The Market Mechanism, Market Failure & Government Intervention Flashcards
1
Q
what is the price mechanism ?
A
the interaction of demand and supply in a market economy, that allocates scarce resources amongst competing needs and wants
2
Q
what did Adam Smith refer to the functions of the market mechanism as ?
A
the ‘invisible hand of the market’
3
Q
what 3 functions does the price mechanism fulfill ?
A
rationing,
incentivising,
signalling
4
Q
what is the ‘rationing’ part of the price mechanism ?
A
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.
5
Q
what is the ‘incentive’ part of the price mechanism ?
A
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)
6
Q
what is the ‘signalling’ part of the price mechanism ?
A
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)
7
Q
what order does the price mechanism work in ?
A
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)
8
Q
what are the advantages of the price mechanism ?
A
There is an efficient allocation of resources under price mechanism as markets adapt to changes quickly
9
Q
what are the disadvantages of the price mechanism ?
A
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
10
Q
why does the price mechanism exist ?
A
to determine the most efficient allocation of scarce resources in response to the competing wants and needs in the marketplace
11
Q
what is market failure ?
A
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
12
Q
what is a complete market failure ?
A
occurs when there is a missing market
the market does not supply products at all despite society having demand for it
13
Q
what is a partial market failure ?
A
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
14
Q
what is the most common cause of a complete market failure (missing market) ?
A
where there is non-excludability and no enforceable property rights
(no way of charging consumers if everyone has access to the resources)
15
Q
what are the 6 main causes of market failure ?
A
public goods
externalities
tragedy of the commons
merit and demerit goods
market imperfections
unequal distribution of income and wealth
16
Q
why do public goods cause market failures ?
A
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.
17
Q
what are externalities why does they lead to market failure ?
A
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
18
Q
what is the Tragedy of the Commons and why does it lead to market failure ?
A
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
19
Q
what does rivalrous mean ?
A
rivalrous goods can be used up
20
Q
what are merit goods why do they lead to market failure ?
A
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
21
Q
what are demerit goods why do they lead to market failure ?
A
goods which have harmful impacts on consumers or society
e.g. cigarettes
22
Q
what are the 3 types of market imperfections, why do they lead to market failure ?
A
1) imperfect information
2) monopoly power
3) factor immobility
23
Q
what is imperfect information and why does it lead to market failure ?
A
when buyers and sellers have different levels of information in a market, this can distort market outcomes, resulting in market failure
24
Q
what is factor immobility, why does it lead to market failure ?
A
when factors of production are unlikely to be perfectly mobile
25
what are public goods and why do they lead to market failure ?
goods that are beneficial to society
non-excludable and non-rivalrous
26
what are private goods ?
goods that firms are able to provide to generate profits
excludable and rivalrous
27
why are non-rivalrous goods beneficial ?
one person consuming it does not prevent another person from consuming it.
they are finite
28
if firms did decide to provide these goods anyways, what would occur ?
the 'free rider problem'
29
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
30
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)
e.g. toll roads, private beaches
31
what is one way the 'free rider problem' can be minimised ?
technology
e.g. number-plate recognition and tracking on motorways for tolls
32
what is an externality ?
when there is an external impact on a 3rd party not involved in the economic transaction
33
when do negative externalties occur ?
when the social costs of an economic transaction are greater than the private costs
34
what is a private cost ?
is what a firm actually pays to produce a good/service
35
when do positive externalities occur ?
when the social benefits of an economic transaction are greater than the private cost
36
when are negative externalties of production created ?
during the production of a good/service
37
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
38
what is a market failure ?
when there is a misallocation of resources in a market
39
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
40
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
41
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
42
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
43
what are common (Pool) resources ?
resources with no private ownership
non-excludable but rivalrous
e.g. oceans, natural forests etc.
44
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
45
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
46
what are solutions to address the tragedy of the commons ?
Property rights
international agreements
47
what are property rights ?
they define the ownership of a resource and set out how they can be used
48
what are some problems with property rights ?
equity (deciding who revives property rights)
cost of enforcement and regulation
divisibility (not easily divided)
49
what are merit goods ?
products that are beneficial for society but the free market does not provide enough of them
50
what are demerit goods ?
products which have harmful impacts on consumers or society
51
what would the optimum allocation of resources for society generate ?
an equilibrium where (MSB = MSC)
52
what is a partial market failure ?
a good/ service is provided but not a socially optimal level
53
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
54
what is a pure monopoly ?
when there is only one producer in the market
55
Monopolies have market power and can set higher ... ?
prices for consumers to earn supernormal profits
56
what is the mobility of factors of production referring to ?
how easily firms can switch between different factors of production
57
The more mobile the factors of production ... ?
the more flexibility there will be in production
58
if firms have high mobility of their factors of production they can be ... ?
very responsive to changes in demand
59
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
60
what are the 7 main government interventions ?
indirect taxes
subsidies
price controls
state provision
regulation
property rights
pollution permits
61
what is an indirect tax ?
a tax paid when goods and services are purchased
62
what is the aim of indirect taxes ?
to increase cost of production for firms
leading to higher prices
reducing quantity demanded
63
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
64
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
- regressive may negatively effect poor greater than the rich (higher burden on the poor)
65
what is a subsidy ?
amount of money given to a firm by the government
66
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
67
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
68
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
69
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
70
how do price controls correct market failure ?
by influencing the levels of production or consumption in markets
71
what are the 2 types of price controls used ?
maximum price (ceiling)
minimum price (floor)
72
the price ceiling is set .... the existing market equilibrium ?
below
73
when will governments use a price ceiling ?
if a market price is too high, especially for essential goods and services to help consumers
74
what are the advantages of price ceilings ?
some consumer benefit (Lower prices)
stabilize markets in the SR
75
what are the disadvantages of price celings ?
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
76
the price floor is set ... the existing market equilibrium ?
above
77
when will governments use price floors ?
Governments will often use price floors to protect producers from price volatility (e.g. farmers dependent on a single commodity)
or to decrease consumption of a demerit good
78
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
79
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
reduced consumer surplus, less choice and higher price
80
what is competition policy ?
a government policy aimed to make market more competitive, to ensure public interest is protected.
81
what are the main forms of consumer exploitation by firms ?
higher prices
lack of choice
poor quality products
82
what is the main aim for competition policy to control ?
anti-competitive mergers and monopolies
(preventing restrictive trading practices and promote competition in markets)
83
what does the CMA stand for ?
The Competition and Markets Authority
84
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
85
why must monopolies be limited, in the governments opinion ?
monopolies can restrict output and raise prices to gain supernormal profit
- This reduces consumer surplus
86
what is consumer surplus ?
consumer welfare gain from consuming goods and services
87
what are the 5 main competition policy's ?
breaking-up monopolies
price regulation (maximum/ minimum prices)
profit regulation
taxation
public (state) ownership
88
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)
89
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
90
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
91
what is public ownership ?
government ownership of firms, industries, or other assets
92
what is privitisation ?
the transfer of assets from the public (state) sector into private ownership
93
what is nationalisation ?
the transfer of assets from the private sector into public (state) ownership
94
what type of goods tend to be nationalised (state provision) ?
merit goods, and public goods
95
what are the benefits of public (state provision) / 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
96
what are the drawbacks of public (state) ownership / nationalisation ?
- The Government may lack the expertise to allocate resources efficiently. (Imperfect information)
- Higher expenditure for the government which means higher taxes
- Publicly owned firms/industries tend to lack dynamic efficiency because they lack competition
- excess demand (where consumption is free)
97
what are the benefits of private ownership / privatisation ?
+ Raises revenue for the government
+ Reduces public spending
+ May lead to productive efficiency and dynamic efficiency
98
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
99
what is the regulation of markets ?
the process of monitoring and enforcing the laws
100
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
101
what are the advantages of regulation ?
+ lower prices which increases consumer surplus
+ positive externalities
+ extra government revenue
102
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
103
what is deregulation ?
the process of removing government controls from markets
104
what are the advantages of deregulation ?
+ In some markets, deregulation promotes contestability in markets allowing lower prices for consumers
+ removes excessive costs of regulation
105
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
106
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
107
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
108
pollution permits: the cost of production represents an additional ........ ?
cost of production
109
what are the advantages of pollution permits ?
+ incentivises and encourages firms to switch to green production methods (reducing negative externality of pollution)
+ raises government revenue
+ pollution should fall to a more socially optimal level of output
110
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
111
when does government failure occur ?
when the government intervenes in a market to correct market failure, but the intervention results in a further misallocation of resources from society's point of view.
(costs intervention > benefits intervention)
112
what are some causes of market failure ?
> imperfect information (financial markets are fast moving & complex)
> conflicting objectives (trade-off between objectives, improving one may come at the expense of another)
> administrative costs
> unintended consequences (black markets, impact on poor)
> market distortions
> regulatory capture
113
where does the price mechanism occur ?
the free market
114
what does the Price Mechanism determine ?
the most efficient allocation of resources in response to the competing wants and needs in the market place
115
what are scarce resources also known as ?
Factors Of Production
116
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.
117
what is an example of the free-market leading to market failure ?
income and wealth inequality
environmental degradation
118
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.
119
what does a market failure lead to other than a misallocation of resources ?
a dead weight loss (DWL) to society
120
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.
121
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'.
122
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.
123
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)
124
what are common pool resources ?
non-excludable but rivalrous (e.g. fish in the sea)
125
what are the 3 main market imperfections that can cause market failure ?
- asymmetric information
- market power
- factor immobility
126
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
127
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
128
what is the Keynesian Economic Theory ?
advocates for government intervention to manage the economy
129
what is a Public Good ?
a good that is non-excludable and non-rivalrous.
e.g. road signs & traffic lights, roads, flood defenses
can lead to the free-rider problem
--> complete market failure (missing market)
130
131
Why do merit goods tend to be state provided ?
Because they are under consumed, society underestimate the benefits they possess. (Information failure)
E.g. healthcare, education
132
Why do public goods tend to be under consumed ?
Non excludable, non rivalrous
(Not profitable, due to the free rider problem)
Therefore they are under provided and under consumed in the free market.
133
How does the government allocate merit/ public goods, in state provision ?
1) consider full cost and social benefit of allocating resources at Q*
2) make it free at the point of consumption (perfectly inelastic supply curve at Q*)
3) solve UP/UC and inequity issues
4) solve missing markets
5) allocative efficiency and society welfare is maximised
134
What is a regulation/ law introduced to correct market failure ?
Rule or law enacted by the government that must be followed by economic agents to encourage a change in behaviour.
. Non market based approach (does not work like a tax, isn’t subject to PED)
. Incentivise changes to behaviour
. Solves issues faced in free market
135
What are the drawbacks of regulation/ law in solving market failure ?
- costly to enforce and regulate
- imperfect information
- black markets (unintended consequences)
- inequity
136
What is information provision, as a method to solve MF ?
Government funded information provision (advertising, education etc) to encourage or discourage consumption of a merit or demerit good/service.
137
How does information provision solve market failure ?
Informs consumers on how beneficial or damaging merit or demerit goods are when consumed.
1) demand shift (from MPB —> MSB, if perfect)
2) consumers make more rational decisions knowing true MPB.
3) solves under/ over consumption
4) alloacirve efficiency, society welfare is maximised
138
What are the drawbacks of information provision ?
- costly (government funded)
- no guarantee of success (poorly targeted or poor quality ads, etc)
- may only be effective in the LR (repetition of adverts)
139
How can property rights solve market failure (tragedy of commons) ?
1) incentive to not exploit common access resources (because you own them) act in a more sustainable way
2) negative externalities internalised
3) will reduce over consumption and provision to a socially optimal level
140
What are the drawbacks of property rights to solve MF (tragedy of commons) ?
- can property rights solve markets be efficiently distributed (divisibility)
- equity (who to give property rights too)
- enforcement costs
141
What are the different economic systems ?
Market economy (private ownership)
Command economy (government owned)
Mixed economy (private + government/public)
142
What are the motives of a market economy ?
Maximise profits
High competition
143
What are the motives of a command economy ?
Allocate resources efficiently, maximise society welfare
Low competition
144
What is the free market ?
Any marketplace where buyers meet sellers to exchange goods and services free from government intervention.
145
What are the benefits of Free market ?
+ allocative efficiency (at equilibrium), never get long run disequilibrium due to market mechanism
+ encourages competition (due to ability to make a profit)
+ as a result of dynamic efficiency should get dynamic efficiency
146
What are the drawbacks of free market ?
- markets can fail (we assume markets are very competitive, e.g. monopoly power) (we assume perfect information, cannot make rational decisions, we assume businesses are profit maximisers)
- inequity given to wide inequality (lack of affordability ,etc,)
- creative destruction (structural unemployment)
147
What are the main barriers to entry for firms ?
Legal: (patents, licenses, regulations)
Technical: (sunk costs, economies of scale)
Strategic: (predatory pricing, heavy advertising)
Strong Brand loyalty
148
What are the main barriers to exit ?
Sunk costs
Contracts
149
What X efficiency ?
When a business has no excess cost (minumising waste).
Producing on their AC curve
Lower prices for consumers (higher consumer surplus)
Higher profits
Increased market share
150
What is dynamic efficiency ?
Re-investment of LR supernormal profits, leading to innovation through R&D, and technological advancements etc.
151
What are the pros of allocative efficiency ?
Lower prices
Maximisation of CS & PS
High choice
High quality
152
What are the pros of productive efficiency ?
Lower prices
Higher consumer surplus
Fully exploiting Economies of scale
