The market mechanism

• What are the three main functions of prices in a market?

  Rationing, incentive, and signalling.
• What is the rationing function of prices?

  Prices rise to ration scarce resources.
• What is the incentive function of prices?

  High prices encourage producers to increase supply.
• What is the signalling function of prices?

  Prices convey information about resource needs.
• What are the advantages of the price mechanism?

  Efficient allocation, consumer choice, producer responsiveness.
• What are the disadvantages of the price mechanism?

  Impersonal, may not account for inequality, market failure.
• How does the price mechanism fail in some human activities?

  Markets can commodify healthcare or education.
• What is market failure?

  A misallocation of resources by the market.
• What is complete market failure?


  When a market does not exist at all.
• What is partial market failure?

  When resources are misallocated in an existing market.
• What are the main causes of market failure?

  Public goods, externalities, monopoly power, inequality.
• What are the characteristics of public goods?

  Non-rival and non-excludable.
• What is the free-rider problem?

  People benefit from public goods without paying.
• What is the tragedy of the commons?

  Overuse of shared resources due to lack of ownership.
• What is a quasi-public good?

  A good with characteristics of both public and private goods.
• How can technology change the nature of public goods?

  It can make non-excludable goods excludable.
• What are externalities?

  Costs or benefits affecting third parties.
• What are negative externalities?

  Private costs lower than social costs, leading to overproduction.
• What are positive externalities?

  Private benefits lower than social benefits, leading to underproduction.
• Why do externalities lead to market failure?

  They create a divergence between private and social costs.
• How does the absence of property rights contribute to externalities?

  No ownership leads to no incentive to reduce negative impacts.
• What are merit goods?

  Goods with positive externalities that are under-consumed.
• What are demerit goods?

  Goods with negative externalities that are over-consumed.
• Why does imperfect information affect merit and demerit goods?

  Consumers may not understand benefits or harms.
• What is an example of government intervention to promote merit goods?

  Subsidies for education or healthcare.
• What are examples of market imperfections?

  Monopoly power, imperfect information, factor immobility.
• How does monopoly power lead to market failure?

  It causes higher prices and allocative inefficiency.
• What is asymmetric information?

  One party has more information than the other.
• How does factor immobility cause market failure?

  It prevents resources from moving to needed areas.
• What is the goal of competition policy?

  To prevent abuse of market power.
• What are the benefits of competition policy?

  Lower prices, improved quality, and innovation.
• What are the costs of competition policy?

  Enforcement costs and potential over-regulation.
• How does competition policy address monopolies?

  By breaking up monopolies or regulating behavior.
• Why is the price mechanism efficient in competitive markets?

  It allocates resources to their most valued uses.
• How does a carbon tax address negative externalities?

  It internalizes the external cost of pollution.
• Why are public goods underprovided in free markets?

  Due to the free-rider problem and lack of profit incentives.
• How do subsidies address positive externalities?

  They reduce costs for producers, encouraging supply.
• What role do property rights play in addressing externalities?

  They incentivize efficient resource management.
• Why might a monopoly underproduce a merit good?

  To maximize profits, leading to inefficiency.
• What is an example of a quasi-public good?

  A toll bridge, which is excludable.