4.1.8 The Market Mechanism, Market Failure And Government Intervention

Question 1

Rationing functions

Answer 1

When there are scarce resources, price increases due to excess demand.

Question 2

Incentive functions

Answer 2

This encourages a change in behaviour of a consumer or producer. E.g a high price would encourage firms to supply more to the market

Question 3

Signalling function

Answer 3

The price acts as a signal to consumers and new firms entering the market. Price changes show where new resources are needed in the market

Question 4

Price mechanism

Answer 4

Determines the market price, ‘the invisible hand of the market’

Question 5

Advantages of the price mechanism

Answer 5

• impersonal method of allocating resources
• it acts as a signal to show the cost of purchasing a good to the consumer
• it signals to producers the revenue they will receive
• allows consumers to gain sovereignty in the market
• efficient allocation of resources

Question 6

Disadvantages of price mechanism

Answer 6

• may be inequality in wealth as it doesn’t consider distribution of wealth
• ignores equality
• under provision of public goods and merit goods

Question 7

Externality

Answer 7

The cost or benefit a third party receives from an economic transaction outside of the market mechanism

Question 8

Public goods

Answer 8

Non excludable and non rival, they are underprovided in a feee market because of the free rider problem

Question 9

Monopolies

Answer 9

Consumer has very little choice where to buy goods from so they are often over charged and under consumed

Question 10

Non excludable

Answer 10

By consuming the good, someone else is not prevented from consuming the good as well

Question 11

Non rival

Answer 11

The benefit other people get from the good does not diminish if more people consume the good

Question 12

Quasi public good

Answer 12

Have characteristics of both private and public goods, semi excludable and semi rival

Question 13

Tragedy of commons

Answer 13

Individuals priorities personal gain over the well being of society

Question 14

Private good

Answer 14

Rival and excludable e.g chocolate bar

Question 15

Social costs

Answer 15

Social costs=private costs+external costs

Question 16

Who is Interested in benefits of a good or service?

Answer 16

The consumer so it is on the demand curve

Question 17

Who is interested in the costs of a good or service?

Answer 17

Producers so it’s on the supply curve

Question 18

Describe the negative production externality graph

Answer 18

• MSC is greater than MPC

* the welfare loss triangle points left to social optimum as it is over produced

Question 19

Describe the positive production externality graph

Answer 19

• MPC is greater than MSC

* welfare loss triangle points right to SOE as it is underproduced

Question 20

Describe the negative consumption externality graph

Answer 20

• MPB is greater than MSB

* welfare triangle points to the left to SOE as it’s over consumed

Question 21

Describe the positive consumption externality graph

Answer 21

• MSB is greater than MPB

* welfare triangle points right to SOE as it’s under consumed

Question 22

Symmetric information

Answer 22

Consumers and producers have perfect market information

Question 23

Asymmetric information

Answer 23

Leads to market failure, where there is unequal knowledge between consumers and producers

Question 24

Agent principal problem

Answer 24

When the agent makes decisions for the principal but the agent is inclined to act in their own interests

Question 25

Market failure

Answer 25

A free market with a misallocation of resources

Question 26

Merit good

Answer 26

Underconsumed in the free market and has a positive affect on the third party

Question 27

Demerit good

Answer 27

Over provided in the free market, has negative affects on the third party

Question 28

Free market

Answer 28

Where resources are allocated by supply and demand without government intervention

Question 29

Social optimum

Answer 29

Where Marginal Social Cost (MSC) meets Marginal Social Benefits (MSB)

Question 30

Consumer surplus

Answer 30

The difference between what someone is willing to pay and what they will pay

Question 31

Welfare loss

Answer 31

The consumer surplus

Question 32

Types of market failure

Answer 32

* externality * under provision of public goods * information gaps * monopolies * Inequality

Question 32

Complete market failure

Answer 32

When a good isn’t provided so there is a missing market

Question 32

Partial market failure

Answer 32

When the market provides a good but the wrong quantity or price

Question 33

Free rider problem

Answer 33

People who don’t pay for the good still receive the benefits of it

Question 34

Why are public goods under provided?

Answer 34

* free rider problem occurs * tragedy of commons * it is hard to measure the value consumers get from public goods so it is hard to put a price on it

Question 35

Social benefit

Answer 35

Social benefit= private benefit + external benefit

Question 36

Indirect taxes

Answer 36

Taxes placed in expenditure, they increase production costs and supply shifts inwards, ideally they are the size of the external cost

Question 37

Ad valorem

Answer 37

Taxes are a percentage such as VAT which adds 20% of the unit price

Question 38

Specific taxes

Answer 38

A set tax per unit, such as the 58p per litre fuel duty on unleaded petrol

Question 39

Subsidies

Answer 39

A payment from the government to a producer to lower costs of production and increase supply, ideally it should be the value of the social benefit

Question 40

Who takes most of the burden for a tax on a good which is inelastic

Answer 40

The consumer

Question 41

Who takes most of the benefit of an inelastic good which has subsidised?

Answer 41

Consumers

Question 42

Maximum price

Answer 42

The government set a max price where consumption of a good is to be encouraged (must be set below FM price)

Question 43

Pros and cons of maximum price

Answer 43

✅they prevent monopolies from exploiting customers ✅could lead to welfare gains for consumer ✅could increase efficiency in firms since they have an incentive to keep costs low ❌could reduce a firms profit leading to less investment ❌firms might raise the price of other goods

Question 44

Minimum price

Answer 44

The government might set a minimum price where consumption of a good is to be discouraged (must be set above FM price)

Question 45

Pros and cons of pollution permits

Answer 45

✅should benefit environment in long run ✅the government could raise revenue from permits because they can sell them to firms ✅raises revenue for greener firms ❌could lead to firms relocating to where there are no pollution permits ❌firms might pass higher cost of production onto consumers ❌permits could create barrier to entry and reduce competition ❌expensive for government to monitor emissions

Question 46

Government failure

Answer 46

When government intervention leads to a worse allocation of resources and there is a welfare loss to society

Question 47

Causes of government intervention

Answer 47

* distortion of price signals * unintended consequences * excessive administrative costs * information gaps