8 - The Market Mechanism, Market Failure and Government Intervention in Markets Flashcards
What are the functions of prices?
- Signalling
- Incentive
- Rationing
- Allocative
How are resources allocated in the free market economy?
Price mechanism
What does the signalling function mean in the price mechanism?
Price acts as the signal (information) to consumers and firms. Price changes show where resources are needed in the market.
What does the price incentive function mean in the price mechanism?
This encourages a change in behaviour of a consumer or producer. Higher price would encourage firms to supply more to the market because it is more profitable.
What does the rationing function mean in the price mechanism?
Rising prices ration demand for the product. Lowering prices ration supply of the product.
What does the allocative funtion mean in the price mechanism?
This is where the markets scarce resources are placed between markets. Resources from markets with excess supply are removed. And resources are added to markets with excess demand.
What did the Adam Smith refer to the price mechanism?
‘The Invisible Hand of the Market’
What are the advantages of the price mechanism?
The price mechanism allows the consumer to gain sovereignty in the market. They have ‘spending votes’ in the market, which enable them to choose what is bought and sold. Consumer is DOMINANT
Is a method of allocating resources, in theory it leads to a productively efficient allocation of resources.
What are the disadvantages of the price mechanism?
However there may be inequality in income and wealth with the price mechanism. Those with money have buying power. Essentially, price mechanism ignores inequality.
Also, in a free market there is under supply of public and merit goods, so gouvernement intervention is required
What is Market Failure?
When the market mechanism leads to an MISALLOCATION of resources in the economy, either completely failing to provide a good or service of providing the wrong quantity.
What is complete market failure?
Occurs when there is a missing market. The market does not supply the products at all.
What is partial market failure?
When the market produces a good, but it is the wrong quantity or the wrong price. Resources are misallocated where there is partial market failure.
What are the types of Market failure?
Externalities
The under-provision of public goods
Information gaps
Monopolies
Inequalities in the distribution of income and wealth
Explain how externalities create market failure?
An externality is the cost of benefit a third party receives from an economic transaction outside the market mechanism. The spill over effect of the production or consumption of a good or service, like cigarettes. Positive externalities are caused by the consumption of merit goods, such as recycling schemes.
Explain how the under-provision of public goods create market failure?
Public goods are non-excludable and non-rival, and they are under provided in a free market because of the free-rider problem.
Explain how information gaps create market failure?
It is assumed consumers and producers have perfect information when making economic decisions. This is rarely the case and lack of information cause misallocation of resources.
Explain how monopolies create market failure?
Since consumers have very little choice where to buy goods from offered by a monopoly, they are often overcharged. Leading to the under consumption of a good or service. Therefore a misallocation of resources as consumer needs and wants aren’t fully met.
Explain how Inequalities in the distribution of income and wealth create market failure?
There is an inequitable distribution in income and wealth. Income refers to a flow of money, whilst wealth refers to a stock of assets. This can lead to negative externalities like Social Unrest.
What are private goods?
A good that is excludable and rival. For example an orange can only be consumed by one consumer.
Explain the two characteristics of a private good.
Excludable good - people who are unprepared to pay can be excluded from benefiting from the good.
Rival good - when one person consumes a private good, the quantity available to others diminishes.
What is a public good?
A good which is non-excludable and non-rival, like a lighthouse, street lights, flood control system, National defense, police
What is the problem with public goods in the free market.
Public goods are not provided but they offer benefits to society.
Explain the two characteristics of public goods.
Non-excludable - by consuming the good someone else is not prevented from consuming the good aswell.
Non-rival - the benefit other people get from the good does not diminish if more people consume the good.
Why are public goods not provided in the free market?
The non-excludable nature of the public good gives rise to the free-rider problem. People who pay for the good still receive the benefits from it, as the people who don’t pay for the good. This is why public goods are under provided in the private sector as they do not make a profit as consumers do not see the need to pay as they still receive the benefits without paying.
What are Quasi Public goods?
A good which is not fully non-rival and/or where it is possible to exclude people from consuming the product. Have characteristics of both public and private goods.
Roads are semi-excludable as there are toll roads and semi-non-rival as if it’s rush hour people are not able to use it.
How has technical change changed previously pure public goods to quasi public goods?
Television broadcasting in now excludable with subscriptions available to those willing and able to pay for them.
Roads also now have electronic pricing to charge all motorists for road use, ULEZ.
What is the tragedy of the commons?
Refers to how individuals prioritise personal gain over the well-being of society. The tragedy of the commons is a situation where there is overconsumption of a particular product/service because rational individual decisions lead to an outcome that is damaging to the overall social welfare.
For example, hypothetical area of common grazing land, in which villagers all took their cows to this common grazing land, but this led to overgrazing and a loss of the resource.
A resource held in common means no one owns the resource but everyone can access it
For example, the problem of over-fishing in areas where fishing grounds are poorly protected
What is an externality?
An externality is the cost or benefit a third party receives from an economic transaction outside the market mechanism.
Spill over effect of the production or consumption of a good or service.
Key feature, externalities are produced and received outside the market, can’t be bought or sold.
What is 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 the negative externalities?
An external cost that occurs when the consumption or production of a good causes a cost to a third party, where the Social Cost is greater than the Private Cost .
What are negative externalities caused by?
And give an example
Demerit goods. Associated with information failure, since consumers are not aware of the long run implications of consuming the good, and they are usually overprovided. For
example, cigarettes and alcohol are demerit goods. The negative externality to third parties of consuming cigarettes is second-hand smoke or passive
smoking.
What are positive externalities caused by?
With example
Caused by merit goods. These are associated with information failure too, because consumers do not realise the long run
benefits to consuming the good. They are underprovided in a free market. For example, education and healthcare are merit goods. The positive externality to third parties of education is a higher skilled workforce.
What is a property right?
The exclusive authority to determine how a resource is used. Like an owner of house
Explain negative consumption externalities.
An example would be going to the cinema and having people on their phones and talking loudly making the experience worse.
Walking trough litter and chewing gum.
Explain negative production externalities in a power house.
A negative production externality (or external cost) from a power station such as pollution. The power station evades paying the true real costs of production to the negative effects on the third parties.
For example the people living in near by houses respiratory problems and visual pollution, people in the commercial forest industry from acid rain caused by pollution.
This under-pricing of the good promotes over-consumption of electricity and therefore over-production of both electricity and pollution.
Explain positive production externalities in a power house.
Production of electricity yields positive production externalities (external BENEFITS). The power station discharges the warm water used into the local lake. Warmer Tempreture increases fish. Therefore fishing boats and fishermen benefit from the power house .
Explain positive consumption externalities.
A good example are passer-by walking past beautiful houses or gardens and gaining pleasure.
Atomosphere created by other people also add pleasure like watching a football match on TV or picking a restraunt .
However positive consumption is very subjective could be negative for others
How do externalities lead to the ‘wrong’ quantity of a good being consumed and produced?
Negative externatlities of production do not take into account the true cost, the third party cost, therefore are under valued. The market has created the wrong incentives Therefore Too much of the good ends up being produced and consumed.
Opposite happens for positive production externalities. Prices end up too high, wrong incentives, this discourages consumption. Not enough of the good is produced or consumed
Explain how the fishing industry has fallen victim to the tragedy of the commons.
Fishing shortages have become apparent due to no regulation and people fishing as many fish as possible in order to make the most amount of money from selling fish.Without keeping enough fish in the sea to keep fish stock high from reproduction. This causes for fish to migrate away and no new breeding stock coming through.
Example of environmental market failure has caused change for Great Britain.
The great Smog in 1952 a mixture of smoke and pollutants. Caused for the Clean Air Act to be introduced. So pollution was to be regulated. As the increase in deaths per day drastically from the smog.
Where does private benefit maximisation occurs:
Marginal Private Benefit (MPB) = Marginal Private Cost (MPC)
Where does social benefit maximisation occurs:
Marginal Social Benefit (MSB) = Marginal Social Cost (MSC)
MSB =
MPB + MEB
(Marginal Private Benefit + Marginal External Benefits)
MSC =
MPC + MEC
(Marginal Private Cost + Marginal External Cost)
What does the private cost determine?
Private costs like rent, Labour, affect the amount supplied and the market price
Where is the external costs on a diagram?
External costs are shown by the vertical distance between the two curves. In other words, external costs are the difference between private costs and
social costs.
What determines the private benefit and what is it?
The price consumers are prepared to pay decides this.
Private benefits could also be a firm’s revenue from selling a good.
Where is external benefits on a diagram?
External benefits are the difference between private and social benefits.
Draw the diagram to show how negative production externalities cause market failure?
Explain this diagram.
The vertical distance between two curves MSC and MPC shows the MEC, marginal external cost
Explain the dead weight loss in this negative productive externalities diagram.
Explain how the MPB and MSB can be written as a straight line in this diagram.
Assuming that there are only negative externalities are being produced no positive externalities. Therefore the MSB and MPB is the same, this is a simplification. For example assuming only pollution is released in a power station.
Draw the diagram to show how postive production externalities cause market failure?
Explain this diagram.
The vertical distance between the two curves MSC and MPC shows a negative external cost (MEC) at each level
Explain the welfare loss in this diagram.
Why is the MPC curve above the MSC curve in this diagram?
Why the absence of property rights leads to externalities in both production and consumption and hence market failure?
Markets become inefficient where there are no property rights. For example:
1) It is practically impossible to establish property rights on goods such as sea water and air. This means that free-riders can have unlimited access, which results in the exploitation of the good.
2) The moral hazard assumes someone else will pay the consequences for a poor choice. For example, some people might litter the street if they think that other people will clear up after them.
3) Scarce resources could be over-used or exploited. For example, rainforests are depleting and many species of fish are becoming endangered. This is because the environment cannot be protected by applying property rights.
What is a Merit Good?
A good, such as healthcare and education, for which the social benefits of consumption exceed the private benefits. They have two characteristics, usually have positive externalities and people lack information on the true benefit. A value judgement is required in deciding whether it’s a merit good.
What is diagram for the positive consumption externalities (merit good)?
A
Explain this Diagram for the positive consumption externalities with the merit good Education?
Draw the diagram to show how negative consumption externalities can cause over-consumption of demerit goods.
Explain this diagram.
How is reducing public spending a case FOR privatisation?
How is Natural Monopoly a case AGAINST privatisation?
Privatisation creates private monopolies, such as water companies and rail companies. These need regulating to prevent abuse of monopoly power. Therefore, there is still a need for government regulation, similar to under state ownership.
How is Short-terminism wins against long-terminism a case AGAINST privatisation?
How is selling the ‘family silver’ a case AGAINST privatisation?
Draw a diagram for tax
Draw diagram for the taxation of cigarettes.
Demand inelastic big change in price results is small change of demand. Consumers may also have a high tax burden.
Explain this diagram.
The incidence of tax might fall differently on consumers and producers. Producers could make consumers pay the whole tax (P3 – P2), or if they feel this would lower sales and lose them revenue, they could choose to pay part
of the tax. Producers might pay P1 – P2, whilst consumers might pay P3 – P1.
The incidence of the tax depends on the price elasticity of demand of the good. For cigarettes, since the demand is fairly price inelastic, consumers might have the larger burden of tax.
This should, in theory, discourage consumption of the demerit good and reduce negative externalities.
Government revenue from ad valorem taxes is larger if demand is price inelastic. This is because demand falls only slightly with the tax.
Draw a diagram for government intervention with subsidy.
Explain this government intervention diagram for subsidies.
The supply curve shifts to the left. More of the merit good is produced and the price falls from P1 to P2.
The vertical distance between the supply curves shows the value of the subsidy per unit.
Consumers gain more from the subsidy when demand is price inelastic, whilst producers supply more when demand is price elastic.
What is the price minimum diagram?
What is the price maximum diagram?
Explain this maximum price diagram?
Maximum prices have to be set below the free market price, otherwise they would be ineffective. The free market equilibrium is at P1, Q1.
If suppliers only produced at Q3, some consumers would be willing to pay P2. The shaded area shows the consumer surplus producers can take with the higher price.
A quantity of Q3 would require rationing or auctioning, since quantity demanded is Q2
Draw the diagram for pollution permits.
