Market Mechanism, Market Failure and Government Intervention in Markets

Question 1

The Price Mechanism

Answer 1

The price mechanism determines the market price. Adam Smith called this ‘the invisible hand of the market’.
Resources are allocated through the price mechanism in a free market economy. The economic problem of scarce resources is solved through this mechanism. The price moves resources to where they are demanded or where there is a shortage, and removes resources from where there is a surplus.

Question 2

Rationing

Answer 2

When there are scarce resources, price increases due to the excess of demand. The increase in price discourages demand and consequently rations resources. For example, plane tickets might rise as seats are sold, because spaces are running out. This is a disincentive to some consumers to purchase the tickets, which rations the tickets.

Question 3

Incentive

Answer 3

This encourages a change in behaviour of a consumer or producer. For example, a high price would encourage firms to supply more to the market, because it is more profitable to do so.

Question 4

Signalling

Answer 4

The price acts as a signal to consumers and new firms entering the market. The price changes show where resources are needed in the market. A high price signals firms to enter the market because it is profitable. However, this encourages consumers to reduce demand and therefore leave the market. This shifts the demand and supply curves.

Question 5

Types of Market Failure

Answer 5

Externalities, The under-provision of public goods, Information gaps, Monopolies, Inequalities in the distribution of income and wealth

Question 6

Market failure

Answer 6

Market failure occurs whenever a market leads to a misallocation of resources.
A misallocation of resources is when resources are not allocated to the best interests of society. There could be more output in the form of goods and services if the resources were used in a different way.
Economic and social welfare is not maximised where there is market failure.

Question 7

Externalities

Answer 7

An externality is the cost or benefit a third party receives from an economic transaction outside of the market mechanism. In other words, it is the spill- over effect of the production or consumption of a good or service. Negative externalities are caused by the consumption of demerit goods, such as cigarettes, and positive externalities are caused by the consumption of merit goods, such as recycling schemes.

Question 8

The under-provision of public goods

Answer 8

Public goods are non-excludable and non-rival, and they are underprovided in a free market because of the free-rider problem.

Question 9

Information gaps

Answer 9

It is assumed that consumers and producers have perfect information when making economic decisions. However, this is rarely the case, and this imperfect information leads to a misallocation of resources.

Question 10

Monopolies

Answer 10

Since the consumer has very little choice where to buy the goods and services offered by a monopoly, they are often overcharged. This leads to the under- consumption of the good or service, and therefore there is a misallocation of resources, since consumer needs and wants are not fully met.

Question 11

Inequalities in the distribution of income and wealth

Answer 11

There is an unequitable 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, such as social unrest.

Question 12

Partial market failure

Answer 12

Partial market failure occurs 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.

Question 13

Non-excludable

Answer 13

This occurs when it is not possible to provide a good without it being possible for others to enjoy. For example, if you erect a dam to stop flooding – you protect everyone in the area (whether they contributed to flooding defences or not.

Question 14

Positive Externality

Answer 14

This occurs when the consumption or production of a good causes a benefit to a third party

Question 15

Social Benefit

Answer 15

With positive externalities, the benefit to society is greater than your personal benefit.
Therefore with a positive externality the Social Benefit > Private Benefit
Remember Social Benefit = private benefit + external benefit.

Question 16

Examples of positive externalities (consumption)

Answer 16

. Good architecture. Choosing a beautiful design for a building will give benefits to everybody in society.
. Buying flowers for front garden gives benefits to others who walk past
. Consuming a healthy diet ultimately will benefit others in society because less health care costs, higher productivity
. Education or learning new skills. With better education, you are more productive and can gain more skills. But, also the rest of society benefits from your new skills.

Question 17

Positive externality (production)

Answer 17

. This occurs when a third party benefits from the production of a good. For example, building a train station may provide shelter for the homeless when it is raining.
. If a company develops new technology, such as a database programme, this new technology can be implemented by other firms who will gain a similar boost to productivity.
. Tim Berners Lee who developed the World Wide Web, made it freely available, creating a very large positive externality.

Question 18

Dealing with positive externalities

Answer 18

Positive externalities lead to under-consumption and market failure. Government policies to increase demand for goods with positive externalities include:

.Rules and regulations – minimum school leaving age
.Increasing supply – the government building of council housing to increase the stock of good quality housing.
.Subsidy to reduce price and encourage consumption, e.g. government subsidy for rural train services.

Question 19

Negative externalities

Answer 19

Negative externalities occur when the consumption or production of a good causes a harmful effect to a third party.

Question 20

Examples of negative externalities:

Answer 20

. Loud music. If you play loud music at night, your neighbour may not be able to sleep.
. Pollution. If you produce chemicals and cause pollution as a side effect, then local fishermen will not be able to catch fish. This loss of income will be the negative externality.
. Congestion. If you drive a car, it creates air pollution and contributes to congestion. These are both external costs imposed on other people who live in the city.
. Building a new road. If you build a new road, the external cost is the loss of a beautiful landscape which people can no longer enjoy.

Question 21

Examples of negative production externalities

Answer 21

. Burning coal for energy creates pollution.
. Producing conventional vegetables with pesticides causes carcinogens to get into the environment.
. Producing beef in South America involves cutting down Amazon rainforest, which has an impact on global climate and local environment

Question 22

Examples of negative externalities of consumption

Answer 22

. Consuming alcohol leads to an increase in drunkenness, increased risk of car accidents and social disorder.
. Consuming loud music late at night keeps your neighbours awake.
. Consuming cigarettes causes passive smoking to others in the vacinity.

Question 23

Merit goods

Answer 23

Merit goods are those goods and services that the government feels that people will under-consume, and which ought to be subsidised or provided free at the point of use so that consumption does not depend primarily on the ability to pay for the good or service.

Question 24

A merit good has two characteristics:

Answer 24

. People do not realise the true personal benefit. For example, people underestimate the benefit of education or getting a vaccination.
. Usually, these goods also have a positive externality.

Question 25

Examples of Merit Goods

Answer 25

. Health Care – people underestimate the benefits of getting a vaccination. If people do get a vaccination, then there will be a personal benefit in protecting against diseases. Also, there will be external benefits to the rest of society because it will help reduce the prevalence of disease in the rest of society. . Museums – the educational benefit of museums may be unappreciated. . Eating fruit and vegetables – A diet of raw fruit gives health benefits to the consumers but we may prefer unhealthy food. . Education – People may undervalue the benefits of studying, and decide to leave school early or not get good grades.

Question 26

Demerit good

Answer 26

A good which harms the consumer. For example, people don’t realise or ignore the costs of doing something e.g. smoking, drugs. Usually, these goods also have negative externalities. If you smoke you harm yourself, but also the smoke negatively affects other people.

Question 27

Examples of Demerit Goods include:

Answer 27

. Smoking – People underestimate health costs or risks of getting addicted. . Drinking – Health costs to drinkers. Costs to society include more expenditure on health care and policing. . Taking drugs – Health costs to drug users – people underestimate risks of getting addicted. . External costs of more crime. . Drinking sugary softdrinks – which damage teeth and cause obesity.

Question 28

Non-rivalry:

Answer 28

This means that when a good is consumed, it doesn’t reduce the amount available for others. – E.g. benefiting from a street light doesn’t reduce the light available for others but eating an apple would.

Question 29

Free rider problem

Answer 29

The problem with public goods is that they have a free-rider problem. This means that it is not possible to prevent anyone from enjoying a good, once it has been provided. Therefore there is no incentive for people to pay for the good because they can consume it without paying for it. . However, this will lead to there being no good being provided. . Therefore there will be social inefficiency. . Therefore there will be a need for the govt to provide it directly out of general taxation.

Question 30

Examples of Public Goods

Answer 30

National defence. If you protect the country from invasion, it benefits everyone in the country. Street lighting. If you provide light at night, you can’t stop anyone consuming the good. Walking under a street light doesn’t reduce the amount of light for others. Police service. If you provide law and order, everyone in the community will benefit from improved security and reduced crime. Flood defences – Protecting the coastline against flooding provides benefits for the whole community. The internet. Once websites are provided, everyone can see the website for free, without reducing the amount available to others. (assuming an individual can access for free, which is not always the case)

Question 31

Quasi-Public Goods

Answer 31

These are goods which have an element of non-excludability and non-rivalry. Roads are a good example. Once provided most people can use them, for example, those who have a driving licence. However, when you use a road, the amount others can benefit is reduced to some extent, because there will be increased congestion.

Question 32

Behavioural economics

Answer 32

Behavioural economics suggests that individuals can have motivations other than just money. People may volunteer to contribute to local flood defences out of a sense of civic pride, peer pressure or genuine altruism. Therefore, in the real world, enough people may contribute to paying for a public good, even if – from a narrow self-interest point of view – it may be rational to avoid paying.

Question 33

Information failure

Answer 33

Information failure is a type of market failure where individuals or firms have a lack of information about economic decisions.

Question 34

Information asymmetries

Answer 34

Where one party has access to information that another party doesn’t. For example, the seller of a car may know it has some problem, but the buyer may not be aware.

Question 35

Failure to disclose information

Answer 35

In many economic transactions, agents may not make full disclosure. For example, when applying for health insurance, you may fail to inform the insurer about genetic traits or your current ill health. When purchasing financial assets, the buyer may not be aware of the risk involved. This was an issue in the period before the credit crunch. This leads to information asymmetries

Question 36

Difficulty in estimating costs and benefits.

Answer 36

It is often difficult to be aware of social costs of goods. Accounting costs are relatively easy to know. But, when it comes to knowing more intangible external costs, it becomes difficult to put an accurate figure.

Question 37

Lack of education/awareness.

Answer 37

Merit and demerit goods have degrees of information failure with consumers unaware of the true personal cost/benefit. For example, if we take tobacco, there was a time when many people were not aware of the ill-effects of tobacco on health. Recently, there has been increasing concern about the health costs of sugar consumption. Many consumers are unaware of the amount of sugar in processed food and the harmful effects of sugar on health

Question 38

Framing issues

Answer 38

When making decisions over whether to purchase a good, consumers will be influenced by how the good is portrayed. For example, a firm may advertise an orange drink has a healthy fruit drink, with added vitamin C. From the packaging a quick glance may give consumers the impression they are buying a healthy drink.

Question 39

Moral Hazard.

Answer 39

This occurs when individuals alter their behaviour because of certain guarantees. For example, an insurance firm may be willing to offer insurance against a bike being stolen. However, the firm may not realise that through offering insurance, it alters consumer behaviour and, after gaining insurance, the consumer takes less care to lock it up. Therefore, the insurance company loses out because it is more likely to pay out than previously expected.

Question 40

Irrelevant information / misinformation.

Answer 40

If you are applying for a job, a firm may search on the internet and find a Facebook post from several years ago. The employer may use this and avoid giving job – even though it is no longer relevant to who you are now. Alternatively, there may be false information/slander circulated which is hard to deny.

Question 41

Information bias

Answer 41

The government has set up regulators to deal with natural monopolies, e.g. gas and electricity. The regulator aims to set fair prices for industry and consumers. However, if they rely on information from the firm, they may become sympathetic to the firm and allow price rises. This is known as regulatory capture – where regulators act in a favourable way to the firm they are regulating