3.1.8 The market mechanism, market failure and government intervention in markets

Price mechanism

The way price changes in response to changes in demand or supply, so that a new equilibrium position is reached.

Functions of price

1. Allocative function

2. Rationing function

3. Signaling function

4. Incentive function

Allocative funtion

When scarce resources are allocated among competing uses

Rationing function

Prices serve to ration resources when market demand is more than supply. The supply of the good will be restricted to those who can afford to pay a high price

Signalling function

When prices adjust to demonstrate when resources are required and when they are not. E.g. a price increase is a signal to producers that demand is high, so firms will increase production and firms may enter the market

Incentive function

This encourages a change in behaviour of a consumer or producer. For example, a higher price encourages firms to supply more products because it is more profitable to do so.

Advantages of the price mechanism

1. Resources will be allocated efficiently to satisfy consumers’ wants and needs - due to the functions of price, excess supply or demand will not exist

2. Price mechanism allows the consumer to gain sovereignty in the market. Consumers decide what is and isn’t produced by producers

3. Price mechanism can operate without the cost of employing people to regulate it.

Disadvantages of the price mechanism

1. Inequality in wealth and income is likely. Those with money have buying power, whilst those without money are left out - The free market ignore equality, the degree of inequality may vary between capitalist societies

2. There will be under-provision of merit goods and an over-provision of demerit goods, as the supply and demand for these goods won’t be at the socially optimal level, causing market failure

3. Public goods won’t be produced because firms are profit maximisers

4. Creative destruction

5. Prices can be volatile due to constant shifts in the supply and demand curves.

Market failure

When the price mechanism fails to deliver efficiency and results in misallocation of resources and a deadweight loss of economic welfare

Complete market failure

Where markets fail to function at all so there is a missing market

Partial market failure

Where a market functions but it delivers the ‘wrong’ quantity of a good/service resulting in resource misallocation

Types of market failure

1. Externalities

2. Merit & Demerit goods

3. Under-provision of public goods

4. Income inequality

5. Monopoly power

Merit goods

Goods whose consumption is regarded as beneficial to society

Demerit goods

Goods whose consumption is regarded as being harmful to the people that consume them, but people are usually unaware or don’t can about the harm

Public goods

Goods that are consumed collectively and are non-rival and non-excludable

Characteristics of public goods

1. Non-excludability

2. Non-rivalry

Non-excludable

Once the product is produced, no person can be excluded from benefiting. No price can be charged for the good because there may not be a cost efficient way of pricing

Non-rivarly

Consumption of the good by one person doesn’t reduce the amount. E.g. more people benefiting from flood defences doesn’t reduce the benefit to the first person to benefit. Public goods have zero marginal cost.

Main reason why public goods are under-provided

1. The free rider problem

2. The valuation problem

The Free Rider problem

Once a public good is provided, it’s impossible to stop someone from benefiting it, even if they haven’t paid for it. Consumers won’t choose to pay for a public good that they can get for free. So, if everyone decides to wait and see who will provide and pay for the good, then it won’t be provided.

The valuation problem

It is difficult to measure the value obtained by consumers of public goods. Producers tend to over-value the benefits of public goods in order to increase the price that they charge. Whereas, consumers will undervalue their benefits to get a lower price.

Private goods

These goods are rival and excludable. e.g. apples

Quasi-public good

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

Example of a quasi-public good

Roads have the characteristics of a public good, but, tolls can make roads excludable by excluding those who don’t pay to use the road, and congestion will make the road exhibit rivalry as there’s a limit to the number of people who can benefit from the roads at any one time.

Tragedy of the Commons

Refers to a situation where individuals, acting in their own self-interest, overuse and deplete a shared common-pool of resources, leading to collective harm.

Negative externalities in production

External costs that occur as part of the process of producing producing products e.g. pollution

Positive externalities in production

When they production of a good or service creates a spillover benefits that help a third party outside of a market transaction e.g. tree farm

Negative externalities in consumption

Costs to third parties as a result of actions of consumers

Merit goods

Goods whose consumptions is regarded as being beneficial to society and the consumer, but people are usually unaware of this. This is a value judgement.

Reasons why they tend to be under-consumed

1. Imperfect information - Information failure where information isn’t present at all or consumers are choosing to ignore the information

2. Positive externalities - In the free market, the positive externalities that merit goods provide are ignored and production and consumption will be below the socially optimum level.

Demerit goods

Goods whose consumption is regarded as harmful to the people that consume them, but people are usually unaware or don’t care about the harm they cause.

Reasons why demerit goods are overconsumed

1. Imperfect information - Information failure as consumers don’t always realise the harm that demerit goods cause, or they choose to ignore it. Asymmetric information - producers may have the information, but choose not to pass it on. Making consumers making irrational decisions

2. Negative externalities in consumption - E.g. cigarettes, alcohol and gambling. In the free market this will be over-consumed - misallocation of resources

Symmetric information

Means that everyone in the market transaction has perfect knowledge

Asymmetric information

Occurs when there is unequal knowledge between consumers and producers, leading to market failure

Mobility of labour

The ability of workers to change between jobs

Geographical immobility

Refers to the obstacles which prevent the factors of production moving between areas

Reasons for geographical immobility

1. Large house-price, rent and costs of living differences between areas makes it difficult

2. High costs involved in moving houses

3. Reluctance to leave friends & family

4. A dislike of change

5. Imperfect information about jobs available

Occupational immobility

Refers to the obstacles which prevent the factors of production changing their use

Reasons for occupational immobility

1. Lack of training, education and transferable skills required for another job

2. Lack of required qualifications

3. Lack of work experience

Monopsony power

The ability for a firm to influence the price of a good in the market

Competiton policy

Government regulations aimed at maintaining fair competition in markets. CMA are the government agency responsible for this.

Arguments for price capping

1. A way to hold back monopoly power - preventing them from making excessive profits at the expense of consumers. Excessive profits is open to debate - value judgement

2. Cuts in real price levels - benefit consumers, making essential goods more affordable and business costs reduces (increases international competitiveness) leading to an increase in consumer surplus and helps improve living standards in the long-run.

3. Stimulates improvements in productive efficiency - lower unit costs are needed to increase a producer’s profits.

4. Can be used to control consumer price inflation.

Arguments against price capping

1. Price caps have led to large number of job losses in the utility industry

2. Setting different price capping regimes (RPI - X or RPI - X +K) for each industry distorts the working of the price mechanism

3. Regulatory failure - the industry regulator may not have enough accurate information when setting the price caps

4. Regulatory capture - when government agencies operate in favour of producers rather than consumers

Nationalisation

The process by which the government takes control of private industries or assets, often with the aim of ensuring public access to essential services and resources.

Arguments for nationalisation

1. Greater economies of scale - By nationalising an industry, natural monopolies are created. Therefore, productive efficiency gains, lower average costs and potential lower costs are achieved.

2. More focus on service provisions - governments can ensure a nationalised industry prioritises public services that citizens need over profit motives.

3. Reduction of market failure - the government tends to maximise the full social welfare. They can set output and prices that mirror socially optimum levels

4. Public sector can be a vehicle for macroeconomic control - Governments can pay public sectors a fair wage or manipulate wages to control inflation

5. Some nationalised industries yield positive externalities - E.g. by using public transport, congestion and pollution is reduced.

Arguments against nationalisation

1. Risk of diseconomies of scale - problems of communication, co-ordination and motivation can arise, leading to an increase in average costs, a loss in productivity efficiency gains and higher prices in the long-run

2. Inefficiency - Lack of an incentive to reduce costs and make abnormal profits. Firms may become complacent and have wasteful production leading to x-inefficiency and higher prices in the long run

3. Higher tax on the tax payer - maintaining state companies is expensive, e.g. maintaining them and paying wages. Can governments maintain to do this with high budget deficit especially during periods of austerity. Opportunity costs involved.

4. Higher prices - Due to a lack of competitive dive. Can lead to monopoly outcomes, leading to allocative inefficiency

5. Greater risk of moral hazard - when individual’s who take the risk do not bear the costs of the risk. The tax payer will bail them out.

Privatisation

when assets are transferred from the public into the private sector to encourage efficiency through competition and profit motivation.

Arguments for privatisation

1. Increased allocative efficiency - since operating in the free market, firms have to produce goods that consumers want and to produce at lower costs and higher quality

2. Reduction in X-inefficiency - Firms will need to drive down costs to remain competitive and maximise profits (reduced waste)

3. Incentive to operate efficiently/dynamic efficiency - For firms to gain an advantage, especially in a highly competitive market, they need to invest overtime to gain advantage.

Arguments against privatisation

1. Limited competition - many firms may not enter the industry even though reduced barriers to entry. Leading to productive and allocative inefficiency. It depends on the level of competition

2. Loss on natural monopoly - Leading to a loss of massive economies of scale benefits

Regulation

Law enacted by the government that must be followed by economic agents to encourage a change in behaviour.

Disadvantages of regulation

1. Setting the right regulation - Setting it too high can make firms less profitable. Leading to unintended consequences like operating abroad or firms reducing production resulting in an increase in unemployment

2. Unintended consequences and black markets - regulation can create incentives for firms and consumers to evade laws, leading to illegal markets and further inefficiencies. Big firms may try to ‘game’ the system and cheat regulation

3. Overregulation may stifle innovation and competition.

4. Regulation is very paternalistic - forceful and lack of choice for consumers

Deregulation

when governments reduce or remove regulations in an industry.

Arguments for deregulation

1. Improves allocative efficiency - markets are more contestable therefore increased competition. There is an incentive for firms to produce where P=MC

2. Increases competition

3. Improved productive efficiency and x-efficiency - firms will produce where ATC is at its lowest to minismise costs and maximise profits. Waste will also be reduced

4. Improved dynamic efficiency - Encourages innovation due to high competition, any profits will be reinvested to get ahead in the market

5. Reduces the amount of red-tape - E.g. environmental laws may result in firms only being able to produce a certain quantity

6. Enhances consumer choice by allowing more firms to operate.

Arguments against deregulation

1. Loss of natural monopoly - May be a wasteful duplication of resources e.g. only one need for one water pipe

2. Reduced consumer protection - Without regulation, consumers may face exploitation, unsafe products, or insufficient information to make informed choices.

3. Formation of oligopolies or local monopolies - there is not guarantee of competition meaning firms with dominant power can reduce quantity to increase price

4. Increased market volatility - Deregulation can lead to less stability as firms may prioritize profit over long-term sustainability and responsible practices.

5. Inequality - Deregulation can exacerbate income inequality, as benefits may disproportionately favor larger firms and wealthier individuals, marginalizing smaller players and disadvantaged communities.

Regulatory capture

a situation where regulators start acting in the interest of the company they are regulating rather than consumers, leading to biased decision-making and outcomes that may not align with the intended goals of regulation.

Indirect taxes

Increases a firms costs of production but can be transferred

Problems with tax to reduce market failure

1. Price inelastic demand - there will be relatively no response in demand, not reaching the social optimum quantity still leading to market failure

2. Assigning the right level of taxation - Governments do not have perfect information over the full cost of externalities

3. Regressive tax - creates equity issues as lower-income consumers may pay a higher proportion of their income compared to wealthier individuals, exacerbating inequality. Therefore losing the macro objective of reducing inequality

4. Encourages ‘boot-legging’ and Black markets - Consumers may find alternatives elsewhere. Goods on the black markets potentially have worse external costs due to safety risks and loss of tax revenue for the government.

Subsidy

A monetary grant given to producers by the government to lower their costs of production and encourage an increase in output

Advantages of subsidy

1. Benefits of goods with positive externalities in internalised - the cost of these externalies is covered by the government subsidy - the price is reduced

2. Subsidies can change preference - producers will sell goods with positive externalities and consumers will consume them and gain the benefits.

3. Subsidies can support domestic industries till they grow

Disadvantages of subsidies

1. costly to the government - if the money is borrowed, taxes may rise in the future and government spending cuts, which can burden the poor e.g. healthcare, education and benefits. In addition, debt interest payments.

2. Opportunity costs - the money spent on it might be better spent of something else

3. Setting the subsidy at the right level - governments do not have perfect information about the monetary value on the ‘benefit’ of the positive externalities

4. How will firms react to the subsidy - Firms may become reliant on subsidies and producers may have less of an incentive to reduce costs or innovate

5. Price inelastic demand - subsidies wouldn’t significantly increase demand for inelastic goods.

Price floors

Also known as minimum price, this is a price below which it is illegal to trade. E.g. NMW