Market Mechanism, Market Failure, Gov intervention Flashcards
The Price Mechanism
- the rationing function
- the signalling function
- the incentive function
- the allocative function
The RAtioning FUnction
- as prices rise, removes excess demand, only consumers with ability to pay can purchase goods
The Signalling Function
-prices provide important information to market participants i.e increase or decrease production
The Incentive function
increased prices strengthen incentive for firms to produce more
The Allocative function
the function of prices that acts to divert resources to where returns can be maximised
Market failure
when the free market leads to a misallocation of resources in an economy
complete market failure
ie missing market
when free market fails to create market for particular goods and services
public goods
goods that are non rival and non excludable in consumption
non excludable
can’t prevent non paying consumers from consumin
non rival
one persons enjoyment of a good does not diminish anothers enjoyment
the free rider problem
individual consumers hope to get a ‘free ride’ without paying for the benefit they enjoy
- public goods = complete market failure- free markets no incentive to provide
private goods
a good that is rival and excludable in consumption
quasi- public goods
a good that exhibits not all but some characteristics of a public good
externalities
third party affects arising from the consumption and production of goods and services
MSC
Marginal private costs + marginal external costs
MSB
marginal private benefit + marginal external benefit
when is social welfare optimises
when MSB = MSC
Positive Externalities in Production
1) MPC > MSC therefore negative marginal external costs
2) free market equilibrium: MPB = MPC
3) socially optimal equilibrium: MSB = MSC
4) welfare gain to society as MSB > MSC at fm eq as FM doesn’t account for external benefits
5) underproduction
Positive Externalities in Consumption
1) MSB > MPB therefore marginal external benefit
2) free market equilibirum: MPB = MPC
3) socially optimal equilibrium: MSB = MSC
4) welfare gain to society as MSB > MSC at fm eq as fm doesnt account for external benefits
5) underconsumption
Negative Externalities in Production
1) MSC > MPC therefore marginal external cost
2) Free market equilibrium: MPB = MPC
3) socially optimal equilibrium: MSC = MSB
4) welfare loss to society as MSC > MSB at fm eq as fm doesnt account for external costs
5) overproduction
Negative Externalities in Consumption
1) MPB > MSB therefore negative marginal external benefit
2) Free market equilbrium: MPB = MPC
3) socially optimal equilibirum: MSC > MSB at fm eq as fm doesnt account for external costs
4) overconsumption
tragedy of the commons
the overuse of natural resources such as oceans, forests or atmospheres
- can be analysed using negative externality diagrams
merit goods
a good that would be underconsumed in a free market
Why are merit goods under consumed?
1) Information failure- people unaware of the potential private benefits from consuming merit goods in the long run
2) expensive
3) society may not take into account the wider benefits to society of their use of merit goods
demerit goods
a good that would be overconsumed in a free market
why are demerit overconsumed
1) information failure- people unaware of the damage to their health
2) cheap
3) society doesnt take into account wider external cost
Market imperfections
- imperfect information
- monopoly
- immbolility of fOp
- occupational immobility
- geographical immobility
occupational immobility
difficult to move jobs due to lack of skills
geographical immbolity
difficult moving to locations where jobs available
government intervention
action taken by government that seeks to change the decisions made by individuals, groups and organisations about social and economic matters.
reasons for gov intervention
- correct market failure
- achieve fairer distribution of income and wealth
- achieve gov macro objectives
indirect tax
- tax on spending, sometimes used to reduce consumption
unit taxes
fixed amount added per unit
ad valorem
adding a percentage of the price of a good eg vat
advantages of indirect tax
1) strong tax revenue, gov can spend on healthcare
2) use of price mechanism, consumers and producers decide how to adjust behaviour
3) helps internalise external costs
disadvantages of indirect tax
1) if placed on inelastic goods, demand may not fall unless large tax
2) difficult to place accurate monetary value on external costs
3) tends to be regressive- larger percentage of poorer persons income
subsidies
payment made to producers to encourage increased production of a good or service
Advantages of subsidies
1) increase consumption of merit goods, internalise external benefit
2) reduce price of goods, more affordable for those on lower incomes
Disadvantages of subsidies
1) opportunity cost
2) firms may become reliant- encourages productive inefficiency, reduces international competitiveness lr
3) little impact on inelastic goods
minimum prices
a price floor placed above free market equilibirum
Advantages of minimum price
1) gives producers guaranteed income (raise living standards)
2) encourage production of essential products
Disadvantages of minimum price
1) consumers pay higher price, reduce disposable income
2) reduce international competitiveness if price raised above foreign competitors
3) may encourage people to seek cheaper, more harmful alternatives
Maximum prices
a price ceiling above which prices are not permitted to rise
Advantages of maximum prices
1) without, people may not be able to afford certain goods
2) reduce ability of firms with monopoly power to exploit
Disadvantages of maximum prices
1) creation of excess demand implies queues shortages waiting list
2) may lead to the establishment of black markets
government failure
when government intervention in a market reduces overall economic welfare
Reasons for government failure
1) inadequate information
2) unintended consequences
3) market distortions
4) administrative costs
inadequate information
- difficult in practice to place an accurate monetary value on external costs and benefits
- therefore unlikely to completely internalize externalities and lead to social optimum or allocative efficiency
administrative costs
costs of researching and implementing any intervention may outweigh the benefit of the policy itself
Competition Policy
government policy that aims to make markets more competitve
Competition Policy focuses on four areas
1) monopolies
2) mergers
3) restrictive trading practices
4) promoting competition
Methods to tackle monopolies;
1) Windfall taxes on snp
2) Maximum prices
3) deregulation = removing B2E = more contestable
mergers
when two or more firms willingly join together
Public ownership
government ownership of firms, industries or other assets
Nationalisation
the transfer of assets from the private sector to public ownership
Advantages of public ownership
1) more likely to take into account externalities not profit maximising
2) social welfare = allocatively efficient
Disadvantages of public ownership
1) Lack of dynamic efficiency = lack of pressure to maximise profits, absence of competition
2) Lack of expertise= could be argued best managers found in private sector, where financial rewards could be higher than public
Advantages of privatisation
1) Raising extra rev for gov = sale of state owned assets to private sector can generate significant short term revenue
2) promoting competition
3) promoting efficiency - profit motive cut costs
Disadvantages of privatisation
1) Exploitation of monopoly power
2) Short termism = pressure from shareholders who demand annual dividends = focus on profit maximising cutting costs rather than long term investment projects
3) ignoring externalities
privatisation
sale of government owned assets to the private sector
