The Market Mechanism, Market Failure & Government Intervention Flashcards
what is the price mechanism ?
the interaction of demand and supply in a market economy, that allocates scarce resources amongst competing needs and wants
what did Adam Smith refer to the functions of the market mechanism as ?
the ‘invisible hand of the market’
what 3 functions does the price mechanism fulfill ?
rationing,
incentivising,
signalling
what is the ‘rationing’ part of the price mechanism ?
When resources become scarce, the price will rise. Only those who can afford to pay for them will receive them. If there is a surplus, then prices fall and more consumers can afford them.
what is the ‘incentive’ part of the price mechanism ?
The incentive function encourages producers to increase or decrease output to increase profits.
-(When prices for a good/service rise, it incentivises producers to reallocate resources from a less profitable market in order to maximise their profits)
-(Falling prices incentivise reallocation of resources to new markets)
what is the ‘signalling’ part of the price mechanism ?
A change in price provides a signal to consumers and producers about where resources are wanted and where they are not
(High prices signals to a producer to produce more of that good/service and would signal to other producers to enter the market)
(A falling price signals to consumers to purchase more or a product)
what order does the price mechanism work in ?
1). rationing (of goods and services due to a change in demand or supply)
↧
2). incentivisng (producers to increase production
↧
3). signalling (other producers to enter the market because the demand for honey is strong)
what are the advantages of the price mechanism ?
There is an efficient allocation of resources under price mechanism as markets adapt to changes quickly
what are the disadvantages of the price mechanism ?
it may create inequality as only those with higher incomes have buying power
e.g. markets for donors
does not take into account consumer utility or decision making
why does the price mechanism exist ?
to determine the most efficient allocation of scarce resources in response to the competing wants and needs in the marketplace
what is market failure ?
when there is a less than optimum allocation of resources from the point of view of society.
(lack of allocative efficiency)
leads to a deadweight loss to society
what is a complete market failure ?
occurs when there is a missing market
the market does not supply products at all despite society having demand for it
what is a partial market failure ?
occurs where the market exists, but does not provide resources in optimum quantities
e.g. over production/ consumption or under production/ consumption of a good or service
what is the most common cause of a complete market failure (missing market) ?
where there is non-excludability and no enforceable property rights
(no way of charging consumers if everyone has access to the resources)
what are the 6 main causes of market failure ?
public goods
externalities
tragedy of the commons
merit and demerit goods
market imperfections
unequal distribution of income and wealth
why do public goods cause market failures ?
are beneficial to society but would be under-provided by a free market, because they are unprofitable as there are unexcludable therefore a price tag cant be put on them.
what are externalities why does they lead to market failure ?
they occur when there is an external impact on a third party not involved in the economic transaction between the buyer and seller.
e.g. passive smoking, which is considered a negative externality
what is the Tragedy of the Commons and why does it lead to market failure ?
occurs when common resources (non-exludable and rivalrous) are used by either the producer or consumer in a way that is not sustainable
e.g. over-fishing
what does rivalrous mean ?
rivalrous goods can be used up
what are merit goods why do they lead to market failure ?
goods or services that are beneficial to consumer and society
but the free market does not provide enough of them
e.g. education or healthcare
what are demerit goods why do they lead to market failure ?
goods which have harmful impacts on consumers or society
e.g. cigarettes
what are the 3 types of market imperfections, why do they lead to market failure ?
1) imperfect information
2) monopoly power
3) factor immobility
what is imperfect information and why does it lead to market failure ?
when buyers and sellers have different levels of information in a market, this can distort market outcomes, resulting in market failure
what is factor immobility, why does it lead to market failure ?
when factors of production are unlikely to be perfectly mobile
what are public goods and why do they lead to market failure ?
goods that are beneficial to society
non-excludable and non-rivalrous
what are private goods ?
goods that firms are able to provide to generate profits
excludable and rivalrous
why are non-rivalrous goods beneficial ?
one person consuming it does not prevent another person from consuming it.
they are finite
if firms did decide to provide these goods anyways, what would occur ?
the ‘free rider problem’
what is the ‘free rider problem’ ?
where customers realise that they can still access the goods, even without paying for them
they stop paying and continue to enjoy the benefits. They are ‘free-riding’ on the backs of other paying customers
what are quasi-public goods ?
are non-pure public goods that have characteristics of public goods and private good
(elements of non-excludability or non-rivalry)
what is one way the ‘free rider problem’ can be minimised ?
technology
e.g. number-plate recognition and tracking on motorways for tolls
what is an externality ?
when there is an external impact on a 3rd party not involved in the economic transaction
when do negative externalties occur ?
when the social costs of an economic transaction are greater than the private costs
what is a private cost ?
is what a firm actually pays to produce a good/service
when do positive externalities occur ?
when the social benefits of an economic transaction are greater than the private cost
when are negative externalties of production created ?
during the production of a good/service
why do negative externalities occur ?
as only the private costs are considered by producers and not the external costs
therefore, firms will over-produce these goods and services, causing market failure
what is a market failure ?
when there is a misallocation of resources in a market
what does a negative externality of production curve look like ?
price level Y axis
quantity X axis
(because its production we are focusing on the supply curves)
2 supply curves
one lower named MPC
one higher named MSC
-this is because MSC are greater than the MPC-
the triangle space infront of the demand curve and inbetween the MSC and MPC is the negative externality & DWL to society that can be shaded in.
1 demand curve
named D=MPB=MSB
what does a negative externality of consumption look like ?
price level Y axis
quantity X axis
(because its consumption we are focusing on the demand curves)
2 demand curves
one lower named MSB
one higher named MPB
-this is because MPB are greater than the MSB-
the triangle space infront of the supply curve and inbetween the MPB and MSB is the negative externality & DWL to society that can be shaded in.
1 supply curve
named S = MPC = MSC
what does a positive externality of production look like ?
price level Y axis
quantity X axis
(because its production we are focusing on the supply curves)
2 supply curves
one lower named MSC
one higher named MPC
-this is because MPC are greater than the MSC-
the triangle space behind the demand curve and inbetween the MPC and MSC is the positive externality & DWG to society that can be shaded in.
1 demand curve
named D=MPB=MSB
however, consumers will have to suffer from higher prices and lower outputs
what does a positive externality of consumption look like ?
price level Y axis
quantity X axis
(because its consumption we are focusing on the demand curves)
2 demand curves
one lower named MPB
one higher named MSB
-this is because MSB are greater than the MPB-
the triangle space behind the supply curve and inbetween the MSB and MPB is the positive externality & DWG to society that can be shaded in.
1 supply curve
named S = MPC = MSC
what are common (Pool) resources ?
resources with no private ownership
non-excludable but rivalrous
e.g. oceans, natural forests etc.
what is the tragedy of the commons ?
occurs when common pool resources are used in an unsustainable way
creating negative externaltiies in production and consumption
why does the tragedy of the commons create negative externaltities ?
P: because there is no incentive for firms to reduce production levels as they seek to maximise profits
C: there is also no incentive for consumers to reduce consumption levels. If an individual consumer cuts back on consumption, other consumers will use the resource
what are solutions to address the tragedy of the commons ?
international agreements
appeal for ownership rights over land
what are property rights ?
they define the ownership of a resource and set out how they can be used
what are some problems with property rights ?
equity (deciding who revives property rights)
cost of enforcement and regulation
divisibility (not easily divided)
what are merit goods ?
products that are beneficial for society but the free market does not provide enough of them
what are demerit goods ?
products which have harmful impacts on consumers or society
what would the optimum allocation of resources for society generate ?
an equilibrium where (MSB = MSC)
what is a partial market failure ?
a good/ service is provided but not a socially optimal level
why can imperfect information lead to over-consumption of demerit goods or an under-consumption of merit goods ?
consumers may have incomplete or inaccurate information about the external consequences associated with merit or demerit goods
what is a pure monopoly ?
when there is only one producer in the market
Monopolies have market power and can set higher … ?
prices for consumers to earn supernormal profits
what is the mobility of factors of production referring to ?
how easily firms can switch between different factors of production
The more mobile the factors of production … ?
the more flexibility there will be in production
if firms have high mobility of their factors of production they can be … ?
very responsive to changes in demand
what are the 5 main reasons governments intervene ?
- correct market failure (ensure resources are being allocated efficiently)
- redistribute income & wealth
- support firms
- collect tax revenues
- achieve macroeconomic goals
what are the 7 main government interventions ?
indirect taxes
subsidies
price controls
state provision
regulation
property rights
pollution permits
what is an indirect tax ?
a tax paid when goods and services are purchased
what is the aim of indirect taxes ?
to increase cost of production for firms
leading to higher prices
reducing quantity demanded
what are the advantages of using an indirect tax ?
- Raises the price and reduces the quantity demanded of demerit goods
- Reduces external costs of consumption and production
- Raises revenue for government programs
what are the disadvantages of using an indirect tax ?
- The effectiveness of the tax (PED inelastic)
- may lead to black markets
- producers may be forced to lay off workers
what is a subsidy ?
amount of money given to a firm by the government
what is the aim of subsidy’s ?
reduces the costs of production and encourages an increase in the output of a good or service
lower prices
what are the advantages of subsidies ?
- A subsidy increases demand for merit goods
-It lowers prices make goods more affordable to those on lower incomes reducing effects of poverty - Can be targeted to helping specific domestic industries
what are the disadvantages of subsidies ?
- It distorts the allocation of resources in markets
E.g. it often results in excess supply when used in agricultural markets - There is an opportunity cost associated with the government expenditure
- Subsidies are a disincentive for firms to become more efficient or competitive
what are price controls ?
a type of government intervention
in markets to change the market price
correct market failure, influence the levels of production or consumption in markets
how do price controls correct market failure ?
by influencing the levels of production or consumption in markets
what are the 2 types of price controls used ?
maximum price (ceiling)
minimum price (floor)
the price ceiling is set …. the existing market equilibrium ?
below
when will governments use a price ceiling ?
if a market price is too high, especially for essential goods and services to help consumers
what are the advantages of price ceilings ?
some consumer benefit (Lower prices)
stabilize markets in the SR
what are the disadvantages ?
Some consumers are unable to purchase due to the shortage
Producers lose out as the price is below what they would usually receive: their producer surplus falls
The unmet demand usually encourages the creation of illegal markets and exploitation of consumers
the price floor is set … the existing market equilibrium ?
above
when will governments use price floors ?
Governments will often use price floors to help producers or to decrease consumption of a demerit good
what are the advantages of price floors ?
In agricultural markets, producers benefit as they receive a higher price (Governments will often purchase the excess supply and store it or export it)
Producers are protected from price volatility
what are the disadvantages of price floors ?
It costs the government to purchase the excess supply and an opportunity cost is involved
Some producers such as farmers may become over-dependent on the Government’s help
Producers lower output which may result in an increase in unemployment in the industry
If demand is price inelastic, the increase in price does not impact QD or solve the market failure
what is competition policy ?
a government policy aimed to make market more competitive, to ensure public interest is protected.
what are the main forms of consumer exploitation by firms ?
higher prices
lack of choice
poor quality products
what is the main aim for competition policy to control ?
anti-competitive mergers and monopolies
(preventing restrictive trading practices and promote competition in markets)
what does the CMA stand for ?
The Competition and Markets Authority
what is the CMA ?
the UK Government regulator tasked with ensuring that the creation of monopoly power is avoided and that consumers are not exploited in markets
why must monopolies be limited, in the governments opinion ?
monopolies can restrict output and raise prices to gain supernormal profit
- This reduces consumer surplus
what is consumer surplus ?
consumer welfare gain from consuming goods and services
what are the 5 main competition policy’s ?
breaking-up monopolies
price regulation (maximum/ minimum prices)
profit regulation
taxation
public (state) ownership
once the government have reduced monopoly power in a market, how do they then increase competition ?
1) promote small businesses
2) deregulation (reducing barriers to entry)
3) privatisation (encourages new firms to enter the market as they feel more confident to compete)
what are the advantages of competition policy ?
+ Increased competition may lead to a fall in market price
+ Firms will strive to provide better quality and a range of products and customer service or risk losing market share
+ allocative and productive efficiency
what are the disadvantages of competition policy ?
- It can be expensive and time consuming to ensure firms or industries are complying with competition policies
- reduces creative destruction (replacement of old technologies due to innovation & intervention) , firms with monopoly power are dynamically efficient as they can provide huge investment in R&D
- may lead to government failure as the authorities create distortions in the market leading to inefficiencies
what is public ownership ?
government ownership of firms, industries, or other assets
what is privitisation ?
the transfer of assets from the public (state) sector into private ownership
what is nationalisation ?
the transfer of assets from the private sector into public (state) ownership
what type of goods tend to be nationalised ?
merit goods, and public goods
what are the benefits of public (state) ownership / nationalisation ?
+ resources can be provided and allocated in such a way that benefits society as a whole, allocatively efficient way
+ can prioritise social welfare over profit
+ can yield strong positive externalities
what are the drawbacks of public (state) ownership / nationalisation ?
- The Government may lack the expertise to run the business
- Higher expenditure for the government which means higher taxes
- Publicly owned firms/industries tend to lack dynamic efficiency because they lack competition
what are the benefits of private ownership / privatisation ?
+ Raises revenue for the government
+ Reduces public spending
+ May lead to productive efficiency and dynamic efficiency
what are the drawbacks of private ownership / privatisation ?
- Privatised, profit maximising monopolies can restrict output to generate supernormal profits
- The price of the good/service usually increases as firms seek to maximise their profit
- Private firms often provide a substandard goods or services as they cut quality to increase profits
what is the regulation of markets ?
the process of monitoring and enforcing the laws
why do the government create laws and rules that have to be regulated ?
to limit harm from negative externalities of consumption/production and to create competitive markets
what are the advantages of regulation ?
+ lower prices which increases consumer surplus
+ positive externalities
+ extra government revenue
what are the disadvantages of regulation ?
- High costs of enforcement/ administration of laws
- reducing profits for firms may compromise with dynamic efficiency
- can act as a barrier to entry
- black markets may be formed
- may lead to regulatory capture
what is deregulation ?
the process of removing government controls from markets
what are the advantages of deregulation ?
+ In some markets, deregulation promotes contestability in markets allowing lower prices for consumers
+ removes excessive costs of regulation
what are the disadvantages of deregulation ?
- May create a private firm with monopoly power as smaller companies are unable to compete
- Consumers may pay higher prices if the market is not regulated
- Private firms have an incentive to cut costs and provide a lower quality of service
what type of goods are unprovided in a free-market ?
merit goods (expensive)
&
public goods (non-excludable, non-rivalrous) leads to free-rider problem, unprofitable
how do pollution permits work ?
Governments calculate an optimum (or preferable) level of pollution
Governments create a pollution permit market and issue permits to polluting firms
The price of the permit is determined by demand and supply
Each permit allows a firm to pollute up to a certain amount. Any surplus can be sold and traded for additional revenue
Firms that pollute more have to buy additional permits from less-polluting firms
pollution permits: the cost of production represents an additional …….. ?
cost of production
what are the advantages of pollution permits ?
+ switch to green production methods (reducing negative externality of pollution)
+ raises government revenue
what are the disadvantages of pollution permits ?
- Firms may relocate production to places where they can pollute without limits
- Expensive and difficult for firms to monitor emissions
- Firms may pass on higher production costs to the consumer
when does government failure occur ?
when the government intervenes in a market to correct market failure, but the intervention results in a misallocation of resources from society’s point of view
what are some causes of market failure ?
> inadequate information (financial markets are fast moving & complex)
> conflicting objectives (trade-off between objectives, improving one may come at the expense of another)
> administrative costs
> market distortions
> regulatory capture
where does the price mechanism occur ?
the free market
what does the Price Mechanism determine ?
the most efficient allocation of resources in response to the competing wants and needs in the market place
what are scarce resources also known as ?
Factors Of Production
when does the free market lead to market failure ?
when there is a less than optimal allocation of resources from the point of society.
as a result economic or society welfare is not maximised.
what is an example of the free-market leading to market failure ?
income and wealth inequality
environmental degradation
why do market failures occur ?
due to an under/over provision of goods and services
leading to an under/over allocation of resources used to make products.
As a result there is a lack of allocative efficiency and therefore social and economic welfare is not maxmised.
what does a market failure lead to other than a misallocation of resources ?
a dead weight loss (DWL) to society
why are Public Goods usually not provided by firms ?
because they are non-excludable and non-rivalrous, which means firms cant make a profit from them because putting a price on the product would be an attempt to exclude the product to some due to its affordability, however consumers know they can get the good for free.
what is the Free-Rider Problem ?
occurs when consumers are aware that they can access the good without paying for them. Therefore, consumers who are paying will stop and enjoy the benefits of the product for free, and as a result, they are ‘free-riding’ on the back of paying consumers.
Over-time, firms will stop producing these products as a result, which will lead to a complete market failure creating a ‘missing market’.
what does the Government have to do with the Free-Rider Problem ?
the government will have to step in to provide these public goods, however the quantity supplied may be less than the socially optimal level.
describe the Tragedy Of The Commons ?
when individuals with access to public goods or an unregulated resource, act in self-interest over the well-being of society.
Consumers will overconsume common pool resources in an unsustainable way leading to the damage or depletion of natural resources over-time. (over-fishing)
what are common pool resources ?
non-excludable but rivalrous (e.g. fish in the sea)
what are the 3 main market imperfections that can cause market failure ?
- asymmetric information
- market power
- factor immobility
how does factor immobility lead to market failure ?
the more mobile your FOP, the greater flexibility a firm has to adapt to changes in demand
if you have factor immobility, demand for your good/service may increase however your supply may remain fixed
creating a miss allocation of resources and leading to a market failure
what is the Classical Economic Theory ?
the theory that emphasises Free-market and the role of the Price Mechanism to determine prices and allocation of resources
what is the Keynesian Economic Theory ?
advocates for government intervention to manage the economy