1.5: The market mechanism, market failure and govt. intervention

How do the 4 function of prices allocate resources?

• Signalling - Prices provide information (e.g. quality and scarcity) for buyers and sellers to plan their activities.

• Incentive - Relative prices create incentives for people to alter their economic behaviour (e.g. supply more).

• Rationing - Prices allocate scarce resources to consumers who value them most highly and are able to pay for them.

• Allocation - Directs resources away from markets with excess supply, towards markets with excess demand.

What problem does the price function solve?

• Solves the basic economic problem of scarcity arising from the conflict of unlimited wants and finite resources

How does Adam Smith’s ‘invisible hand’ influences decision-making?

• If the market is highly competitive, both firms and consumers will passively accept market prices set by the interaction of supply and demand.

What are the advantages and disadvantages to this price mechanism?

Advantages (free-market view):

• Promotes consumer sovereignty

• Efficient allocation of resources

 

Disadvantages (inteventionist view):

• Possible producer sovereignty in imperfectly competitive markets (monopolies)

• Can lead to market failures

What is market failure?

What types of market failure are there?

How can the 4 functions of prices indicate market failure?

• Occurs when a market leads to a misallocation of resources.

• Partial market failure – market produces at the wrong quantity

• Complete market failure – market does not exist

• In general, there is market failure when one or more of the price functions break down.

What are private goods, public goods and quasi-public goods?

• Private goods - Excludable and rival

• e.g. cheese from a cheese shop

 

• Public goods - Non-excludable and non-rival

• e.g. listening to a radio broadcast

 

• Quasi-public goods - Partially excludable and partially rival

• e.g. roads

What can cause a change in these goods from one to another?

• Technological change

• e.g. television broadcasting is now excludable

What is the problem with public goods?

How can this be corrected?

• ‘Free-rider’ problem - users can benefit without contributing/paying (due to non-excludability)

  • Producers won’t profit, so there is no incentive to produce

  • Missing markets/complete market failure

 

• Govt. provision

• Charity/Philanthropy (voluntary provision)

• Open-source software e.g. Wikipedia

What are externalities?

When do they exist?

Link externalities to property rights

• Spill-over effects of consumption or production decisions on third parties

• When there is a divergence between private and social costs and benefits.

  • Market price does not reflect the full costs/benefits to society

• Externalities make property rights (exclusive authority to determine how a resource is used) disappear

  • ‘Free-rider’ problem occurs

What are the types of externalities?

What are the costs of these externalities?

Positive externalities – Spill-over effects that increases the welfare of third parties

• Providers cannot charge a price on free-riders (market failure)

 

Negative externalities – Spill-over effects that reduce the welfare of third parties or   impose costs to society

• Unwilling free-riders cannot charge a price on the provider (market failure)

 

• These costs can be the costs of prevention or the costs of mitigation

What are production externalities?

Production externalities

• Externalities generated from producing a good or service

• Represented in the form of an impact on costs, thus a different supply curve

 

Negative production externalities (a.k.a. external cost)

• Welfare-reducing effects generated from producing a good or service

  • Represented as imposing extra costs on society. (supply shifts left)

e.g. Costs of mitigating pollution from power stations

• Unwilling people affected cannot charge the power station for the pollution

 

Positive production externalities (a.k.a. external benefits)

• Welfare-increasing effects generated from producing a good or service

  • Represented as imposing less costs on society. (supply shifts right)

e.g. the benefit of firm training employees received by a firm who employ those employees later on

• The original firm cannot charge the next firm for the skill of the employees

What are consumptioijn externalilties?

Consumption externalities

• Externalities generated from consuming a good or service

• Represented in the form of an impact on benefits, thus a different demand curve

 

Negative consumption externalities

• Welfare-reducing effects generated from consuming a good or service

  • Represented as extra costs on society (demand shifts left)

e.g. the ringing of mobile phones in a cinema disrupting pleasure

• Unwilling audience cannot charge a price on the mobile phone users

 

Positive consumption externalities

• Welfare-increasing effects generated from consuming a good or service

  • Represented as extra benefits on society (demand shifts right)

e.g. the benefit of having more educated workers to society

• The schools cannot charge a price on society for the skilled workers
  

Explain all 4 of these exernalities diagrammatically

How do production externalities lead to over and underproduction?

• Overproduction of goods with negative externalities in production

  • Prices underestimate costs of production, wrong incentives, too much of the good ends up being produced

• Underproduction of goods with positive externalities in production

  • Prices overestimate the costs of production, wrong incentives, too little of the good ends up being produced

How do consumption externalities lead to over and underconsumption?

• In the same way