4.1.8 - The market mechanism, market failure and government intervention in markets

Price Mechanism =

The interaction of supply and demand in a market economy that allocates scarce resources amongst competing needs and wants (to resolve the basic economic problem of unlimited wants but scarce resources)

4 Functions of the Price Mechanism

- Rationing

- Incentive

- Signalling

- Allocative

RATIONING Function of Prices

Increasing prices rations demand for a product. Helps establish equilibrium.

• When there is a shortage of a good, the price will rise to deter consumers who cannot afford it from buying it.

• When there is a surplus of a good, the price will fall to allow more consumers to afford it.

INCENTIVE Function of Prices

Prices create incentives for people to alter their economic behaviour.

• Encourages firms to increase or decrease output to increase profits.

• For example, a higher price creates an incentive for firms to supply more of a good/service to increase profits.

SIGNALLING Function of Prices

Prices provide information to buyers and sellers about where resources are wanted (markets with increasing prices) and where they are not (markets with decreasing prices).

• For example, a sudden rise in a competitor's prices might indicate a rise in demand for similar products.

• High prices signal to a producer to produce more of that good/service, and would signal to other producers to enter the market

ALLOCATIVE Function of Prices

Changing relative prices allocate scarce resources away from markets exhibiting excess supply and into markets in which there is excess demand --> allocative efficiency.

• Prices are useful because they allocate resources to different markets based on market conditions. When prices are set above equilibrium in markets and there is therefore excess supply, resources are allocated away from these markets and towards markets with excess demand. This pushes prices towards equilibrium in both markets.

Advantages of Price Mechanism

• More efficient allocation of resources - resources are allocated to their most valued use for production and consumption (where they are most needed)

• Greater productive efficiency - firms need to have efficient production to maximise their output from their given resources and max profits, Consumers have to be efficient in choices to max their utility from limited income

• Freedom of choice - Consumers choose goods and services based on tastes, preferences, and income that producers then allocate resources towards the needs & wants of consumers.

• Lower Prices & Higher Quality - Competition of firms keeps down prices and drives up the quality of goods and services & also leads to innovation to retain customers in order to max profits

Disadvantages of Price Mechanism

• Inequality - People with higher income have more buying power (effective demand), whilst lower income people may end up deprived of necessities.

• Market Failure of Externalities - Over-provision of goods that have negative externalities, Under-provision of goods that have positive externalities

• Market Failure of Missing Markets - Under-provision of public goods (gov intervention therefore necessary)

• Information Failure - If left to free market, consumers may be exploited by assymetric info --> market failure

• The use of the price mechanism in some markets could be undesirable or distort incentives

  • e.g. Using price mechanism for markets for life saving treatments such as blood or organ donations would incentivise high prices and create inequalities in access

Government Failure =

= When government intervention leads to a misallocation of resources that is worse than the free-market outcome, and a net welfare loss.

• would have been better off if the gov did not intervene

Reasons for Government Failure:

• Inadequate Information

• Conflicting Objectives

• Costs of Intervention (admin costs)

• Market Distortions

• Unintended Consequences

Inadequate Information Gov Failure

• Governments and regulators do not have perfect information / have poor-quality information

• Government is subject to the same information gaps and cognitive biases that consumers face

• This could lead to the government intervening in the wrong way, or by the wrong amount --> resulting in a worsening of the market failure

Conflicting Objectives Gov Failure

• The implementation of government intervention in one market to maximise social welfare causes a loss in social welfare in another market.

or

• Government policy will raise social welfare in the LONG-RUN, but may be unpopular in the SHORT-RUN

• Therefore, governments have to make a trade-off that it believes will maximise social welfare, at the expense of another objective.

Conflicting Objectives Gov Failure Example

e.g.

The imposition of tax on sugary drinks decreases the overconsumption of sugary drinks, improving the social welfare in that market.

However, it may shift consumption towards drinks low in sugar but higher in artificial sweeteners. This substitute good are also demerit goods as they also have adverse private effects of consumption, so the gov may have worsened market failure.

Costs of Intervention Gov Failure (Administrative Costs)

- Administrative or enforcement costs of government intervention can be expensive.

- These costs may end up outweighing the benefits of improved social welfare of gov intervention, leading to a worsening of resource allocation.

Market Distortions Gov Failure

• Price intervention may help solve one problem, but can create others by DISTORTING PRICE SIGNALS

• The SIGNALLING FUNCTION of the PRICE MECHANISM is artificially altered

• This causes changes to QUANTITIES traded for goods and services

• This can lead to an inefficient allocation of resources - surpluses and shorages

Unintended Consequences =

Government intervention policies can lead to unpredictable, unintended consequences which worsen the allocation of resources and net welfare

Minimum Price Unintended Consequences

Loss of international competitiveness

• Minimum price must be placed above free market equilibrium

• Therefore, market price of factor inputs (labour, energy) rises, meaning firms prefer to produce goods abroad rather than in the UK.

Bans/Tax/Regulation Unintended Consequences

Formation of Informal Black Markets with worse social outcomes

• When products are sold legally, governments are able to regulate them through quantity, packaging, ingredients, production methods, who they are sold to.

• However when banned, people may turn to sell them in informal black markets which are UNREGULATED.

• Suppliers are able to exploit customers, use dangerous ingredients, sell to minors

• Therefore, damaging social welfare

Subsidies Unintended Consequences

Inefficiency among Producers

• Producers may rely on subsidies to survive, rather than cost-cutting and innovation

• They devote less resources to improving their production process to keep costs of production down

• It also protects inefficient firms from competition and create barriers to entry for new firms because prices are kept 'artificially' low.

• Leads to moral hazard

Market Failure =

When the market mechanism results in a misallocation of resources and social welfare is not maximised

Complete Market Failure =

When there is no market / the market does not supply products at all.

- there are "missing markets"

Partial Market Failure =

When the market produces either the wrong quantity of a product or at the wrong price

Public Good Market Failures

- Complete Failure / Missing Market

- Public Good

- Quasi-public Good

Externality Market Failures

- Partial Failure / Incomplete Markets

- Positive Externality

- Negative Externality

- Consumption Externality

- Production Externality

- Absence of Property Rights

Merit/Demerit Good Market Failure

- Partial Failure / Incomplete Markets

- Merit Good

- Demerit Good

Information Market Failure

- Partial Failure / Incomplete Markets

- Imperfect Information

- Asymmetric Information

Public Good =

Goods that are not provided in a market because it is non-excludable and non-rivalrous

[define non-excludable & non-rivalrous in exam definition]

2 Main Characteristics of Public Goods

- Non-Excludable

- Non-Rivalry

Private Good =

Goods that are excludable, rivalrous and rejectable

Non-excludable =

Consumers cannot be excluded from consuming the product even if they didn't pay for it.

If provided for one person, anyone can accesss them.

(free rider problem)

Non-rivalry =

One person's consumption of a product does not reduce the amount available for other people to consume

Rejectability =

Private goods and services can be rejected as a person may not wish to buy them (have a choice whether to consume)

Quasi-Public Good =

A good which is partly rivalrous and partly excludable.

- exhibits some but not all the characteristics of a public good.

Why do Public Goods lead to Market Failure?

The FREE RIDER PROBLEM - When people can enjoy the benefits of consumption without paying anything for it.

• If you cannot exclude the non-payers, profit-motivated businesses may decide not to supply these products.

• This is as there is a loss of the incentive function to provide these goods, therefore the good becomes under-provided, resulting in a missing market - complete market failure.

Public Goods Market Failure Free Rider Problem Chain of Analysis

- Public goods are subject to the free rider problem, where people can enjoy the benefits of consumption without paying anything for it.

- This is due to the public goods being 'non-excludable' meaning non-payers cannot be excluded from consuming the product.

- This means individuals have no incentive to pay for the good.

- If individuals aren't willing to pay for it, firms cannot make money from producing the good.

- Therefore, profit-motivated firms would decide not to supply these products.

- As a result, the public goods become under-provided if left to the free market, resulting in a MISSING MARKET.

- There is under allocation of scarce resources to this particular market, in fact none are allocated at all.

- Therefore, the free market mechanism has caused allocative inefficiency and a loss in welfare, resulting in complete market failure.

How can the Government solve the Market Failure of Public Goods?

- State Provision

- Subsidies

- Charge Consumers for public goods (e.g. tolls on roads)

- Regulation

Technological Change/Advancements (& its implication for public goods) =

The process of innovation, invention and the widespread use of technology in society. This means that public goods can become private goods over time.

How has Technological Change impacted the nature of Public Goods? (chain of analysis)

- Technological advancements have made pure public goods more excludable, thus transforming them into more of a private good, or a quasi-public good.

- For example, encryption has allowed TV broadcasting to only stream to paying subscribers, thus making the service excludable to non-payers.

- This, in turn, means that firms can now make money from producing this service, encouraging firms to enter the market.

- So it reduces the under-provision and solves the problem of missing markets.

- Therefore, solving the market failure and reduces the need for government intervention.

The Tragedy of the Commons =

A situation where individuals acting independently and rationally in their own self-interest behave contrary to the best interests of society by depleting a common resource.

Common Resource =

A natural resource with no private ownership, which is non-excludable, but is rivalrous in consumption.

Why does the Tragedy of the Commons occur?

- There is an absence of property rights on the common resource as it has no private ownership.

- It is unregulated as there is no market in place to manage the allocation of these common resources

- As no one owns the resource and it is non-excludable, no one personally suffers the consequences of depleting it.

- As people will act in their self-interest (+ moral hazard), people have no incentive to look after the good

- This can lead to exploitation and overuse of the resource, leading to its depletion if used unsustainably. (tragedy of the commons)

- Leads to negative externalities in consumption, hence market failure

How can the Government solve the Market Failure of the Tragedy of the Commons?

Extend Property Rights to create a market/private good

Examples of the Tragedy of the Commons:

- Overfishing - As fishers have an incentive to maximise profits of selling fish, they attempt to catch as many as possible --> Decline in fish population --> Depletes population of fish to unsustainable levels --> Habitat degradation & less available resource of fish in the long-run

- Deforestation

- Litter

- Tasty Animals

Externality =

A 'spillover' effect from production or consumption that affects third parties either positively or negatively

Positive Externality =

A spillover effect from production or consumption that affects third parties positively

Negative Externality =

A spillover effect from production or consumption that affects third parties negatively

Production Externality =

A positive or negative externality arising from the production of a good or service

- Divergence between private & social costs (MSC & MPC curves)

Consumption Externality =

A positive or negative externality arising from the consumptionof a good or service

- Divergence between private & social benefits (MSB & MPB curves)

Social Cost =

Private Cost + External Cost

Social Benefit =

Private Benefit + External Benefit

Positive Production Externality Analysis (9 marker)

• In free market --> producers consider own actions --> so equilibrium is at point A where MPC=MPB

• Positive Production Externality occurs where the production of a good benefits third parties [insert application]

• This means at Point A --> private cost [insert application] is greater social cost (shown by MPC>MSC) --> so an external benefit exists of A-B.

• Socially optimal point is at C where MSC=MSB at Ps, Qs.

• Therefore, the good is underproduced at Qm and overpriced at Pm compared to what is best for society.

• There is under allocation of scarce resources, resulting in Deadweight Welfare Loss shown by area ABC

• Therefore, allocative inefficiency occurs, resulting in partial market failure

Negative Production Externality Analysis (9 marker)

• In free market, producers consider own actions --> so equilibrium is at point A where MPC=MPB

• Negative production externality occurs where the production of a good costs to third parties. [insert application]

• This means that at point A --> social cost [insert application] is greater than private cost (shown by MSC>MPC) --> so an external cost exists of A-B

• Socially optimum point is at C where MSC=MSB at Ps, Qs

• Therefore, the good is overproduced at Qm and underpriced at Pm compared to what is best for society

• There is over allocation of scarce resources, resulting in Deadweight Welfare Loss shown by area ABC

• Therefore, allocative inefficiency occurs, resulting in partial market failure

Positive Consumption Externality Analysis (9 marker)

• In free market, producers consider own actions --> so equilibrium at point A where MPB=MPC

• Positive consumption externality occurs where the consumption of a good benefits to third parties. [insert application]

• Therefore at point A, social benefit [insert application] is greater than private benefit (shown by MSB>MPB) --> external benefit exists of A-B

• Socially optimum point at C where MSB=MSC at Ps, Qs

• Therefore, the goods are under consumed at Qm compared to what is best for society

• There is under allocation of scarce resources, resulting in Deadweight Welfare Loss shown by area ABC

• Therefore, allocative inefficiency occurs, resulting in partial market failure

Negative Consumption Externality Analysis (9 marker)

• In free market, producers consider own actions --> so equilibrium is at point A where MPC=MPC

• Negative consumption externality occurs where the consumption of a good costs to third parties. [insert application]

• This means that at point A --> private benefit [insert application] is greater than social benefit (shown by MPB>MSB) --> so an external cost exists of A-B

• Socially optimum point is at C where MSC=MSB at Ps, Qs

• Therefore, the goods are over consumed at Qm compared to what is best for society

• There is over allocation of scarce resources, resulting in The Deadweight Welfare Loss shown by area ABC

• Therefore, allocative inefficiency occurs, resulting in partial market failure

Property Rights =

The authority to determine how an economic resource is used - who gets it, who is excluded from it, what it's used for etc.

Why do Lack of Property Rights lead to the Tragedy of the Commons

Non-excludable resources tend not to be looked after, or are overused, because the lack of clear property rights means it's not worth any one person taking responbility for them.

Moral Hazard =

Risk that people will behave antisocially/recklessly when they won't bear the costs of their own behaviour

Why can lack of property rights lead to externalities, hence market failure

• The LACK of property rights means no one owns the good so no one is responsible and can be held accountable for their actions.

• As people will act in their self-interest (+ moral hazard), people have no incentive to look after the good

• Leads to tragedy of the commons → negative consumption externalities therefore market failure

Merit Good =

A good that is underconsumed because consumers underestimate the benefits to themselves of consuming it (imperfect information)

• Imperfect Information

• Positive Externalities

Demerit Good =

A good that is overconsumed because consumers underestimate the costs to themselves of consuming it (imperfect information)

• Imperfect Information

• Negative Externalities

What does the classificiation of merit & demerit goods depend on?

Value judgements

Imperfect Information =

Occurs when people have inaccurate, incomplete, misleading, or misunderstood information which leads them to make wrong/suboptimal choices

Merit Good Chain of Analysis

• In a free market, said good may lead to market failure due to it being a merit good.

• This is because imperfect information arises when consumers don't know the full benefits to themselves of consumption.

• For example, [application] vegetables improve immune system

• As a result, consumers underestimate the private benefits of consuming the merit good. This often occurs as a result of short-term bias in decision-making.

• This causes consumers' actual demand to be determined by information that is only partial (shown by D (partial)), so the free-market equilibrium occurs at point A at Pm,Qm

• However, with full information about the good the demand would be higher at D (full), which results in the social optimum being at point C at Ps,Qs

• Therefore, information failure results in consumers underestimating the benefits of consuming the good so causes underconsumption

• There is under allocation of scarce resources to the good, resulting in deadweight welfare loss shown by area ABC

• Therefore, the free market mechanism has caused allocative inefficiency, resulting in partial market failure.

Demerit Good Chain of Analysis

• In a free market, said good may lead to market failure due to it being a demerit good.

• Imperfect information arises when consumers attribute goods with benefits that are not true or fail to take account of long-term costs of consumption.

• For example, [application] sugary drinks can lead to obesity, diabetes, cancer.

• As a result, consumers overestimate the private benefits & underestimate the private costs of consuming the demerit good. This often occurs as a result of short-term bias in decision-making.

• This causes consumers' actual demand to be determined by information that is only partial (shown by D (partial)), so the free-market equilibrium occurs at point A at Pm,Qm

• However, with full information about the good the demand would be lower at D (full), which results in the social optimum being at point C at Ps,Qs.

• Therefore, information failure results in consumers overestimating the benefits of consuming the good so causes overconsumption of the good.

• There is over allocation of scarce resources to the good, resulting in deadweight welfare loss shown by area ABC

• Therefore, the free market mechanism has caused allocative inefficiency, resulting in partial market failure.

Assymetric Information Application

15-30% of household food waste stems from the premature disposal of products based on misunderstanding the best before date.

Imperfect Information =

When individuals don't have the full information available to them, which leads them to make suboptimal choices

Asymmetric Information =

When one party to a transaction has access to more information about the good than the other party —> leads to adverse selection or moral hazard

Immobility of Labour =

Frictions in markets that make it difficult for workers to move between jobs

• Geographical

• Occupational

Geographical Immobility =

Frictions that prevent workers from moving from one area to another where the jobs are

How Geographical Immobility leads to Market Failure (chain of analysis)

• Geographical barriers (like costs of moving, leaving family...) prevent FoP from moving from one area to another

• Surplus of resources in one area not able to be used in other areas where there is a shortage of resources

• Therefore, scarce resources will not be allocated in the way that maximises welfare

• Therefore, there is allocative inefficiency, thus market failure

Reasons for Geographical Immobility (Geographical Barriers)

• Costs of moving

• Cost of rent/property/ living costs

• Leaving family & friends

• Restrictions to move (visa issues)

Occupational Immobility =

When workers are unable to move from one type of job to another because different skills are needed that these workers lack.

How Occupational Immobility leads to Market Failure (chain of analysis)

• Structural changes in economy causes certain sectors to decline so reducing derived demand for labour

• Rise in structural unemployment of workers in these declining sectors

• Unemployed workers lack the different skills that other jobs require

• Workers unable to gain employment

• Therefore, scarce resources will not be allocated in the way that maximises welfare

• Therefore, there is allocative inefficiency, thus market failure

Ways to Solve Occupational Immobility

• Provide education

• Provide training

• Improve job centres and job information

Competition Policy =

Government policy which seeks to promote competition and efficiency in different markets and industries.

Government Agency for UK Competition Policy

Competition and Markets Authority (CMA)

• Independent deparment responsble for advising on and implementing competition policy in monopolistic markets and regulated industries.

Anti-Competitive Behaviour =

Strategies by firms designed to limit the degree of competition inside a market and reinforce the monopoly power of established businesses.

3 Focuses of the CMA

• Abuse of Monopoly Power

• Merger Policy - concerned with takeovers or mergers that might create a new monopoly

• Restrictive Trading Practice - price-fixing, market-sharing, cartel activities

3 Ways that Competition Policy promotes competition

• Change the market stsructure

• Prevent the abuse of monopoly power

• Prevent monopolies arising in the first place

Types of Competition Policy (& real world examples)

Compulsory Break-up of Monopolies - CMA has power to order the breakup of a monopoly

• e.g. In 2011, airport operator BAA were forced to sell London Stansted, and either Glasgow or Edinburgh airport.

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Price Controls - Max prices to limit monopoly profits

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Taxing Monopoly Profits

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Nationalisation - Government takes private monopoly into state ownership

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Privatisation of Monopolies - Selling state-owned industries to private sector to improve efficiency and performance

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Deregulation - Deregulatory policies to remove barriers to entry

• e.g. UK ‘Big Bang’ - deregulation of financial markets

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Introducing a Regulatory Body for a specific industry

• e.g. Ofcom, Ofgem

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Prevent Merger or Takeover - CMA has power to block mergers/takeovers if it believes it will act against the public’s interest

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Fines

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Prosecute Directors

Benefits of Competition Policy

If competition policy is effective, it should boost competition & decrease monopoly powers/cartel activity, which leads to the following benefits:

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Productive Efficiency

• ↑Competition → ↑Price competition → Firms need to minimise costs so they can offer similar prices → ↑Productive efficiency

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Reduce X-Inefficiency:

• ↑Competition → Firms have to reduce unnecessary costs and cut organisational slack to survive → Reduces X-Inefficiency

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Allocative Efficiency:

• ↑Competition → Price competition - firms undercut each other’s prices → Price falls closer to P=MC → More allocatively efficient

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Improves consumer choice:

• More alternative firms to buy from

Costs of Competition Policy

Reduces possible benefits of Monopolies:

• Reducing supernormal profits may eliminate R&D opportunities → ↓Dynamic efficiency

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Costly:

• Regulation requires lengthy investigations → large cost to taxpayers

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May lack power:

• Government may reject CMA’s recommendations

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Risk of Gov Failure:

• Regulatory capture - regulatory agencies, meant to protect the public, instead promote the commercial interests of the industry they regulate → makes misallocation of resources worse

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Free market argument:

• Process of creative destruction will remove monopoly power in LR

Public Ownership =

State control of firms, industries or other assets

Nationalisation =

The transfer of assets from the private sector to public ownership

Examples of Nationalisation in UK

• Network Rail in 2014

• Bank of England in 1946

Arguments FOR Public Ownership / Nationalisation

Ability to Control Natural Monopolies

• Natural monopoly is when the most efficient number of firms in an industry is one because of high entry costs meaning always achieving EOS

• Therefore, if no nationalisation and controlled by private sector, it would create a private monopoly which might seek to set higher prices which exploit consumers → reduced allocative efficiency

• Therefore, better to nationalise to have a public monopoly

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Maximise Social Welfare

• Gov will focus more on maximising social welfare rather than just maximising profits for shareholders. Can therefore:

  • Minimise negative externalities in production

  • Provide non-profit goods/services

  • Provide socially optimum level of g&s

  • Ensure prices are low and fair for consumers

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Greater Control of Economy

• Control of key strategic industries (coal, steel, rail, utilities) can be seen as best way to control an unstable market economy

• Also, a single integrated system run by gov may be more efficient than multiple businesses operating simultaneously (e.g. one rail network, one road system)

Arguments AGAINST Public Ownership / Nationalisation

X-Inefficieny & Lack of Dynamic Efficiency:

• Lack of competitive pressure & subsidies from gov leads to:

  • Organisational slack & average costs rise → X-inefficiency

  • Less pressure on managers to drive down unit costs → ↓Productive efficiency

  • Less incentive to reinvest in innovation & R&D + Less supernormal profit → ↓Dynamic efficiency

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Lack of Expertise:

• Often better managers & leaders are found in the private sector where the financial rewards are greater

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Worsen Gov Finance:

• Gov responsible for funding all the required costs of the industry → Large opportunity cost

• Funding all capital investment

• + Gov will not collect any corporation tax revenue

Privatisation =

Sale of government owned (public owned) assets to the private sector

Examples of Privatisation in UK

• Royal Mail in 2013

• British Gas in 1986

• British Airways in 1987

Arguments FOR Privatisation

Monopoly vs PC diagram

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Increased Competition Improves Efficiency

• Competition & profit motive → firms incentivised to cut average costs → ↑Productive efficiency

• To be competitive and survive, must cut unnecessary costs → ↓X-inefficiency

• ↑Price competition → firms undercut each other’s prices → Lower prices → ↑Allocative efficiency

• ↑Supernormal profits → ↑Dynamic efficiency

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Improves Gov Finances

• In SR, Sale of assets increases revenue

• In LR, reducues public spending & borrowing + increases corporation tax rev

Arguments AGAINST Privatisation

Cannot Control Natural Monopolies

• Natural monopoly is when the most efficient number of firms in an industry is one because of high entry costs meaning always achieving EOS

• Therefore, if privatisation, it could create a private monopoly which might seek to set higher prices which exploit consumers → reduced allocative efficiency

• If do attempt to split natural monopoly when privatising, loss of a lot of economies of scale → Less productive efficient

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Loss of Social Welfare

• Private firms focus on profit maximising rather than improving social welfare. Could lead to:

  • Increased negative externalities in production

  • Under-provide merit goods

  • High and unfair prices for consumers → ↓Allocative efficiency

Evaluating Privatisation (IDO’s)

• The type of industry - industries that produce public goods should not be privatised as introducing profit motive does not make sense

• Effectiveness of regulators - Need regulators to prevent abuse of monopoly power

• Degree of contestability or competition - If low barriers to entry, competition likely to be healthy

Regulation =

Setting rules and controls that restrict market freedom

Example of Regulation in UK

2012 Financial Services Act in response to GFC, introduced the FCA, PRA & FPC to regulate financial services.

Arguments FOR Regulation

Allocative Efficiency

• Max prices → ↑allocative efficinecy

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Reduces Monopoly Power

• Block mergers, break up monopolies

• Max prices to limit monopoly profits

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Health & Safety at work

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Price Discrimination & Consumer Rights

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Reduces Neg Externalities

Arguments AGAINST Regulation

Reduces possible benefits of Monopolies:

• Reducing supernormal profits may eliminate R&D opportunities → ↓Dynamic efficiency

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Costly:

• Regulation requires lengthy investigations → large cost to taxpayers

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Risk of Gov Failure:

• Regulatory capture - regulatory agencies, meant to protect the public, instead promote the commercial interests of the industry they regulate → makes misallocation of resources worse

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Free market argument:

• Process of creative destruction will remove monopoly power in LR

Regulatory Capture =

A form of government failure where regulatory agencies, meant to protect the public, instead promote the commercial interests of the industry they regulate.

• i.e. operating in favour of producers rather than consumers

Deregulation =

Removal of rules and controls that restrict market freedom in order to increase the efficiency of markets

• Supply-side policy which removes barriers to entry

Deregulation Chain of Analysis

• Deregulation is the removal of rules & controls that restrict market freedom.

• This is a supply-side policy, which removes barriers to entry and thus facilitates contestability

• This should increase both actual & potential competition

• As a result, monopoly firms convert to monopolistic competition

• Therefore, in LR, supernormal profits are eroded away.

• Market price should become lower, closer to that of allocative efficiency

Example of Deregulation in UK

‘Big Bang’ - Deregulation of financial markets