The Market Mechanism, Market Failure and Government Intervention

Question 1

What does the price mechanism do and how does it work?

Answer 1

The price mechanism provide a method to which scarce resources are allocated to competing uses. It does this by only allowing those who can afford a good access to it.

Question 2

What are the three key functions of the market and how do they work?

Answer 2

The signalling function - prices signal what is available in abundance and what is scarce. The Incentive function - prices create incentives for economic agents to behave consistently to the self-interest. The rationing function - prices allocate goods only to those who most value a good and will pay the price for it.

Question 3

What does price do through these functions?

Answer 3

Price allocates resources and coordinates decisions of buyers and sellers.

Question 4

What is an externality?

Answer 4

And unintended spill over effect on third parties, of an economic activity. Generated by production or consumption.

Question 5

What is a negative externality?

Answer 5

A negative externality is when production or consumption imposes a negative cost on the third party.

Question 6

What is an external cost?

Answer 6

This is the cost of the negative externality in money terms.

Question 7

What is a positive externality?

Answer 7

Opposed to text not he is one production or consumption cause the benefits to a third party.

Question 8

What is an external benefit?

Answer 8

This is the benefit of the positive externality in money terms.

Question 9

What the businesses or individuals do when making a decision?

Answer 9

The only consider the private costs – they ignore external costs and weigh up the private costs with the private benefits.

Question 10

Give two examples of private costs and private benefits.

Answer 10

Wages factory workers, wages of admin staff. Fill in private benefits.

Question 11

How do you calculate the social costs and social benefits?

Answer 11

Social cost equals private cost plus social costSocial benefit equals private benefit plus social benefit

Question 12

Ideally, on what basis would decisions been made?

Answer 12

With full consideration of all social costs and benefits.

Question 13

What is the purpose of the carbon tax?

Answer 13

To internalise the externality of pollution and make a social cost of private cost.

Question 14

What are the positives and negative’s of the carbon tax?

Answer 14

Positive - The earth friendly - Encourage eco-friendly activities - Simple and effective - Would raise government revenuesNegative - May shift production to pollution havens - May encourage tax evasion - Hard to know how much to tax - Developed countries may just pay the tax

Question 15

What are the alternatives to the carbon tax?

Answer 15

A possible alternative is the tradable pollution permits scheme.

Question 16

Why hasn’t the scheme being totally effective so far?

Answer 16

Because there was an excess of permits this meant there value fell so companies or countries could exceed the limit and buy more permits cheaply.

Question 17

What is needed for the permits scheme to work effectively?

Answer 17

A gradually shrinking number of permits available, and affective enforcement of the scheme.

Question 18

What is needed for a worldwide reduction in CO2 missions and why is this unlikely?

Answer 18

They would need to be a global scheme with limits on maximum pollution levels for all countries to follow. This is unlikely because places like China and India need a fast form of energy to fuel the development.

Question 19

Permits are ineffective at getting firms to reduce pollution because..?

Answer 19

The number of permits is fixed meaning it an inelastic supply this means any change to demand has a drastic impact on price.

Question 20

What occurs if the social supply curve is for the right than the private supply curve?

Answer 20

A positive externality

Question 21

What occurs if the social supply curve is further left than the private supply curve?

Answer 21

A negative externality

Question 22

Give examples of activities that generate positive externalities.

Answer 22

Benefits from high-quality public service broadcastingBenefits from healthcare and medical researchBenefits from vaccination and immunisation programs

Question 23

Some examples of activities they generate negative externalities.

Answer 23

Costs from people smokingCosts from people drinking excessivelyCosts from litteringCosts from serious obesity

Question 24

What are merit goods?

Answer 24

Goods or services that the government thing consumers undervalued because of imperfect information and unknown positive externalities.

Question 25

What type of consumption will there be a merit goods in a free market?

Answer 25

Under consumption

Question 26

Give three examples of merit goods.

Answer 26

Healthcare, education, and exercise.

Question 27

How are economic inequalities shown?

Answer 27

They are showing the most obviously by people with different positions within economic distribution of income, pay and wealth.

Question 28

What does inequality lead to?

Answer 28

Market Failure

Question 29

Why does inequality lead to a market failure?

Answer 29

Because each pound is like an economic vote, therefore the rich drive the market and only there needs get met - misallocation. Also poor people cannot effectively interact with the market because of the price of services. The signalling and rationing functions can’t be accessed by poor people. High inequality - alienation - more crime - More use of demerit goods - more negative externalities.

Question 30

What are the two main types of poverty?

Answer 30

Absolute poverty - the number of people living below a certain income threshold and can’t afford basic goods.Relative poverty - the extent to which a households financial resources for below an average income threshold for the economy.

Question 31

What are the causes of poverty?

Answer 31

UnemploymentLow wagesSingle parent hoodHealth problemsDebt

Question 32

What are the possible solutions for inequality?

Answer 32

Redistribute income through increased taxes for the rich to benefit poor people.Subsidisation of basic needs. Introduced price controls or improve education/training.

Question 33

What is the potential problem with these solutions?

Answer 33

They may need to government failure – when government intervention in the economy needs to other forms of misallocation of resources.

Question 34

What are the causes of government failure?

Answer 34

Inadequate informationConflicting objectivesShort termism Unnecessary administrative costsRegulatory capture (political corruption ruins decision-making)Law of unintended consequences

Question 35

What is the law of unintended consequences?

Answer 35

When the policy designed to fix one problem create another issue.(E.g. Rent control leading to rogue land lords)

Question 36

What are public goods?

Answer 36

Goods that are non-excludable and non-rivalrous - you can’t stop anyone using them and the quality doesn’t drop when more people start using them.

Question 37

Why does the government have to provide public goods?

Answer 37

Produces don’t provide them because others free ride so the government uses taxes to supply public goods because providers can’t make a profit there is no incentive to supply so in a free market there would be no public goods.

Question 38

What is the problem with government provision of public goods?

Answer 38

It’s difficult to provide the correct level as there is no market so no demand and supply to determine the equilibrium.

Question 39

What do people do when asked about how much of the product they use and why?

Answer 39

People always overestimate their demand because the goods (in this instance) are provided free by the government.

Question 40

Why does this make it harder for the government?

Answer 40

They can’t go on what the consumers tell them so have to estimate demand at a given price and supply that.

Question 41

What are quasi-public goods?

Answer 41

These are goods/services that typically a public goods but in some cases act like a private goods. E.g. if a lane on the road closes it becomes very congested and becomes rivalrous

Question 42

What are private goods?

Answer 42

The opposite to public goods - goods that are both excludable and rivalrous - the more people use it the worse the quality of the good becomes.

Question 43

Why does the state provide public goods?

Answer 43

On the grounds of equity and efficiency To overcome market failure and supply sufficient public goodsAlthough the state finance are good they can be provided by others at the point of need

Question 44

When does information failure cause market failure?

Answer 44

When we don’t have perfect informationWhen there is asymmetric information - one person exploits the other through their extra knowledge (E.g. Banks with PPI)

Question 45

Using example to illustrate the principal agent problem.

Answer 45

When the government provide money to schools they assume they will focus on gaining best education results. The head will want to do this but will also have personal aims (a new car) therefore the agent here is not fully aligned to the government wishes so they’re not totally profit making.

Question 46

What are the benefits and drawbacks of state provision of the NHS?

Answer 46

+’s Economies of scaleNot profit driven R&D and focus on patient careAddresses under consumption of merit goods-‘s Diseconomies of scaleMonopoly provision - allocative inefficiency No price signals for cons/prodsMay cause overconsumption

Question 47

What are the benefits and drawbacks of private provision of the NHS?

Answer 47

+’s More efficientAllows price signals, allocative and rationing functionsMore dynamically efficient? Maybe better quality?-‘s Focus on profitsNo economies of scaleInequalityOverconsumption bc it’s a merit good