5- The Market Mechanism, Market Failure And Government Intervention

Question 1

What is a free market?

Answer 1

Market with no government intervention

Question 2

How does the economy allocate resources effectively?

Answer 2

The price mechanism is used to allocate resources effectively. The price mechanism consists of

• rationing function
• incentive function
• signalling function

Question 3

Define what market failure is?

Answer 3

Market failure
- occurs when the free market, left alone, fails to deliver an efficient allocation (productive and allocative efficiency) of resources and so results in the loss of economic welfare and leads to economic inefficiency.

When price is too high or too low

Question 4

Complete market failure results in a missing market.

Define what a missing market is?

Answer 4

Missing market

- is a situation in which there is no market for a good because prices have broken down

Question 5

Partial market failure is mire common. Define what partial market failure is?

Answer 5

Partial market failure

- is where a market exists but contributes to misallocation of resources and so does not maximise economic welfare

Question 6

What are the main causes of market failure?

Answer 6

1) positive and negative externalities
2) merit and demerit good
3) public goods
4) monopoly and other market imperfections
5) inequalities in the distribution of income and wealth
6) factor immobility causing unemployment
7) imperfect information

Question 7

Define what public goods are?

Answer 7

Public goods 
- a good that possesses the characteristics of:
> non- excludability
> non- rivalry
> non- rejectablilty
.. inconsumption

Question 8

Define what non-excludable means?

Answer 8

Non- excludable-

Once provided, no person can be excluded from benefitting

Question 9

Define what non-rivalry means?

Answer 9

Non-rivalry

- consumption of the good by one person does not reduce the amount available for consumption by another person

Question 10

Define what non-rejectable means?

Answer 10

Non- rejectable

- when a public good is provided, you cannot reject it

Question 11

Examples of public goods?

Answer 11

• traffic lights
• defence
• clean air
• environmental goods
• public service broadcasting

Question 12

Define what a quasi-public good is?

Answer 12

Quasi-public good
- a good that has some of the qualities of a public good but does not fully possess one or two required characteristics of non-rivalry, non-excludability, non-rejectability

Question 13

Examples of quasi-public goods?

Answer 13

Beaches
Park
Open wifi networks

Question 14

Define what a private good is?

Answer 14

Private good

- a good that is both excludable and rival in consumption

Question 15

Define what a free rider is?

Answer 15

Free rider

- a person or organisation which receives benefits that others have paid for without making any contribution themselves

Question 16

How do public goods lead to market failure?

Answer 16

If the market mechanism is used to provide public goods, there will be market failure (and so a missing market) because of the free rider problem
> consumers have no incentive to pay for it nor it is possible to force them
> producers don’t have the incentive to supply as they won’t get much profits in supplying it
And so therefore there will be a missing market- where there is a need for a product or service- and so market failure

This is why the government/state provides public goods

Question 17

What type of government intervention can solve the free rider problem and prevent market failure?

Answer 17

State Provision
> used for public goods otherwise problem of free riders. And/or deals with inequality eg education>private
schools only rich would be able to afford it

Analysis:
One way to prevent free rider problem is to have government intervention. State provision

Question 18

Evaluation of using state provision as a form of government intervention?

Answer 18

Evaluation of state provision

• Expensive, there are opportunity costs
• government is not driven by the profit motive and so goods/services may not be best quality, innovated etc
• overconsumption
• how much to produce- imperfect information
• political bias

Question 19

Define what externalities are?

Answer 19

Externalities

- costs or benefits that spill over to third parties external to a market transaction

Question 20

Define what positive externalities are?

Answer 20

Positive externality
- a positive spill over effect to third parties of a market transaction

Social benefits exceed private benefits

Question 21

Define what negative externalities are?

Answer 21

Negative externality
- a negative spillover effect to third parties of a market transaction

Socials costs exceed private costs

Question 22

Define

• marginal private cost
• marginal external cost
• marginal social cost

Answer 22

Marginal private cost
- the cost to an individual or firm of an economic transaction

Marginal external cost
- the spillover cost to third parties of an economic transaction

Marginal social cost
- the full cost to society of an economic transaction, including private and external cost

MSC= MPC+ MEC

Question 23

Define

• marginal private benefit
• marginal external benefit
• marginal social benefit

Answer 23

Marginal private benefit
- the benefit to an individual or firm of an economic transaction

Marginal external benefit
- the spillover benefit to third parties of an economic transaction

Marginal social benefit
- the full benefit of an economic transaction, including private and external benefits

MSB=MPB+MEB

Question 24

Define merit goods?

Answer 24

A good that would be under consumed/ underprovided in a free market, as individuals do not fully perceive the benefits obtained from consumption

• ought to be subsidised or provided free at the point of use or funded by government
• society values and judges that everyone should have them regardless of whether an individual wants them

Question 25

Define a demerit goods?

Answer 25

A good that would be overconsumed/overprovided in a free market, as it brings less overall benefit to consumers than they realise - consumption leads to negative externalities - consumers unaware of negative externalities because they have information failure- imperfect info - consumers underestimate long run costs to themselves of consuming demerit goods

Question 26

Define subsidy?

Answer 26

Subsidy is money given to firms or individuals from government to lower costs of production and increase supply

Question 27

Define taxation?

Answer 27

A means by which governments finance their expenditure by imposing charges on citizens and corporate entities. Governments use taxation to encourage or discourage certain economic decisions.

Question 28

Define direct taxation?

Answer 28

A direct tax is paid directly by an individual or organization to an imposing entity - tax on income - used more to redistribute income and wealth.

Question 29

Define indirect taxes?

Answer 29

the levying of tax on goods and services rather than income or profits. - tax on spending - taxes on suppliers which affects costs of production - taxes on specific kind of consumer spending eg excise duties on cigarettes, alcohol, petrol and VAT - PRODUCERS pay the indirect tax eg VAT not consumers. Producers have the ability to pass on the tax to consumers. Its good or service is elastic its easy to pass on

Question 30

Analysis of using taxation to prevent market failure?

Answer 30

- taxes (on producer) of negative externalities - if government levied a tax on producer of P1- P2, this would increase the costs of production of firms - (firms would internalise the external costs of the good) - this would result in a shift to the left in supply from S-S1 - Price would rise from P- P1 - consumption will fall to the socially optimal level of Q1

Question 31

Evaluation if tax on producers to prevent market failure?

Answer 31

- blck market - success/ effectiveness depends on the size of tax - taxes costly to implement, monitor - look at elasticities - taxes will cause inequality - difficult to measure the level of negative externalities - government may increase tax revenue, reducing budget deficit, but consumption may not fall as much as desired

Question 32

How does a demerit good lead to market failure?

Answer 32

A demerit good may be over consumed/overprovided because consumers only consider the private costs so the negative externalities are not taken into account. MPC is less than MSC and the level of consumption ends up below the socially optimal level

Question 33

How does a merit good lead to market failure?

Answer 33

A merit good is a good that is underconsumed/ underprovided in a free market because consumers only consider the private benefits, MPB, so the positive externalities are not taken into account. MPB is less than the MSB and the level of consumption ends up below the socially optimal level > there is also greater consumer surplus

Question 34

Analysis of subsidising producers?

Answer 34

- when you subsidise producers you give a sum of money for each unit produced, thus lowering costs of supply - supply shifts right, lowers price p-p1 - consumption increases social optimal level - if supply increases, there is an extension in demand - consumption increases

Question 35

Evaluation of subsidy?

Answer 35

- size of subsidy- greater subsidy, the more shift, cheaper, the more increase in consumption - PES - costly, expensive, opportunity costs - does not encourage innovation, increases in productivity, efficiency

Question 36

Define regulations and legislations? Analysis? Evaluation?

Answer 36

Legislation- law Regulation- organisations which make sure the industry complies with legislation One way gov inter. is L&R. Give specific example. Show shift Evaluation - black market - expensive to implement/ police, opportunity costs - elasticities - only effective if there are effective consequences- must be substantial(worth) but that itself is also costly - requires strict supervision

Question 37

# Define - symmetric information? - asymmetric information? - imperfect information?

Answer 37

Symmetric information - is when both the seller and the buyer are well informed about the goods and services and prices in the market - if information is imperfect, then it will not be possible to make rational decisions and so market failure will occur Asymmetric information - is when either the seller or buyer has more information than the other party in a transaction - the extra information means that they have additional bargaining power that can lead to non-rational decisions by the other party Also can lead to incorrect policies and incorrect judgements Imperfect information - incomplete on incorrect information Eg of gov intervention - advertisment

Question 38

How does immobility of factors of production lead to market failure?

Answer 38

- The market assumes that resources (factors of production) move automatically to where they are needed most >>>> eg if pears are more popular apples, then the higher prices of pears will attract resources away from apples supply, which now offers a lower reward - this theory relies on perfect mobility of labour- meaning factors of production can easily shift from one use to another - if immobility of factors of production exists, then factors of production do not easily transfer to different uses. This means that the market does not produce the desired market equilibrium and so market failure occurs

Question 39

Immobility takes place in two forms. What are they?

Answer 39

Geographical immobility - where the resources cannot easily move from one geographical area to another Occupational immobility - where the resources cannot easily move from a particular use or job to another

Question 40

Immobility of factors of production- Labour?

Answer 40

Occupational immobility of labour- - as patterns of demand and unemployment change, many workers may find it difficult to easily secure new jobs, since they may lack necessary skills Geographical - where workers find it difficult to move where employment opportunities maybe due to family ties and differences in housing costs

Question 41

Monopoly and market failure?

Answer 41

- restrict supply - increases prices - (as demand is price inelastic, total rev will increase) - TC will be lower as fewer products are produced so the monopolies make higher profits - the monopolist has benefitted but at the expense of the consumers- fewer consumers now have the product and they are paying a higher price - miss allocation of resources

Question 42

Possible intervention when monopolies cause market failure?

Answer 42

- regulation - max price - tax

Question 43

Define - income - wealth

Answer 43

Income - is a flow of money received over a period of time, such as annual wages Wealth - is a stock of assets accumulated over time, such as ownership of property and cash balances held in the banking system

Question 44

Why does inequalities in the distribution of income and wealth lead to market failure?

Answer 44

- The market mechanism operates on the basis of people offering their skills in return for financial rewards. As skills differ, incomes vary and so inequality. Wealth is also influenced by inheritance - market failure because people on low incomes satisfy fewer wants, cannot benefit from merit goods whereas higher income people can satisfy less vital wants therefore misallocation of resources - however, the extent to which an economy should create a more even distribution of income and wealth is a value judgement. A lot of measures would need to put in place to know how much... is needed - costly

Question 45

Argument for the free market?

Answer 45

- the free market is one where there is minimal government intervention - we believe that the free market generally works to allocate resources effectively - it results in more competition, greater choice, lower price and better quality goods - goods are allocated via the market mechanism - supply and demand determines the prices of good and this in turn dictates the quantity that is sold - when prices rise, consumers ration their consumption and less is consumed - a new equilibrium arises - 1 line to state how the market in context would be good with no intervention - HOWEVER, market failures