Intro to market failure

• In a free market, what does the price mechanism determine?

  In a free market, the price mechanism determines the most efficient allocation of scarce resources in response to the competing wants and needs in the marketplace
• What are scarce resources in a free market?

  • Scarce resources are the factors of production (land, labour, capital, enterprise)
  • Free markets often work very well
• How does the free market lead to market failure?

  •  where there is a less than optimum allocation of resources from the point of view of society
  • For example, when the free market causes a lack of equity (inequality) or environmental degradation
  • There is either over-provision or under-provision of the goods/services and therefore an over-allocation or under-allocation of the resources (factors of production) used to make these goods/services
  • From society’s point of view, there is a lack of allocative efficiency
  • Economic or social welfare is not maximised when there is a market failure
• What is complete market failure?

  • A complete market failure occurs when there is a missing market
  • The market does not supply products at all despite society having demand for it
  • This is the case for public goods, for example the provision of national defence
• What is partial market failure?

  • A partial market failure occurs where the market exists, but does not provide resources in the optimum quantities
  • There is an over production/consumption or under production/consumption of a good or service
• What are the causes of market failures?

  Public goods, externalities, tragedy of the commons, merit and demerit goods, market imperfections, unequal distribution of income and wealth.
• What are public goods and how do they cause market failure?

  • Public goods are beneficial to society but would be under-provided by a free market, e.g. flood defences
• What are externalities and how do they cause market failure?

  • Occur when there is an external impact on a third party not involved in the economic transaction between the buyer and seller, e.g. passive smoking, which is considered a negative externality 
  • These impacts can be positive or negative and are often referred to as spillover effects
  • These impacts can be on the production side of the market (producer supply) or on the consumption side of the market (consumer demand)
• What are tragedy of the commons and how do they cause market failure?

  • The tragedy of the commons occurs when common pool resources are used by either the producer or consumer in a way that is not sustainable
  • When left to the free market, there is no private ownership over these resources as it is costly and inefficient to find ways to exclude other producers 
• What are merit and demerit goods and how do they cause market failure?

  • Merit goods are goods or services that are beneficial to consumer and society but the free market does not provide enough of them e.g. education or healthcare  
  • Demerit goods are goods which have harmful impacts on consumers or society, e.g. cigarettes
• What are market imperfections and how do they cause market failure?

  • Imperfect information is when buyers + sellers have different levels of information in a market and this can distort market outcomes.
  • Monopoly power causes market failures when a monopolist charges higher prices, which may lead to under consumption and reduced output, resulting in a partial market failure
  • Factor immobility is when factors of production can't be moved
  • If cannot be easily reallocated to match a change in demand, markets will not clear, resulting in the misallocation of resources and partial market failure
• What is unequal distribution of income and wealth and how does it cause market failure?

  • The unequal allocation of wealth or income can result in a misallocation of resources and market failure
  • When wealth or income is not distributed in society, some consumers may not be able to afford to purchase goods and services
  • This could lead to poverty or increased negative externalities such as social unrest
• What is the price mechanism?

  • The price mechanism is the interaction of demand and supply in a market economy that allocates scarce resources amongst competing needs and wants
• What did Adam Smith refer to the 3 functions of the price mechanism as?

  invisible hand of the market
• What are the 3 functions of the price mechanism?

  • The price mechanism fulfils three functions in the relationship between buyers and sellers which include rationing, incentivising and signalling
  • When any of these functions breaks down, market failure can occur
• What is rationing?

  • When resources become scarce, the price will rise. Only those who can afford to pay for them will receive them. If there is a surplus, then prices fall and more consumers can afford them
  • E.g The price of plane tickets might rise as seats are sold, because spaces are running out. This is a disincentive to some consumers to purchase the tickets, which rations the tickets
• What is an incentive?

  • The incentive function encourages producers to increase or decrease output to increase profits
  • When prices for a good/service rise, it incentivises producers to reallocate resources from a less profitable market in order to maximise their profits
  • Falling prices incentivise reallocation of resources to new markets
• What is signalling?

  • A change in price provides a signal to consumers and producers about where resources are wanted (markets with increasing prices) and where they are not (markets with decreasing prices)
  • This allows consumers and producers to make informed decisions
  • High prices signals to a producer to produce more of that good/service and would signal to other producers to enter the market
  • A falling price signals to consumers to purchase more or a product
• What are the advantages of the price mechanism?

  • Resources are allocated to their most valued use for production and consumption - efficient
  • Consumers have the freedom to choose goods and services based on tastes, preferences, and income
  • This gives consumers more power to influence what firms produce
  • As a result, producers then allocate resources towards needs and wants of consumers
  • Giving them an incentive to be innovative and develop new areas of business activity 
  • This allows them to maximise their profits 
• What are the disadvantages of the price mechanism?

  does not take into account consumer utility or decision making creates inequality as only those with higher incomes  have buying power.

  Asymmetric information and monopoly power can lead to consumers being exploited by firms. Under provision of public goods causes 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