8. The market mechanism, market failure and government intervention in markets Flashcards
What is the signalling function of prices?
Prices provide information to buyers and sellers
What is the incentive function of prices?
Prices create incentives for people to alter their economic behaviour, e.g. a higher price creates an incentive for firms to supply more of a good or service
What is the rationing function of prices?
Rising prices ration demand for a product
What is the allocative function of prices?
Changing relative prices allocate resources away from markets exhibiting excess supply and into markets in which there is excess demand
What four functions do prices perform?
- Signalling information
- Creating economic incentives
- Rationing scarce resources
- Allocating them between competing uses
What is the advantage of the operation of the price mechanism in competitive markets?
Promoting consumer sovereignty
What happens when consumer sovereignty ‘the consumer king’ exists?
Firms and industries that produce goods other than those for which consumers are prepared to pay, do not survive in highly competitive markets
What does the operation of the price mechanism lead to in imperfectly competitive markets and monopoly
An outcome in which firms exploit their producer sovereignty. In these situations, ‘the producer is king’
What is the price mechanism?
‘Value neutral’ in that it has no regard for equality and the fairness or otherwise of the allocation of buying power between different income groups
What is market failure?
When the market mechanism leads to a misallocation of resources in the economy, either completely failing to provide a good or service or providing the wrong quantity
What is complete market failure?
A market fails to function at all and a ‘missing market ‘ results
What is partial market failure?
A market does function but it delivers the ‘wrong’ quantity of a good or service, which results in resource misallocation
What is a missing market?
A situation in which there is no market because the function of prices have broken down
What is a private good?
A good that is excludable and rival, such as an orange
What is an excludable good?
People who are unprepared to pay can be excluded from benefiting from the good
What is a rival good?
When one person consumes a private good, the quantity available to others diminishes
What is a public good?
A good that is non-excludable and non-rival, such as a radio programme
What is a quasi-public good?
A good which is not fully non-rival and/or where it is possible to exclude people from consuming the product e.g. roads
What are some examples of public goods?
National defence, police, street lighting, roads, and terrestrial television and radio programmes
When does the optimal level of consumption for public goods and quasi-public goods occur?
When they are available free of charge - providing there is no capacity constraint
What is externality?
A public good, in the case of an external benefit, or a public bad, in the case of an external cost, that is ‘dumped’ on third parties outside the market
What is a positive externality?
An external benefit that occurs when the consumption or production of a good causes a benefit to a third party, where the social benefit is greater than the private benefit
What is a negative externality?
An external cost that occurs when the consumption or production of a good causes costs to a third party, where the social cost is greater than the private cost
What is property right?
The exclusive authority to determine how a resource is used
What is a free-rider problem?
A free rider is someone who benefits without paying as a result of non-excludability. Customers may choose not to pay for a good, preferring instead to free ride, with the result that the incentive to provide the good through the market disappears
What is production externality?
An externality (which may be positive or negative) generated in the course of producing a good or service
What is consumption externality?
An externality (which may be positive or negative) generated in the course of consuming a good or service
What is a merit good?
A good, such as healthcare and education, for which the social benefits of consumption exceed the private benefits. Value judgements are involved in deciding that a good is a merit good
Once consumed the resulting positive externalities benefits other people
What is information failure?
Occurs when people make wrong decisions because they do not possess or they ignore relevant information. Very often they are myopic (short-sighted) about the future
What is Social benefit?
The total benefit of an activity, including the external benefit as well as the private benefit. Expressed as an equation: social benefit = private benefit + external benefit
What is a subsidy?
A payment made by government or other authority, usually to producers, for each unit of the, subsided good that they produce. Consumers can also be subsidised: for example, bus passes given to children to enable them to travel on buses free or at a reduced price
What is demerit goods?
Goods, such as tobacco, for which the social costs of consumption exceed the private costs. Value judgements are involved in deciding that a good is a demerit good.
Once consumed the resulting positive externalities harm other people
What is social cost?
The total cost of an activity, including the external cost as well as the private cost. Expressed as an equation: social cost = private cost + external cost
What is a moral hazard?
The tendency of individuals and firms, once insured against some contingency, to have so as to make that contingency more likely
What exceeds the short-term private benefit of consumption?
The long-term private benefit resulting from consuming a merit good
What is immobility of labour?
The inability of labour to move from one job to another, either for occupational reasons (e.g. the need for training) or for geographical reasons (e.g. the cost of moving to another part of the country)
What are firms in a imperfectly competitive market likely to lack?
Accurate information about how their rivals may react to their pricing decisions
What might imperfectly competitve firms do to get rid of uncertainty?
May be tempted to collude, and in some cases to form cartels. A cartel has the disadvantages but not the advantages of monopoly. As the next section explains, by restricting output and raising prices, monopoly is a form of market failure
How does geographical immobility of labour?
When workers find it difficult or impossible to move to jobs in other parts of the country or in other countries for reasons such as higher housing costs in locations where the jobs exist
What is competition policy?
The part of the government’s microeconomic policy and industrial policy which aims to make goods markets more competitive. It compromises policy toward monopoly, mergers and restrictive trading practices
What is the Competition and Markets Authority (CMA)?
A government agency responsible for advising on and implementing UK competition policy
It adopts a cost-benefit approach to competition policy
What does monopoly lead to?
The manipulation of consumers and the exploitation of producer sovereignty
What happens after restricting output and raising prices?
Monopoly results in a net welfare loss as well as a transfer of consumer surplus into producer surplus and monopoly profit
What are the aims of competition policy?
- Preventing the exploitation of monopoly power
- Reducing costs of production
- Improving efficiency
- Getting rid of excessive profit so that prices reflect costs of production
- Removing entry and exit barriers which separate markets
What is public ownership?
Ownership of industries, firms, and other assets such as social housing by central government. The state’s acquisition of such assets is called nationalisation
What is privatisation?
The transfer of assets from the public sector to the private sector
Arguments for privatisation?
- Revenue raising
- Reducing public spending and the government’s borrowing requirement
- The promotion of competition (through the break-up of monopoly)
- The promotion of efficiency
- Popular capitalism
Arguments against privatisation?
- Monopoly abuse
- Short-termism wins over long-termism
- Selling the ‘family silver’ (getting rid of something valuable in order to get a quick advantage when it would be better to keep it for an advantage in the future e.g. capital assets)
- The free-lunch syndrome (opponents claiming that state-owned assets have been sold too cheaply, encouraging the belief among first-time share buyers that there is such a thing as a free lunch
What is regulation and why is it used?
The imposition of rules and other constraints which restrict freedom of economic action.
Its used to limit and deter monopoly exploitation of consumers e.g Ofwat who regulate privatised utility industries and the railways
What is deregulation?
The removal of previously imposes regulations
What is regulatory capture?
Occurs when regulatory agencies act in the interest of regulated firms rather on behalf of the consumers they are supposed to protect
What are publicly owned or state-owned industries also known as?
Nationalised industries
What was public ownership regarded as and used as
Was regarded as essential for efficient operating of key industries which were regarded as too important to be left to the vagaries of private ownership and market forces
It was used as a method of regulating the problem of monopoly - in particular, the problem of natural monopoly in the utility industries
What is tax?
A compulsory levy imposed by the government to pay for its activities. Taxes can also be used to achieve other objectives, such as reduced consumption of demerit goods
What is a price ceiling?
A price above which it is illegal to trade. Price ceilings, or maximum legal prices, can distort markets by creating excess demand
What is a price floor?
A price below which it is illegal to trade. Price floors, or minimum legal prices, can distort markets by creating excess supply
Reasons for government intervention in markets?
- The correction of market failures, which includes government provision of public goods and merit goods and forcing or incentivising firms and consumers to generate positive externalities
What are some methods of intervention?
Regulation and taxation, the imposition of price ceilings and price floors, and the introduction of pollution permits
What is government failure?
Occurs when government intervention reduces economic welfare, leading to an allocation of resources that is worse than the free-market outcome
What are some reasons for government failure?
- The pursuit of conflicting policy objectives
- Administrative costs
- The ‘law of unintended consequences’
- Decisions made on the basis of inadequate information
What are some examples of possible government failure?
- Government price controls create black markets
