3.1.5 - Market Mechanism, Market Failure, Gov. Intervention

Question 1

Define price mechanism

Answer 1

a system where forces of demand and supply determines the prices or commodities and their changes
(Way that basic economic problem is resolved in a market economy)

Coined the ‘invisible hand of the market’ by Adam Smith

Question 2

What 3 functions does the price mechanism use

Answer 2

1. Rationing;
   When there are scarce resources, price increases which discourages demand
2. Incentive;
   Encourages change in behaviour of a consumer or a producer
   High prices encourage firms to supply more to a market
3. Signalling;
   Price acts as a signal to consumers and new firms entering the market
   HIGH PRICE signifies PROFITABILITY which encourages reduced demand — consumers leave markwr

Question 3

Define market failure

Answer 3

Occurs whenever market leads to a misallocation of resources in the economy

2 types:

1. Complete
   Market doesn’t exist, missing
2. Partial
   Market exists but contributes to resource misallocation

Question 4

Define misallocation of resources

Answer 4

When resources aren’t allocated to the best interests of society

Question 5

Define missing market

Answer 5

No market as functions of prices have broken down

Question 6

What is a public good?

Answer 6

Commodity / service made available to all members of society

Characteristics include:

• non-excludability:
  Free riders
• non-rival consumption:
  Each parties consumption of the food doesn’t compromise others enjoyment
• non-rejectable:
  Collective supply of a pure public good where it can’t be rejected by people

Examples include flood defence, public service broadcasting, sanitation infrastructure

Question 7

What is a quasi-public good?

Answer 7

Near public good

Characteristics include:

• semi non-rival
  Up to an extent, more consumers using a park, beach, road etc do not not reduce space available for others (eventually things get crowded)
• semi non-excludable
  It is possible but not easy or cheap to exclude non-paying customers

Question 8

Define free rider

Answer 8

Person who benefits from provision of public goods without paying

Question 9

How has technology changed the nature of public goods?

Answer 9

• advances in technology are causing a blurring of the distinction between public and private goods
• encryption allows suppliers to exclude non-payers

Question 10

Why should the government provide public goods? (What may happen if they don’t)

Answer 10

Why should they?

State provision may help to prevent under provision and under consumption of public goods so that social welfare is improved

Question 11

What is an externality? + provide some examples

Answer 11

Type of external benefit (public good) or external cost (public bad) which is dumped on third parties outside the market

Positive:
- early years education
- free school
- museums / galleries

Negative:
- noise pollution
- air pollution from smokers

They exist when there is a divergence between private and social costs / benefits

Question 12

What are private costs?

Answer 12

Producers are concerned with private costs of production

I.e rent, cost of machinery

Question 13

Formula for social costs?

Answer 13

Private + external costs = social costs
costs

Question 14

What are private benefits

Answer 14

Consumers are concerned with the private benefit derived from the consumption of a good

The price a consumer is prepared to pay determines this

Question 15

Formula for social benefit

Answer 15

Private + external = social
benefits benefits benefits

Question 16

When do external costs occur?

Answer 16

When a good is being produced / consumed

Question 17

Define free market

Answer 17

Prices of goods are self regulated by buyers / sellers negotiating in an open market

Question 18

What is allocative efficiency?

Answer 18

In a market which involves comparing the full social cost of producing an extra unit (MSC) with the full social benefit from its consumption (MSB)

Achieved when consumer satisfaction is maximised

Question 19

What are the 8 causes of market failure?

Answer 19

1. Market power
2. Positive externalities
3. Negative externalities
4. Demerit foods
5. Merit goods
6. Information failure
7. Public goods
8. Immobility of factor inputs

Question 20

Define a merit good, provide 2 of its characteristics and give an example

Answer 20

Goods for which the social benefits of consumption exceed the private benefits

Characteristics:
- excludable
- rivalrous

Governments believe these will be under-consumed and so should be subsidised or provide free at the point of use

i.e educations, vaccinations

Under provision may result from imperfect info

Question 21

What is a demerit good?

Answer 21

Goods for which the social costs of consumption exceed the private costs (goods are subject to negative externalities in consumption)

Over provision of demerit goods may result from imperfect information

i.e tobacco, alcohol

Question 22

Why would geographical and occupational immobility lead to market failure?

Answer 22

Geographical immobility:

When workers find it impossible or difficult to move to other parts of the country / countries

Occupational immobility:
When workers find it impossible or difficult to move between jobs because they lack skills required for new jobs

Both could lead to unemployment and a waste of scarce resources
Contributes to market failure

Question 23

Why would imperfect information lead to market failure?

Answer 23

Asymmetric information means one party has better or more information than the other when making decisions or transactions

This can cause an imbalance in power
Can lead to market failure

Question 24

Simply define income, and state what could occur within the market mechanism if there is no Gov intervention regarding income — what can this lead to

Answer 24

Flow of money

In absence of gov intervention, the market mechanism is likely to generate unequal distribution of wealth.
Can lead to negative externalities

Question 25

Define wealth

Answer 25

Stock of assets In absence of gov intervention the market mechanism is likely to lead to the unequal distribution of wealth. Can lead to negative externalities

Question 26

What ways can wealth inequality be reduced?

Answer 26

- Progressive taxes - Gov spending - welfare payments

Question 27

What is a pro-free market economist?

Answer 27

Believes market mechanism works through incentives via price signals

Question 28

What is an interventionist economist?

Answer 28

Believes that markets are often uncompetitive, prone to monopoly power and producer sovereignty corrected through gov intervention

Question 29

In what ways can methods of gov intervention be assessed?

Answer 29

- impact of alternative policies on different groups I.e producers and consumers - financial and opportunity cost of alternative policies - effects of intervention on equity and efficiency - significance of elasticity on the method

Question 30

2 types of taxation?

Answer 30

1. Indirect: Tax levied on goods and service I.e VAT 2. Direct: Tax levied on incomes of firms and people I.e income tax

Question 31

(Gov intervention) Advantages and disadvantages of taxation?

Answer 31

Advantages: - reduces production and consumption of demerit goods and those with negative externalities - raises revenue to fund merit and public goods - market orientated solution Disadvantages: - ineffective if PED for product / service is inelastic - inefficiencies may occur — costs to collect tax - tax evasion

Question 32

Simply define subsidy, and who can they be for?

Answer 32

Payment from government to: 1. Producers: For each unit of good they produce I.e bus payments 2. Consumers I.e over 60s winter fuel

Question 33

(Gov intervention) Advantages and disadvantages of subsidies

Answer 33

Advantages: - encourages consumption and production of merit goods with positive externalities - purpose is to increase real income of consumers by keeping prices below market equilibrium Disadvantages: - inefficiency - cost and opportunity cost

Question 34

(Gov intervention) Advantages and disadvantages of regulation, standards and legal control

Answer 34

Advantages: - forces consumers to consume more merit goods - can be cheap and easy to impose - backed by fines Disadvantages: - cost of enforcement - opportunity cost - black markets can develop

Question 35

(Gov intervention) advantages and disadvantages of information provision

Answer 35

Advantages: - move towards free market approach - provides info needed to maximise welfare Disadvantages: - cost and opportunity cost - may be ineffective, often ignored - may not reach target audience

Question 36

Define price ceiling

Answer 36

Maximum price laws set, illegal to sell below the price i.e rent prices

Question 37

Define price floor

Answer 37

Minimum legal prices where it’s illegal to sell below it when trading i.e EU agricultural prices

Question 38

What does Polluter Pays Principle mean?

Answer 38

Producer is responsible for paying for damage done to the environment Underpins environmental policy Traceable pollution permits allow owners to emit certain amounts of pollution

Question 39

What is the state provision of goods?

Answer 39

Governments provide public goods which are under provided in the free market i.e education, healthcare These make merit goods more accessible, might increase their consumption and yield positive externalities Could be expensive

Question 40

What is a private good?

Answer 40

A private good is a product that must be purchased to be consumed, and consumption by one individual prevents another individual from consuming it. I.e dinner at a restaurant

Question 41

How can public goods lead to market failure?

Answer 41

If some consumers decide not to pay but use the good anyway — leads to underfunding

Question 42

How can externalities lead to market failure?

Answer 42

When the good / services price equilibrium doesn’t accurately reflect the true costs and benefits of that product / service The market will fail by not supplying the socially optimal amount of the good. The imbalance causes allocative inefficiency, which is the over- or under-consumption of the good.

Question 43

How can merit goods lead to market failure?

Answer 43

In the free market they are provided at a quantity below the socially optimum level thus creating market failure as there is a misallocation of resources

Question 44

How can demerit goods lead to market failure?

Answer 44

In the free market these goods are over consumed — prices rise to in theory to deter buyers

Question 45

How can a monopoly cause market failure?

Answer 45

Because not enough of a good / service is available or the price gets too high

Question 46

How can income inequality lead to market failure?

Answer 46

Only products and activities that create profits are manufactured or pursued. This causes a large portion of consumers to be excluded from the market because they lack the income to purchase these products

Question 47

How can governments influence the allocation of resources?

Answer 47

- public expenditure - taxation - regulation

Question 48

When does government failure occur?

Answer 48

When gov intervention in the economy leads to a misallocation of resources Potential sources include: - inadequate information - conflicting objectives - administrative costs Gov intervention can lead to unintended consequences

Question 49

What are the types of market failure?

Answer 49

1. externalities Negative externalities are caused by consumption of demerit goods, i.e cigarettes 2. under provision of public goods Public goods are non-excludable and non-rival. They are under-provided in a free market because of the free-rider problem 3. information gaps Imperfect / asymmetric info leads to a misallocation of resources 4. monopolies Consumers are often overcharged leading to underconsumption of the good / service (therefore needs and wants aren’t fully met) 5. inequalities in the distribution of income and wealth Can lead to negative externalities I.e social unrest

Question 50

Define symmetric information

Answer 50

Consumers and producers have perfect market information to make their decision leading to an efficient allocation of resources

Question 51

Define asymmetric information

Answer 51

Unequal knowledge between consumers and producers leading to a misallocation of resources, hence market failure

Question 52

What is the principal-agent problem?

Answer 52

When the agent makes decisions for the principal, but the agent is inclined to act in their own interest rather than those of the principal I.e shareholders and managers having different objectives

Question 53

Define mobility of Labour

Answer 53

The ability of workers to change between jobs > unemployment is evidence that labour markets don’t work efficiently

Question 54

What is frictional unemployment?

Answer 54

When people are in-between jobs and are in search of a new one

Question 55

What is structural unemployment?

Answer 55

Occurs when there is a decline in an industry, meaning worker skills don’t match the location and skills required for the job

Question 56

What does geographical immobility of FOP refer to?

Answer 56

Obstacles which prevent FOP moving between areas I.e Labour finding it hard to find work due to family ties etc

Question 57

What does occupational immobility of FOP refer to?

Answer 57

Obstacles which prevent FOP changing their use i.e Labour finding it hard to change their occupation m

Question 58

Why would the government impose taxes i.e ad valorem tax on demerit goods like cigarettes?

Answer 58

To discourage consumption of the demerit good and reduce negative externalities. For price inelastic goods like cigarettes most of the burden of tax is placed on the consumer

Question 59

What are specific taxes?

Answer 59

Set taxes per unit

Question 60

What does it mean for a firm to internalise an externality?

Answer 60

The polluter pays for the damage. Increased prices of goods, whereby tax is equal to the external cost of each unit, then the supply curve becomes MSC rather than MPC, therefore the free market equilibrium becomes the socially optimum equilibrium

Question 61

Do consumers gain more or less from price elastic or inelastic subsidies?

Answer 61

Consumers gain more when demand is price inelastic, whilst producers supply more when demand is price elastic

Question 62

What is a maximum price?

Answer 62

Where the consumption or production of a good is to be encouraged — so the good doesn’t become too expensive to produce or consumer >have to be set below free market price SAME AS PRICE CEILING

Question 63

What are price ceilings good for consumers?

Answer 63

It prevents monopolies exploiting consumers i.e price caps on roaming charges in the EU Could lead to welfare gains for consumers by keeping prices low Could increase efficiency in firms

Question 64

What is a minimum price?

Answer 64

Where consumption or production of a good is discouraged. It ensures the good never falls below a certain price I.e alcohol > makes goods less affordable hence reducing negative externalities from consumption Have to be set above the free market price otherwise they would be ineffective

Question 65

What does a tradeable pollution permit do?

Answer 65

- limits the amount of negative externalities, in the form of pollution, created in industries > firms can buy and sell surplus allowances among themselves

Question 66

Advantages of a tradeable pollution permit?

Answer 66

- should be a benefit in the long run by encouraging firms to use green production methods - Gov can raise revenue from permits - greener firms can raise revenue

Question 67

Disadvantages of a tradeable pollution permit?

Answer 67

- could lead to some firms relocating to where they can pollute without limits, which will reduce their production costs - firms might pass higher costs onto consumers - competition could be restricted in the market (barrier to entry) - could be expensive for governments to monitor emissions

Question 68

Why would governments want to implement information provision?

Answer 68

To ensure there is no information failure and so consumers and firms can make informed economic decisions

Question 69

What are 4 causes of government failure?

Answer 69

1. Distortion of price signals - Gov subsidies could distort price signals by distorting the free market mechanism. 2. Unintended consequences - When actions of producers and consumers have unexpected or unintended consequences 3. Excessive administrative costs - The social benefits of a policy might not be worth the financial cost of administering the policy. 4. Information gaps - Some policies might be decided without perfect information I.e gov housing policies which failed

Question 70

What is a public bad?

Answer 70

Opposite of a public good > provides dis utility or dissatisfaction to people when consumed > reduces welfare