Complete market failure
When a good isn’t provided so there is a missing market
Partial market failure
When the market provides a good but the wrong quantity or price
Free rider problem
People who don’t pay for the good still receive the benefits of it
Why are public goods under provided?
- free rider problem occurs
- tragedy of commons
- it is hard to measure the value consumers get from public goods so it is hard to put a price on it
Social benefit
Social benefit= private benefit + external benefit
Indirect taxes
Taxes placed in expenditure, they increase production costs and supply shifts inwards, ideally they are the size of the external cost
Ad valorem
Taxes are a percentage such as VAT which adds 20% of the unit price
Specific taxes
A set tax per unit, such as the 58p per litre fuel duty on unleaded petrol
Subsidies
A payment from the government to a producer to lower costs of production and increase supply, ideally it should be the value of the social benefit
Who takes most of the burden for a tax on a good which is inelastic
The consumer
Who takes most of the benefit of an inelastic good which has subsidised?
Consumers
Maximum price
The government set a max price where consumption of a good is to be encouraged (must be set below FM price)
Pros and cons of maximum price
✅they prevent monopolies from exploiting customers
✅could lead to welfare gains for consumer
✅could increase efficiency in firms since they have an incentive to keep costs low
❌could reduce a firms profit leading to less investment
❌firms might raise the price of other goods
Minimum price
The government might set a minimum price where consumption of a good is to be discouraged (must be set above FM price)
Pros and cons of pollution permits
✅should benefit environment in long run
✅the government could raise revenue from permits because they can sell them to firms
✅raises revenue for greener firms
❌could lead to firms relocating to where there are no pollution permits
❌firms might pass higher cost of production onto consumers
❌permits could create barrier to entry and reduce competition
❌expensive for government to monitor emissions
Government failure
When government intervention leads to a worse allocation of resources and there is a welfare loss to society
Causes of government intervention
- distortion of price signals
- unintended consequences
- excessive administrative costs
- information gaps
