8. The market mechanism, market failure and government intervention in markets

Question 1

What is the signalling function of prices?

Answer 1

Prices provide information to buyers and sellers

Question 2

What is the incentive function of prices?

Answer 2

Prices create incentives for people to alter their economic behaviour, e.g. a higher price creates an incentive for firms to supply more of a good or service

Question 3

What is the rationing function of prices?

Answer 3

Rising prices ration demand for a product

Question 4

What is the allocative function of prices?

Answer 4

Changing relative prices allocate resources away from markets exhibiting excess supply and into markets in which there is excess demand

Question 5

What four functions do prices perform?

Answer 5

• Signalling information
• Creating economic incentives
• Rationing scarce resources
• Allocating them between competing uses

Question 6

What is the advantage of the operation of the price mechanism in competitive markets?

Answer 6

Promoting consumer sovereignty

Question 7

What happens when consumer sovereignty ‘the consumer king’ exists?

Answer 7

Firms and industries that produce goods other than those for which consumers are prepared to pay, do not survive in highly competitive markets

Question 8

What does the operation of the price mechanism lead to in imperfectly competitive markets and monopoly

Answer 8

An outcome in which firms exploit their producer sovereignty. In these situations, ‘the producer is king’

Question 9

What is the price mechanism?

Answer 9

‘Value neutral’ in that it has no regard for equality and the fairness or otherwise of the allocation of buying power between different income groups

Question 10

What is market failure?

Answer 10

When the market mechanism leads to a misallocation of resources in the economy, either completely failing to provide a good or service or providing the wrong quantity

Question 11

What is complete market failure?

Answer 11

A market fails to function at all and a ‘missing market ‘ results

Question 12

What is partial market failure?

Answer 12

A market does function but it delivers the ‘wrong’ quantity of a good or service, which results in resource misallocation

Question 13

What is a missing market?

Answer 13

A situation in which there is no market because the function of prices have broken down

Question 14

What is a private good?

Answer 14

A good that is excludable and rival, such as an orange

Question 15

What is an excludable good?

Answer 15

People who are unprepared to pay can be excluded from benefiting from the good

Question 16

What is a rival good?

Answer 16

When one person consumes a private good, the quantity available to others diminishes

Question 17

What is a public good?

Answer 17

A good that is non-excludable and non-rival, such as a radio programme

Question 18

What is a quasi-public good?

Answer 18

A good which is not fully non-rival and/or where it is possible to exclude people from consuming the product e.g. roads

Question 19

What are some examples of public goods?

Answer 19

National defence, police, street lighting, roads, and terrestrial television and radio programmes

Question 20

When does the optimal level of consumption for public goods and quasi-public goods occur?

Answer 20

When they are available free of charge - providing there is no capacity constraint

Question 21

What is externality?

Answer 21

A public good, in the case of an external benefit, or a public bad, in the case of an external cost, that is ‘dumped’ on third parties outside the market

Question 22

What is a positive externality?

Answer 22

An external benefit that occurs when the consumption or production of a good causes a benefit to a third party, where the social benefit is greater than the private benefit

Question 23

What is a negative externality?

Answer 23

An external cost that occurs when the consumption or production of a good causes costs to a third party, where the social cost is greater than the private cost

Question 24

What is property right?

Answer 24

The exclusive authority to determine how a resource is used

Question 25

What is a free-rider problem?

Answer 25

A free rider is someone who benefits without paying as a result of non-excludability. Customers may choose not to pay for a good, preferring instead to free ride, with the result that the incentive to provide the good through the market disappears

Question 26

What is production externality?

Answer 26

An externality (which may be positive or negative) generated in the course of producing a good or service

Question 27

What is consumption externality?

Answer 27

An externality (which may be positive or negative) generated in the course of consuming a good or service

Question 28

What is a merit good?

Answer 28

A good, such as healthcare and education, for which the social benefits of consumption exceed the private benefits. Value judgements are involved in deciding that a good is a merit good

Once consumed the resulting positive externalities benefits other people

Question 29

What is information failure?

Answer 29

Occurs when people make wrong decisions because they do not possess or they ignore relevant information. Very often they are myopic (short-sighted) about the future

Question 30

What is Social benefit?

Answer 30

The total benefit of an activity, including the external benefit as well as the private benefit. Expressed as an equation: social benefit = private benefit + external benefit

Question 31

What is a subsidy?

Answer 31

A payment made by government or other authority, usually to producers, for each unit of the, subsided good that they produce. Consumers can also be subsidised: for example, bus passes given to children to enable them to travel on buses free or at a reduced price

Question 32

What is demerit goods?

Answer 32

Goods, such as tobacco, for which the social costs of consumption exceed the private costs. Value judgements are involved in deciding that a good is a demerit good.

Once consumed the resulting positive externalities harm other people

Question 33

What is social cost?

Answer 33

The total cost of an activity, including the external cost as well as the private cost. Expressed as an equation: social cost = private cost + external cost

Question 34

What is a moral hazard?

Answer 34

The tendency of individuals and firms, once insured against some contingency, to have so as to make that contingency more likely

Question 35

What exceeds the short-term private benefit of consumption?

Answer 35

The long-term private benefit resulting from consuming a merit good

Question 36

What is immobility of labour?

Answer 36

The inability of labour to move from one job to another, either for occupational reasons (e.g. the need for training) or for geographical reasons (e.g. the cost of moving to another part of the country)

Question 37

What are firms in a imperfectly competitive market likely to lack?

Answer 37

Accurate information about how their rivals may react to their pricing decisions

Question 38

What might imperfectly competitve firms do to get rid of uncertainty?

Answer 38

May be tempted to collude, and in some cases to form cartels. A cartel has the disadvantages but not the advantages of monopoly. As the next section explains, by restricting output and raising prices, monopoly is a form of market failure

Question 39

How does geographical immobility of labour?

Answer 39

When workers find it difficult or impossible to move to jobs in other parts of the country or in other countries for reasons such as higher housing costs in locations where the jobs exist

Question 40

What is competition policy?

Answer 40

The part of the government’s microeconomic policy and industrial policy which aims to make goods markets more competitive. It compromises policy toward monopoly, mergers and restrictive trading practices

Question 41

What is the Competition and Markets Authority (CMA)?

Answer 41

A government agency responsible for advising on and implementing UK competition policy

It adopts a cost-benefit approach to competition policy

Question 42

What does monopoly lead to?

Answer 42

The manipulation of consumers and the exploitation of producer sovereignty

Question 43

What happens after restricting output and raising prices?

Answer 43

Monopoly results in a net welfare loss as well as a transfer of consumer surplus into producer surplus and monopoly profit

Question 44

What are the aims of competition policy?

Answer 44

• Preventing the exploitation of monopoly power
• Reducing costs of production
• Improving efficiency
• Getting rid of excessive profit so that prices reflect costs of production
• Removing entry and exit barriers which separate markets

Question 45

What is public ownership?

Answer 45

Ownership of industries, firms, and other assets such as social housing by central government. The state’s acquisition of such assets is called nationalisation

Question 46

What is privatisation?

Answer 46

The transfer of assets from the public sector to the private sector

Question 47

Arguments for privatisation?

Answer 47

• Revenue raising
• Reducing public spending and the government’s borrowing requirement
• The promotion of competition (through the break-up of monopoly)
• The promotion of efficiency
• Popular capitalism

Question 48

Arguments against privatisation?

Answer 48

• Monopoly abuse
• Short-termism wins over long-termism
• Selling the ‘family silver’ (getting rid of something valuable in order to get a quick advantage when it would be better to keep it for an advantage in the future e.g. capital assets)
• The free-lunch syndrome (opponents claiming that state-owned assets have been sold too cheaply, encouraging the belief among first-time share buyers that there is such a thing as a free lunch

Question 49

What is regulation and why is it used?

Answer 49

The imposition of rules and other constraints which restrict freedom of economic action.

Its used to limit and deter monopoly exploitation of consumers e.g Ofwat who regulate privatised utility industries and the railways

Question 50

What is deregulation?

Answer 50

The removal of previously imposes regulations

Question 51

What is regulatory capture?

Answer 51

Occurs when regulatory agencies act in the interest of regulated firms rather on behalf of the consumers they are supposed to protect

Question 52

What are publicly owned or state-owned industries also known as?

Answer 52

Nationalised industries

Question 53

What was public ownership regarded as and used as

Answer 53

Was regarded as essential for efficient operating of key industries which were regarded as too important to be left to the vagaries of private ownership and market forces

It was used as a method of regulating the problem of monopoly - in particular, the problem of natural monopoly in the utility industries

Question 54

What is tax?

Answer 54

A compulsory levy imposed by the government to pay for its activities. Taxes can also be used to achieve other objectives, such as reduced consumption of demerit goods

Question 55

What is a price ceiling?

Answer 55

A price above which it is illegal to trade. Price ceilings, or maximum legal prices, can distort markets by creating excess demand

Question 56

What is a price floor?

Answer 56

A price below which it is illegal to trade. Price floors, or minimum legal prices, can distort markets by creating excess supply

Question 57

Reasons for government intervention in markets?

Answer 57

• The correction of market failures, which includes government provision of public goods and merit goods and forcing or incentivising firms and consumers to generate positive externalities

Question 58

What are some methods of intervention?

Answer 58

Regulation and taxation, the imposition of price ceilings and price floors, and the introduction of pollution permits

Question 59

What is government failure?

Answer 59

Occurs when government intervention reduces economic welfare, leading to an allocation of resources that is worse than the free-market outcome

Question 60

What are some reasons for government failure?

Answer 60

• The pursuit of conflicting policy objectives
• Administrative costs
• The ‘law of unintended consequences’
• Decisions made on the basis of inadequate information

Question 61

What are some examples of possible government failure?

Answer 61

• Government price controls create black markets