The Market Mechanism, Market Failure and Government Intervention in Markets

Question 1

Rationing function

Answer 1

When there are scarce resources, price increases due to the excess of
demand. The increase in price discourages demand and consequently rations
resources. e.g. plane tickets

Question 2

Incentive functions

Answer 2

This encourages a change in behaviour of a consumer or producer.

Question 3

Signalling function

Answer 3

The market price sends signals to buyers and sellers that help to determine their economic behaviour. An increase in demand (a shift to the right) leading to a higher equilibrium price sends a signal to producers to increase the quantity supplied and vice versa for a fall in demand. A rise in supply (a shift to the right) leading to lower equilibrium price sends a signal to buyers to increase the quantity demanded and again vice versa for a fall in supply.

Question 4

Advantages of the price mechanism

Answer 4

• Efficiency
• Flexibility
• Decentralised Decision Making

Question 5

Disadvantages of price mechanism

Answer 5

• Inequality
• Externalities
• Public goods

Question 6

Market failure occurs when…

Answer 6

a market leads to a misallocation of resources

Question 7

Complete market failure

Answer 7

occurs when there is a missing market. The market does not supply the products at all.

Question 8

Partial market failure

Answer 8

occurs when the market produces a good, but it is the wrong quantity or the wrong price. Resources are misallocated where there is partial market failure.

Question 9

Types of market failure

Answer 9

• Externalities (consumption of demerit goods)
• Public goods (Public goods are non-excludable and non-rival, and they are underprovided in a free market because of the free-rider problem)
• Inequalities in the distribution of income and wealth (This can lead to negative externalities, such as social unrest)
• Monopoly (Since the consumer has very little choice where to buy the goods and services offered by a monopoly, they are often overcharged. This leads to the underconsumption of the good or service, and therefore there is a misallocation of
  resources, since consumer needs and wants are not fully met)
• Imperfect information (misallocation of resources)

Question 10

Pure public goods

Answer 10

Non- rival and non- excludable

Question 11

Private goods

Answer 11

Rival and excludable

Question 12

Quasi public good

Answer 12

They are partially provided by the free market. For example, roads are
semi-excludable, through tolls and they are semi-non-rival.

Question 13

The free-rider problem

Answer 13

Since public goods are non-excludable (lack of property rights), consumers have an incentive not to contribute to the costs of their provision. This is because they receive the benefit of the good whether they contribute or not.

Question 14

The Tragedy of the Commons

Answer 14

A situation in which individuals with access to a public resource (also called a common) act in their own interest and, in doing so, ultimately deplete the resource.

Question 15

Why does the absence of property rights lead to externalities

Answer 15

Markets become inefficient, the moral hazard assumes someone else will pay the consequences for a poor
choice.

Question 16

Demerit goods

Answer 16

These are associated with
information failure, since consumers are not aware of the long run implications of
consuming the good, and they are usually overprovided. For example, cigarettes and
alcohol are demerit goods. The negative externality to third parties of consuming
cigarettes is second-hand smoke or passive smoking.

Question 17

Merit goods

Answer 17

These are associated with
information failure too, because consumers do not realise the long run benefits to
consuming the good. They are underprovided in a free market. For example,
education and healthcare are merit goods. The positive externality to third parties of
education is a higher skilled workforce.
MSB>MPB

Question 18

Why imperfect and asymmetric information can lead to market failure

Answer 18

It means that there cannot be an informed decision leading to a misallocation of resources, Consumers might pay too much or too little, and firms might produce the incorrect amount. For example, monopolies might exploit the consumer by charging them more than they need to.

Question 19

How a monopoly can lead to market failure

Answer 19

Monopolies could exploit the consumer by charging them higher prices.
This means the good is under-consumed, so consumer needs and wants are not fully
met.
This loss of allocative efficiency is a form of market failure.
Monopolies have no incentive to become more efficient, because they have few or
no competitors, so production costs are high.
There is a loss of consumer surplus and a gain of producer surplus.

Question 20

Immobility of factors of production can lead to market failure

Answer 20

Unemployment is evidence that labour markets do not work efficiently

Question 21

Principles of UK competition policy

Answer 21

1. Enhancing competition between firms through promotion of small business
2. Deregulation and privatisation- firms can compete in a competitive market, which should also help improve economic efficiency.
3. Competitive tendering for government contracts- private firms operate things such as roads or hospital.

Question 22

Arguments for and against the public ownership of firms

Answer 22

Some nationalised industries yield strong positive externalities. For example, by
using public transport, congestion and pollution are reduced.
Nationalised industries have different objectives to privatised industries, which are
mainly profit driven. Social welfare might be a priority of a nationalised industry.
By nationalising an industry, natural monopolies are created. This is because it is
inefficient to have multiple sets of water pipes, for example. Therefore, only one
firm provides water.
Some nationalised ind

Question 23

Arguments for and against privatisation

Answer 23

Free market economists will argue that the private sector gives firms incentives to
operate efficiently, which increases economic welfare. This is because firms
operating on the free market have a profit incentive, which firms which are
nationalised do not.
Since they are operating on the free market, firms also have to produces the goods
and services consumers want. This increases allocative efficiency and might mean
goods and services are of a higher quality.
Competition might also result in lower prices.
By selling the asset, revenue is raised for the government. However, this is only a
one-off payment.

Question 24

The problem of regulatory capture

Answer 24

Where the regulator become overly sympahtetic to the firm it is regulating
e.g. OFGEM – UK regulator for gas and electricity markets. In early 2016, with falling gas wholesale prices, the big energy companies were able to increase their profit margins, equalt to £120 per customer.

Question 25

Government failure

Answer 25

When government intervention in the economy leads to a misallocation of resources

Question 26

Causes of government failure

Answer 26

Distortion of price signals
Unintended consequences
Excessive administrative costs
Information gaps