8. The Market Mechanism, Market Failure and Govt Intervention in Markets (All in 1)

What are the three main functions of the price mechanism in resource allocation

Rationing, incentive, and signalling

How does the rationing function of the price mechanism work

It determines how scarce resources are distributed among competing uses based on price levels

What is the incentive function

Higher prices provide an incentive to producers to increase supply due to potential higher profits

What is the signalling function

Prices signal to consumers and producers about the relative scarcity or abundance of goods and help guide their economic decisions

What are the advantages of the price mechanism

• Efficient resource allocation

• Consumer power

• Responsiveness to changes in demand and supply

Disadvantages of the price mechanism

• May lead to inequality

• Under-provision of public goods

• Failure to account for externalities

What is market failure

A misallocation of resources

What is complete market failure

When the market ceases to exist

What is partial market failure

When the market provides a good or service but in inefficient quantities or at inefficient prices

What are common causes of market failure

• public goods

• externalities

• asymmetric information

• monopoly power

• income inequality

Why do public goods lead to market failure

Public goods are non-rival and non-excludable, which causes the free rider problem, where people benefit without paying

Why do externalities cause market failure

Market fail to include social costs and benefits, leading to the overproduction of harmful goods and underproduction of beneficial goods, misallocating resources

How does asymmetric information lead to market failure

When one party knows more than the other in a transaction can lead to consumers making poor decisions, resulting in moral hazard and the production of lower quality goods or services

How does monopoly power lead to market failure

A monopoly has the power to reduce output or raise prices, leading to allocative and productive inefficiencies. Monopolies also might not prioritise allocating resources efficiently, as they can focus on gaining market share

Why does inequality cause market failure

Unequal distribution means some cannot afford essential goods, meaning there is an underproduction of necessary goods and services, leading to a misallocation of resources and increased social tensions.

What are the characteristics of pure public goods

They are non-rival and non-excludable, meaning one person’s use doesn’t reduce availability to others, and people can’t be prevented from using them

Why do public goods cause market failure

Because of the free-rider problem, where people benefit without paying, leading to under-provision or no provision at all

What is the free rider problem

It occurs when individuals benefit from a good without contributing to its cost, discouraging private firms from providing the good

What is a private good

A good that is rivalrous and excludable, meaning consumption by one reduces availability for others, and people can be prevented from using it

What is a quasi-public good

A good that is partially rivalrous and excludable, typically provided by the government to ensure availability to the public but still allows for some competition in usage.

How can technology change the nature of goods

Technological advances can make previously public goods excludable, turning them into private or quasi-public goods

What is tragedy of the commons

Overuse or depletion of common resources, where individuals acting in self-interest harm overall availability

How does the tragedy of commons lead to market failure

No one has ownership or incentive to conserve shared resources, leading to overuse and eventual depletion

What is an externality

A cost or benefit affecting a third part not involved in a transaction

Why do negative externalities lead to overproduction

Because producers don’t bear the full cost, so output exceeds the socially optimal level

Who do positive externalities lead to underproduction

Because producers or consumers don’t gain the full benefit, so output falls below the socially optimal level

How do externalities cause market failure

Market prices don’t reflect social costs of benefits, causing misallocation of resources

How does absence of property rights lead to externalities

Without ownership, there is no incentive to prevent pollution or overuse, allowing negative effects on others

What is merit goods

A good that is under-consumed in the free market because people underestimate its benefits

A demerit good

A good that is over-consumed because people underestimate its harms

How do merit and demerit goods cause market failure

Consumers make poor decisions due to imperfect information, leading to under-or over consumption and a misallocation of resources

How can merit and demerit goods be related to externalities?

Merit and demerit goods may be subject to positive or negative externalities in consumption, meaning their use affects third parties. Merit goods create positive externalities, while demerit goods cause negative externalities

What is imperfect information

A situation where both parties don’t have the relevant information to make a rational economic decision

What is asymmetric information

A situation where one party knows more than the other in an economic transaction

How does monopoly power cause market failure

A monopoly can restrict output and raise prices, leading to allocative and productive inefficiency

How does factor immobility cause market failure

Labour or capital can’t move quickly enough to its desired location, leading to a misallocation of resources

What is competition policy

Government actions to promote market competition, prevent monopolies and protect consumers

What are tools of UK competition policy

Merger control, antitrust laws, and market investigation

What is the role of the CMA

The Competition and Markets Authority enforces laws to ensure fair competition

What happened in the Sainsbury’s - Asda merger case and how is it an example of UK competition policy

In 2019, the CMA blocked the proposed £12 billion merger between Sainsbury’s and Asda. It found the deal would reduce competition, lead to higher prices and fewer choices for consumers, and create a dominant supermarket chain. This is an example of merger control under UK competition policy to protect consumers and prevent market dominance

What is public ownership/nationalisation

When enterprise are owned and operated by the government, often in natural monopolies or essential serviceds

What is privatisation

Transfer from public enterprise to the private sector to increase efficiency and competiton

Advantages and Disadvantages of Nationlisation

Advantages -

• Greater economies of scale

• More focus of service provision

• Less likely to be market failures arising from externalities

Disadvantages -

• Diseconomies of scale

• Lack of incentive to minimise costs

• Burden on taxpayer

• Higher prices due to low competition

Advantages and Disadvantages of Privatisation

Advantages -

• Increased efficiency and innovation

• Lower costs and prices due to competition

• Enhanced consumer choice

Disadvantages -

• Potential loss of public accountability

• Risk of inequality in service access

• Possible neglect of non-profitable services

What is regulation

Government rules to control business behaviour, correct market failures, or protect consumers

What is deregulation

Reducing or eliminating government rules to allow more market freedom and efficiency

What is regulatory capture

When a regulator acts in the interest of the industry it oversees, not public, undermining regulation’s purpose and contributing to government failure

Why do government intervene in Markets

To correct market failures, promote equity, and support macroeconomic goals

What are key methods of government intervention

Taxes, subsides, price controls, regulation, state provision, property rights, pollution permits

What is the role of taxes in government intervention

Taxes are used to increase the cost of demerit to reduce consumption or production, internalising the external cost and correcting market failure

What is the role of subsidies in government intervention

Subsidies are payments from the government to encourage the production of merit goods helping increase their supply or demand

What is state provision

When the government directly provides goods or services, such as healthcare or education, especially when the private market fails to supply them efficiently of equitably

What are potential downsides to intervention

Unintended consequences, inefficiencies, administrative costs, and risk of government failure

What is government failure

When government intervention causes a worse allocation of resources than the market

What are causes of government failure

Imperfect information, conflicting objectives, administrative costs, unintended consequences

Example of unintended consequence

Raising minimum wage increase unemployment due to excess supply of labour

Can government occur even when there is market failure

Yes, sometimes government intervention can worsen the situation rather than improve it