Market Mechanism Flashcards
What is a perfectly competitive market?
Many buyers and sellers Sellers are price takers Perfect knowledge Free entry to and exit from market Homogeneous goods Firms are short run profit maximisers
In a perfectly competitive market how do firms determine price?
Supply and demand
What might firms also aim to do other than compete on price?
Improve prouducts - innovating, quality
Reduce costs - less competition (new firms)
Improve the quality of the service y
What two things makes something a public good?
Non excludability
Non rivalry
What is non rivalry?
Consumption of a public hood by one person does not reduce the amount avalible of a good to everyone
What is non excludability?
The benefits derived from the provision of pure public goods can’t be confined to only those who have actually paid for them
What gives rise to the free rider problem?
Non excludability of public goods
What is the free rider problem?
Consumers have no willingness to pay as they can enjoy the benefits without paying
This means there is no effective demand for the good
No incentive for firms to produce it
ABSOLUTE MARKET FAILURE
Why would governments provide a public good?
The opportunity cost is outdated by the expected benefit of doing so
What are private goods?
Goods that we buy and consume
Consumption of these goods generates utility
Define externality?
Effect on a third party from the consumption or production of a good or service
Why do externalities cause market failure?
As the price of the food does not accurately reflect the costs of production or the benefit of consumption
Examples of positive externality in consumption?
Perfume
Immunisations
Examples of positive externality in production?
Visual benefit of farm cultivation or building
Examples of negative externality in consumption?
Passive smoking
Examples of begative externality in production?
Pollution
What arises from consumption?
Benefit
What arises from production?
Cost
What is the social cost of production?
Included the cost borne by the producer (private cost) and any effect on third parties
When does a market failure occur?
Whenever a market leads to misallovation of resources
When resources are not allocated to the best interests of society
More output in the form of goods and services if he resources were used in a different way
Types of market failure?
Externalities Underprovisioon of public goods Information gaps Monopolies Inequalities in the distribution of income and wealth
Describe how the under provision of public goods can lead to market failures?
Public goods are non excludable and non rival
They are underprovidrd in a free market because of the free rider problem
Describe how externalities lead to market failure?
The cost or benefit a third party revives from an economic transaction outside of the market mechanism
The spill over effect of the production or consumption of a good or service
Positive - merit goods
Negative - demerit goods
Describe how information gaps lead to market failure?
Consumers and producers have perfect information when making economic decisions
This imperfect information leads to a misallocation of resources
Describe how monopolies lead to market failure?
Since the consumer has very little choice
Where to buy the goods and services offered by a monopoly, they are often overcharged
Leading to the underconsumption of the good or service
There is a misallocation of resources since consumer needs and wants are not fully met
Describe how inequalities in the distribution of income and wealth can lead to market failure?
Inequitable distribution in income and wealth
Income refers to the flow of money
Wealth refers to a stock of assets
Negative extermslities such as social unrest
What is partial market failure?
Occurs when the market produces a good but is the wrong quantity or the wrong price
Resources are misallocation where there is partial market failure
Why are public goods underprovidrd by the private sector?
They do not make a profit from providing the good since consumers do not see a reason to pay for tbf good
If they still receive the benefit without paying
It is difficult to measure the value consumers get from public goods, so it is hard to put a price on the good
Consumers undervalue the benefit
Producers overvalue so they can charge more
Why do governments provide public goods?
They have to estimate what the social benefit of the public good is when deciding what output of the good to provide
They are funded using tax revenue but the quantity provided will be less than the socially optimum quantity
What are quasi public goods?
Both public and private goods
Semi excludable
Semi non rival
Partially provided by the free market
When do externalities exist?
When there is a divergence between private and social costs and benefits
Describe demerit goods?
Information failure
Long run implications
Overprovided
Descrive merit goods?
Long run benefits
Underprovidrd in a free market
Information failure
What are merit goods?
Merit goods are goods which will be underconsumed if left to party market forces
Why do merit goods happen?
INFORMATION FAILURE
The failure to take into account future benefits
A lack of knowledge about future benefits
POSITIVE EXTERNALITIES
A benefit to a third party (not the producer or consumer) of the consumption of the goods
What does symmetric information mean?
Means that consumers and producers have percect information to make their decision
Efficient allocation of resources
What is asymmetric information?
Unequal knowledge between consumers and produces
Leads to market failure
What is Imperfect information?
Where information is missing so an informed decision cannot be made
How could information be made more available?
More widely avalible through advertising or government intervention
How can governments intervene?
Indirect taxes Subsidies Maximum and minimum prices Traceable pollution permits State provision of public goods Provision of information Regulation
Describe how governments can intervene through indirect taxes?
Taxes on expenditure
They increase production costs for producers so producers supply less
This increases market price and demand contracts
They could be used to discourage the production or consumption of a demerit good or service
What is a subsidy?
A payment from the government to a producer to lower their costs of production and encourage them to produce more
How do government subsidies work?
Encourage the merit goods
Includes the full social benefit in the market price of the good
The external benefit is internalise
What are the disadvantages of subsidies?
Opportunity cost to the government
Potential higher taxes
Potential for firms to become inefficient if reliant on subsidy
How do indirect taxes work?
Reduce the quantity of demerit goods consumed
By increasing price of good
Interbnalizes the externality
Why might a government set a maximum price?
The consumption or production of a good is to be encouraged
This is so the good does not become too expensive to produce or consume
When deciding on a maximum price what should be considered?
Free market price
SET BELOW
otherwise it would be ineffective
Disadvantages with maximum prices?
Reduce firms profits
Less investment long run
Firms might raise price of other goods - no net gain
Could lead to gov failure if they misjudge where optimum market price should be
Advantages of maximum prices?
Prevent monopolies exploiting customers
Control market price
Welfare gain for consumers by keeping prices low
Increase efficiency in firms since they have an incentive to keep their costs low to maintain their profit level
Why would a government introduce a minimum price?
Where the consumption or production of a good is to be discouraged
This ensures the good never falls below a certain price
Reduce the negative externality from consuming a demerit good
What should be considered when setting the minimum prices?
Have to be set above the free market price
Otherwise they would be ineffective
Why introduce a traceable pollution permits?
Limits the amount of negative externalities in the form of pollution created in industries
Firms will r allowed to pollute up to a certain amount any surplus on their permit can be treated
Firms can buy and sell between themselves
Advantages of traceable pollution permits?
Benefit the environment long run by encouraging firms to use green production methods
Government could raise revenue from the permits because they can sell them to firms - revenue reinvested in green technology
If firms exceed their permit, they will have to purchase more permits from firms which did not use their whole permit - raises revenue for greener firms who might then invest in green production methods
Disadvantages of traceable pollution permits?
It could lead to some firms relocating to where they can pollute without limits which will reduce their production costs
Firms might pass the higher costs of production on to the consumer
Competition could be testrixted in the market if the permits create a barrier to entry
Could be expensive for governments to monitor
Why would governments provide information to prevent market failure?
Governments can ensure there is no information failure, so consumers and firms can make informed economic decisions
Expensive to police
Why do governments intervene and provide public goods?
They can provide goods that are underprovidrd in the free market such as education and healthcare
These have external benefits
This makes merit goods more accessible which might increase their consumption and yield positive externalities
Could be expensive for governments to provide education and the government will incur an opportunity cost of spending their revenue
Why do governments regulate to prevent market failure?
Government could use laws to ban consumers from consuming a good
They could make it illegal
Positive externalities
Firms who don’t follow fregualtiom face heavy fines which act as a disincentive to break the rule
Could raise the cost of firms who might pass on the higher costs to consumers
What happens when governments fail?
They could worsen the market failure already present or a new failure might occur
Bet welfare loss to society
The loss could be ineffective intervention or when harm is caused
What are the causes of government failure?
Distortion of price signals
Unintended consequences
Excessive administrative costs
Information gaps
How does the distortion of price signals cause government failure?
Government subsidies could distort price signals by distorting the free market mechanism
A free market economicst would argue that this lead to government failure
There could be an inefficient allocation of resources because the market mechanism is not able to act freely
How do information gaps cause government failure?
Some policies might be decided without perfect information
This might require a full cost benefit analysis and it could be time consuming and expensive
However it is impractical for governments to gain every bit of information they need so assumptions are made
Why do de merit goods happen?
Negative externalities
Information failure - failure to take into account negative consequences, lack of knowledges about future negative consequences
Examples of demerit goods?
Cigarettes
Drugs
Alcohol
Why do merit goods happen?
Information failure
- failure to take into account future benefits or a lack of knowledge about future benefits
Positive externalities
Examples of merit goods?
Preventative treatments Insurance Education Healthy eating Defence spending
what is a market structure?
the organisation of a market in terms of the number of firms in the market and the ways in which they behave
what is perfect competition?
a market which displays:
large numbers of buyers and sellers
the ability to buy or sell as much as is desired at the ruling market prices
the inability of an individual buyer or seller to influence the market price
a uniform product
no long run barriers to entry or exit
what is a concentrated market?
a market contained very few forms in the extreme only one firm
what is price maker and price taker?
price taker - a firm that passively accepts the ruling market price set by the market conditions outside its control
price marker - a firm possessing the power to set the price within the market
what is the concentration ratio?
indicates the total market share of a number of leading firms in a market, or the output of those firms as a percentage of total market output
what is the main objective of firms?
profit maximisation
when a firms sales revenue is furthest above total cost of production
pure public good?
it is impossible to exclude free riders
eg defence and police
complete absence of a market
what are minimum prices generally associated with?
demerit goods
what are maximum prices generally associated with?
merit goods
what happens if a maximum proves is set above the equilibrium price?
it will have no effect
what will happen if a maximum price is set below the equilibrium price?
SHORTAGE
demand is greater than supply
why are maximum prices imposed?
essential good (some may be unable to afford) monopoly exploration (reduces monopoly price closer to competitive market price)
what does a price ceiling lead to?
shortage
what does a price floor lead to?
surplus
when is the only time a price ceiling would have an effect on the market?
below equilibrium price
what will happen if a minimum price is below equilibrium?
it will have no effect
where does a price ceiling go to be effective?
below equilibrium price
where does a price floor go to be effective?
above equilibrium price
what are costs to do with?
producers
what are benefits to do with?
consumers
why are merit goods uber provided in the free market?
social benefits exceed private benefits
why is there underconsumption of merit goods
people consuming merit goods ignore or downplay information about the long term private benefits that result from consumption
why is there overconsumption of demerit goods
people consuming demerit goods ignore or downplay information about the long term private costs that result from consumption
sources of government failure
immobility of labour
monopolies
information failure
if a government subsidies a product, when will the largest increase in sales occur?
demand is price elastic
supply curve is shifted right
consumer expenditure than increases if the demand curve is price elastic
why are merit goods likely to be underprovided in a free market economy
positive externalities are generated when merit goods are consumed
the social benefit enjoyed by the whole population exceeds the private benefit enjoyed by individual consumers
what is market failure
free market failed to allocate resources at the socially optimum level
leading to a net loss in social welfare
evaluation points for indirect tax
demand is inelastic so adverse consumer welfare
regressive - lower incomes suffer more
rise in black market activity particularly if severe tax
difficult to know if government sets the right tax
evaluation points for subsidies
expensive - opportunity cost for government best been allocated elsewhere
not all is passed on to consumer
elasticity of demand
inefficient firms not best targeted as firm is wasteful
when the state provides something what is supply
perfectly inelastic
evaluation of state provision of goods or services
oppertunity cost (money best been used elsewhere e.g. defence)
state run organisation tends to be wasteful (no profit motive so inefficiency occurs)
ignores private sector (useful in bringing down costs and improving quality and innovating)
what does a maximum price lead to
excess demand
what does a minimum price lead to
excess supply
short run vs long run indirect tax evaluation
short run ineffective with inelastic demand
long run this tax generates revenue
this revenue can be used to subsidise alternatives or provide information
making demand more price elastic
