Market Mechanism, Market Failure and Government Intervention in markets

Question 1

What are the four functions of price?

Answer 1

-Signalling: prices signal information to buyers and sellers regarding excess demand (shortages) and excess supply (surpluses)
-Incentive: prices incentivise producers to alter their production according to where signals identify changing needs and wants.
-Rationing: prices serve the function of rationing scarce resources when demand exceeds supply; only those willing and able to pay a higher price do so.
-Allocative: prices allocate scarce resources across competing uses until a new equilibrium is found.

Question 2

What is complete market failure?

Answer 2

A complete market failure is when the price mechanism fails to perform or performs badly, leading to an inefficient allocation of resources.

Question 3

When does complete market failure occur?

Answer 3

Complete market failure occurs when a market for a good/ service does not exist, there is a “missing market”.

Question 4

What is a partial market failure?

Answer 4

A partial market failure is when there is a market for a good or service but at the wrong quantity, it can lead to overconsumption/ overproduction or underconsumption/ underproduction of certain goods.

Question 5

What is meant by non-excludable?

Answer 5

Non-excludable is when an individual cannot be prevented from consuming or benefitting from a good, service or resource.

Question 6

What is meant by non-rival?

Answer 6

Non-rival is when the consumption of a good, service or resource by an individual does not lessen its availability to others.

Question 7

What is meant by non-rejectable?

Answer 7

Non-rejectable is when individuals cannot reject the consumption of a particular good or service.

Question 8

What is meant by a private good?

Answer 8

A private good is a good which is both excludable and rival.

Question 9

What is meant by a public good?

Answer 9

A public good is a good which is both non-excludable and non-rival. (lighthouses, street lighting, the air/atmosphere, the ocean)

Question 10

Why is there typically a missing market for public goods?

Answer 10

Public goods are non-excludable and non-rival and so are unlikely to be provided by the private sector, leading to a missing market. Non-excludable means that individuals can benefit from public goods without paying for their provision (free ride). If everyone can benefit from a good without having to pay for it, private companies would not earn any profit and so would have no incentive to provide the good. Therefore, the government has to intervene, otherwise public goods would likely not be provided by the market at all.

Question 11

What are quasi-public goods?

Answer 11

Quasi-public goods are “non-pure” public goods; these goods exhibit some characteristics of public goods but not all.

Question 12

What are common goods?

Answer 12

Common goods are goods which are non-excludable but rivalrous.

Question 13

What are club goods?

Answer 13

Club goods are goods which are excludable but non-rival.

Question 14

What is meant by the tragedy of the commons?

Answer 14

The “tragedy of the commons” is a social and economic problem whereby an individual’s independent and self-interested consumption of a common resource can lead to depletion and degradation for all users. Common goods are non-excludable but rival eg river, sea, atmosphere so no one has any incentive to to maintain or upkeep reserves, because they cannot prevent anyone else from benefitting from it. As a result, this leads to rapid exploitation and depletion and widespread societal problems eg climate change, overfishing.

Question 15

What are externalities?

Answer 15

Externalities occur when there are spillover effects on third-parties as a result of the production or consumption of a good or service.

Question 16

Describe some facts about externalities.

Answer 16

-Externalities occur outside of the price mechanism (price and quantity do not reflect the impact of these spillover effects.
-Externalities are an example of partial market failure.
-The effects of externalities can either be positive or negative.

Question 17

What is a private cost?

Answer 17

A private cost is the internal cost incurred by a consumer or producer involved in the transaction.

Question 18

What is an external cost?

Answer 18

An external cost is the price of the negative impacts of consumption or production on a third-party.

Question 19

What is a social cost?

Answer 19

social cost = private cost + external cost

Question 20

What is a private benefit?

Answer 20

A private benefit is the internal benefit (eg opportunity cost, utility gained) derived by the consumer or producer involved in the transaction.

Question 21

What is an external benefit?

Answer 21

An external benefit is the price of the positive impacts of consumption or production on a third-party.

Question 22

What is a social benefit?

Answer 22

Social benefit = private benefits + external benefits

Question 23

What are the 4 types of externalities?

Answer 23

-Negative production: when the production of a good/ service creates external costs on third-parties, outside of the price mechanism.
-Positive production: when the production of a good/ service creates external benefits on third-parties outside of the price mechanism.
-Negative consumption: when the consumption of a good/ service creates external costs on third-parties outside of the price mechanism.
-Positive consumption: when the consumption of a good/ service creates external benefits on third-parties outside of the price mechanism.

Question 24

Why are externalities an example of partial market failure?

Answer 24

-Externalities occur outside of the price mechanism (the price only reflects the private costs/ benefits rather than the complete social costs/ benefits).
-Consumption/ production of goods or services that create externalities are therefore supplied at the wrong output level and price.
-Goods that create negative externalities are overproduced and overconsumed as the price is too low.
-Goods that create positive externalites are underproduced and underconsumed as the price is too high.

Question 25

What are merit goods?

Answer 25

Merit goods are goods for which the social benefits of consumption exceed the private benefits - they have positive externalities in consumption.

Question 26

What are demerit goods?

Answer 26

Demerit goods are goods for which the social costs of consumption exceed the private costs - they have negative externalities in consumption.

Question 27

What would happen if negative production externalities were taken into account?

Answer 27

For negative externalities in production, social costs exceed private costs. If producers took into account negative externalities of production, less would be supplied (Q2) and at a higher price (P2).

Question 28

What would happen if positive production externalities were taken into account?

Answer 28

For positive externalities in production, private costs exceed social costs. If producers took into account positive externalities of production, more would be supplied (Q2) and at a lower price (P2).

Question 29

What would happen if negative consumption externalities were taken into account?

Answer 29

For negative consumption externalities, private benefits exceed social benefits. If consumers took into account the negative externalities of consumption, less would be demand (Q2). The lower price (P2) reflects the price consumers would be willing to pay if they knew the true social value of the good.

Question 30

What would happen if positive consumption externalities were taken into account?

Answer 30

For positive consumption externalities, social benefits exceed private benefits. If consumers took into account the positive externalities of consumption, more would be demanded (Q2). The higher price (P2) reflects the price consumers would be willing to pay if they knew the true social value of the good.

Question 31

What can the government do to increase the supply of merit goods?

Answer 31

The government can subsidise the production of merit goods to increase supply. A subsidy is a payment, or grant, paid by the government to producers to help reduce their costs. A subsidy would lower a firm’s costs of production, allowing them to afford to supply merit goods at the lower, socially optimum price.

Question 32

What can the government do to decrease the supply of demerit goods?

Answer 32

The government can place a specific tax on demerit goods to reduce supply. A specific tax is a fixed amount of tax paid per unit sold of a good; specific taxes are paid by producers, increasing their costs of production. Producers pass these higher costs of production on to consumers through higher prices, raising them to the socially optimum level.

Question 33

What are the reasons why merit and demerit goods are not consumed at the right quantity?

Answer 33

-Disregard for the positive/ negative externalities of consumption.
-Information failure which occurs when people make the wrong decisions because they do not possess or they ignore all the relevant information. Individuals tend to be myopic (short-sighted) we often value short-term benefits over long-term costs. This can lead to consumers making decisions in favour of their short-term interests rather than their long-term ones.