Functions of Price and Market Failure

Question 1

List the Functions of Price

Answer 1

Consumers- Rationing Function
Producers- Incentivising Function
Entrepreneurs- Signalling Function

Question 2

Explain the Rationing Function

Answer 2

Consumers ration their consumption at higher prices. When there is a shortage, the price is bid up – leaving only those with the willingness and ability to pay to purchase the product.

Question 3

Explain the Incentivising function

Answer 3

Through their choices consumers send information to producers about the changing nature of needs and wants
Higher prices act as an incentive to raise output because the supplier stands to make a better profit.
When demand is weaker in a recession then supply contracts as producers cut back on output.

Question 4

Explain the Signalling function

Answer 4

Prices perform a signalling function – they adjust to demonstrate where resources are required, and where they are not
Prices rise and fall to reflect scarcities and surpluses
If prices are rising because of high demand from consumers, this is a signal to suppliers to expand production to meet the higher demand
If there is excess supply in the market the price mechanism will help to eliminate a surplus of a good by allowing the market price to fall.

Question 5

Advantages of Price mechanism

Answer 5

The idea of consumer sovereignty - consumers have the power to determine what is bought and sold in the market.
The freedoms of choice, property and enterprise can only be fulfilled in a system with operation of the price mechanism.
Prices are as low as possible and resources go to the most efficient use.
The system operates without regulation.

Question 6

Disadvantages of Price mechanism

Answer 6

Inequality of income and wealth
Without government intervention, there will be under-provision of public and merit good
Unemployment
Inflation

Question 7

Define Market Failure

Answer 7

When the free market, when left alone, fails to deliver an efficient allocation of goods and services

Question 8

What is the difference between complete and partial market failure

Answer 8

Complete market failure occurs when the market does not make a product at all. Partial market failure occurs when the market does not supply products in the quantity demanded or at the price consumers are willing to pay.

Question 9

What are the different types of market failure

Answer 9

Productive and allocative inefficiency

Monopoly power

Missing markets

Incomplete markets

De-merit goods

Negative externalities

Property rights

Imperfect Information

Unstable markets

Inequality

Question 10

What is a public good and its characteristics.

Answer 10

A public good is one that the free market may fail to provide or provide efficiently so government intervention is needed.
They are:
Non-Excludable
Non Rival
Non-Rejectable

Question 11

What does Non-Exludability mean

Answer 11

Non-excludability: The benefits derived from pure public goods cannot be confined solely to those who have paid for it. Indeed non-payers can enjoy the benefits of consumption at no financial cost – economists call this the ‘free-rider’ problem. With private goods, consumption ultimately depends on the ability to pay

Question 12

What does Non-Rejectability mean

Answer 12

Non-rejectable: The collective supply of a public good for all means that it cannot be rejected by people, a good example is a nuclear defence system or flood defence projects.

Question 13

What does Non-Rivalry mean

Answer 13

Non-rivalry: Consumption by one consumer does not restrict consumption by other consumers – in other words the marginal cost of supplying a public good to an extra person is zero. If it is supplied to one person, it is available to all.

Question 14

Define Private Good

Answer 14

A private good is a product that must be purchased to be consumed, and consumption by one individual prevents another individual from consuming it.

Question 15

Define Quasi-Public Good

Answer 15

A good that is only partly public so possesses one or more of the public good characteristics but not all

Question 16

Define Free Rider Problem

Answer 16

Non-payers can enjoy the benefits of consumption at no financial cost – economists call this the ‘free-rider’ problem.

Question 17

Define Equilibrium

Answer 17

The price at which demand is equal to supply and there is no tendency for change

Question 18

Continue the chain of reasoning:

Excess Demand leads to prices increasing causing consumers to…

Answer 18

Excess demand leads to prices increasing causing consumers to ration their consumption leading to a contraction in demand and an extension in supply as producers are incentivised by higher prices to produce more to maximise profits.

Question 19

Explain how Productive and Allocative Inefficiency is a market failure

Answer 19

Productive and allocative inefficiency

Markets may fail to produce and allocate scarce resources in the most efficient way.

Question 20

Explain how Monopoly power is a market failure

Answer 20

Monopoly power

Markets may fail to control the abuses of monopoly power.

Question 21

Explain how Missing Markets is a market failure

Answer 21

Missing markets
Markets may fail to form, resulting in a failure to meet a need or want, such as the need for public goods, such as defence, street lighting, and highways.

Question 22

Explain how Incomplete Markets is a market failure

Answer 22

Incomplete markets

Markets may fail to produce enough merit goods, such as education and healthcare.

Question 23

Explain how Demerit Goods is a market failure

Answer 23

De-merit goods
Markets may also fail to control the manufacture and sale of goods like cigarettes and alcohol, which have less merit than consumers perceive.

Question 24

Explain how Negative Externalities is a market failure

Answer 24

Negative externalities
Consumers and producers may fail to take into account the effects of their actions on third-parties, such as car drivers, who may fail to take into account the traffic congestion they create for others. Third-parties are individuals, organisations, or communities indirectly benefiting or suffering as a result of the actions of consumers and producers attempting to pursue their own self interest.

Question 25

Explain how property rights could be a market failure

Answer 25

Property rights
Markets work most effectively when consumers and producers are granted the right to own property, but in many cases property rights cannot easily be allocated to certain resources. Failure to assign property rights may limit the ability of markets to form.

Question 26

Explain how imperfect information could be a market failure

Answer 26

Imperfect Information
Markets may not provide enough information because, during a market transaction, it may not be in the interests of one party to provide full information to the other party.

Question 27

Explain how Unstable Markets is a market failure

Answer 27

Unstable markets
Sometimes markets become highly unstable, and a stable equilibrium may not be established, such as with certain agricultural markets, foreign exchange, and credit markets. Such volatility may require intervention.

Question 28

Explain how inequality is a market failure

Answer 28

Inequality
Markets may also fail to limit the size of the gap between income earners, the so-called income gap. Market transactions reward consumers and producers with incomes and profits, but these rewards may be concentrated in the hands of a few.