Free Markets Flashcards
What is a free market economy also known as
The market mechanism/the price mechanism
What is the market mechanism
It is a system of allocating scarce resources by allowing consumers and producers to come together freely to agree what to exchange and for what price
What are the 3 functions of a price mechanism
The signalling function
The incentive function
The rationing function
What is the signalling function
That prices provide information to buyers and sellers about the scarcity of a good and shows them about the cost of their actions
Consumers that pays a high price for a good has a high opportunity cost
Producers that is selling a cheap good has a high opportunity cost
What is the incentive function
Firms are incentivised by potential profit and as prices change the profitability of production changes
The function refers to movements along the supply curve
What is the rationing function
It is the method of changing prices to decide who gets the limited good by increasing prices if there is too much demand and vise versa
This refers to extensions and contractions along the demand curve
What 3 problems exist in a free market
What to produce
How to produce it
For whom to produce
How is the problem of what to produce solved
Private firms compete against each other to meet consumer demand and earn profit
The firms which meet consumer preferences will make the lost profit
Consumers decide what to produce by deciding what to buy
This is called Consumer Sovereignty
How is the problem of how to produce goods decided
Firms engage in free and open competition and are motivated by profits
The firm which uses its resources most effectively are able to sell at the lowest price and earn the most profit
This is known as competition
How is the problem of for whom to produce solved
Prices are set at a price so quantity demanded equals quantity supplied and so price acts as a rationing mechanism and the goods given to people able to pay
What are externalities
They are a type of allocative inefficiency when external effects are placed on third parties who are not involved in the production or consumption of the good or service
This causes too many or too few resources to be used bu over or under producing
What do externalities cause
Partial market failure
What happens when only the seller and buyer are effected
Then all the costs and benefits are private and internal
What will cause a rational buyer and seller to by or sell
If their private benefits exceed their private costs
What types of externalities are there
Externalities can be positive or negative e.g. perfume and alcohol
They can also happen when the good is being produced or consumed
What are the two reasons for market failure
Public goods and externalities
What are public goods
They are non-rivalry - consumption of the good doesn’t leave any less for others
There is non-excludability - No one can be prevented from enjoying the benefits of the good if they didnt pay - Free Riders
There is non-rejectability - Consumers cant decide whether to consume the good or not
What are examples of public goods
Street lighting
Firework displays
Flood barriers
What problem does public goods cause
They have the free rider problem which means private firms cant force people to pay so providing the good isnt profitable so isnt produced
This causes the good to not be produced at all and a market goes missing
What are Quasi-Public goods
Non pure public goods
Goods that meet all the characteristics of a public good some of the time
Meet some of the characteristics of a public good
When is a market allocatively efficient
When the market is at equilibrium
No shortages or surpluses
Social Welfare is maximised
What is social welfare
The sum of consumer surplus and producer surplus
What is the demand curve also know as
Marginal Private Benefit
MPB
Why is the new demand curve named like that
Because a rational buyer will be assessing the extra benefits, or marginal utility, that he will receive from consuming the good
What is another name for the supply curve
Marginal private cost
Why is the new supply curve named like that
A rational seller will think how much it costs to make the next unit of output and whether it can be sold profitably
Where is free market welfare maximised on a MPB and MPC graph
At the equilibrium where MPB = MPC
Move to far too the right and there is more cost than benefit
What are the names of the demand and supply curve changed to when they take into account externalities
Marginal Social Costs
Marginal Social Benefits
How do you measure the size of an externality
It is the vertical distance between the new supply or demand curve and the old one
What curve will move when the externality happens at the point of production
The MPC
Supply
What curve will move when the externality happens at the point of consumption
The MPB
Demand
When externalities are present what point is most allocatively efficient
MSB = MSC
What is the welfare or deadweight loss on an allocativly inefficient graph
The triangle that represents the net benefit to society that is lost because not enough or too many resources were produced
Triangle connects the three lines together
Triangle points left when the externality is negative
Triangle points right when the externality is positive
What are goods called with positive externalities
Merit Goods
What are goods with negative externalities called
Demerit Goods
What do negative externalities lead to
Overproduction of a good
What does positive externalities lead to
Underproduction of a good
What is information failure
When consumers and producers are not fully aware of all the costs and benefits of a transaction
What does information failure cause
It means that it will be impossible for consumers and producers to trade the right amount of output
What are the causes of information failure
Consumer ignorance of the costs and benefits
The disconnection in time between the costs and benefits being felt
Consumers are deceived
Complex Information
Asymmetric Information
What will happen if consumers underestimate the costs or overestimate the benefits of consumption
They will overconsume the good
The MPB will shift inwards when they have full information
What will happen if consumers overestimate the costs or underestimate the benefits of consumption
The consumers will under consume the good
The MPB would move outwards when they have the full information
What happens when there is information failure with a demerit good
There is over consumption
What happens when there are negative production or consumption externalities with a demerit good
Over consumption and over production
What happens when there is information failure for merit goods
Under consumption and production
What happens when there are positive production and consumption externalities with merit goods
Under consumption and production
Examples of supply side policies
Deregulation of markets e.g. Banking, energy supply
Industry Privatisation e.g. Royal Mail
Work Visa’s for occupations like doctors, engineers, vets - Points based immigration system
Industry Regulation e.g. environmental laws affecting waste - drive innovation
Fiscal supply side policies e.g. early year childcare
Tax incentives for specific sectors - life sciences
What are property rights
It is when a firm or group is given the rights to a common resource
What are the advantages of property rights
It incentives the owners not to exploit common resources
The negative externalities are internalised
Will reduce the quantity to socially optimal level
What are the problems with property rights
Hard to distribute efficiently
Enforcement costs money
Hard to judge equity
What is 1st degree price disrimination
Charging different prices for each individual unit purchased
What is 2nd degree price discrimination
Prices varying by quantity sold
Prices varying by time of purchase
What is 3rd degree price discrimination
Charging different prices to groups of consumers segmented by price elasticity of demand, income, age, sex
How do you show 3rd degree price discrimination in a diagram
2 different diagrams
One with elastic price elasticity of demand and one with inelastic
The MC is a flat line and the same for both diagrams
What are the advantages of price discrimination
Makes better use of spare capacity - less waste and unsold stock
Helps generate cash flow for firms which can ensure they survive in recession
Can help fund cross subsidy of goods and services
Higher monopoly profit can finance research which improves dynamic efficiency and lead to social benefits
What are the disadvantages of price discrimination
Price discrimination mainly benefits producers as they turn consumer surplus into profit
Can be used as a pricing tactic to reduce competition
May lead to manipulation of groups with inelastic demand
Can be perceived as unfair or inequitable to certain groups
What is the evaluation of price dicrimination
Assumes the same marginal cost of supply
Impact of price discrimination depends on how the profit is used
Some buyers must pay more to cover development costs
Is a fair price only ever a fixed price - valuer judgements
What are examples of price dicrimination
Coca Cola selling cans for more when its hot
Uber increasing prices during peak times
Higher prices for heavier people on airlines- Samoa airlines
What are the conditions required for price discrimination
Firms must have sufficient monopoly power
Identifying different market segments
Ability to separate different groups: Requires information on the purchasing behaviour of consumers
Ability to prevent re-sale (arbitrage): No secondary markets where arbitrage can take place at intermediate prices
What are the aims of price dicrimination
To increase total revenue by extracting consumer surplus
To increase total profit
To generate cash-flow especially during a recession
To increase market share and build customer loyalty
To make more efficient use of a firm’s spare capacity
To reduce waste and cut the cost of keeping products in stock / storage
