Topic 4.1.8 (Market mechanism, failure and govt intervention

• Signalling Function of Prices - prices provide information that allow buyers and sellers in a market to plan and co-ordinate their economic activity
• Mixed Economy - when part of the economy is left to the free market and part of it is managed by the government
• Incentive Function of Prices - prices create incentive for people to alter their economic behaviour (e.g. higher prices give firms the incentive to produce more due to being profit maximisers: Illustrated as an extension on a supply curve)
• Rationing Function of Prices - rising prices rations demand for a product when there's excess demand

  • illustrated as a contraction of demand until excess demand is eradicated
• Allocative Function of Prices - directs resources between markets; away from markets where there's excess supply and towards markets where there's excess demand
• The Invisible Hand of the Market - if markets are highly competitive, both producers and consumers will passively accept the market prices set by the interaction of supply and demand in the market as a whole
• The Invisible Hand of the Market:

  • Producers will use the most efficient methods of production to maximise profits
  • Consumers buy from sellers who charge the lowest price
  • Firms switch productive resources into markets that maximise return
• Advantages of Price Mechanism:

  • (In competitive markets) promotes consumer sovereignty
  • leads to allocative and productive efficiency
• Disadvantages of Price Mechanism:

  • Imperfectly competitive markets sometimes leads to firms exploiting their producer sovereignty
  • The unrestricted operation of it may lead to many major market failures
• Market Failure - when the market mechanism leads to a misallocation of resources in the economy, either completely failing to provide a good or service or providing it at the wrong quantity
• Government Intervention - when the government takes action to remedy allocatively inefficient markets
• Allocative Inefficiency - where the resources in a market are not distributed optimally and therefore consumers can't purchase the quantity of goods that they demand
• Misallocation of Resources - when resources are not put to their best, most effective or most efficient use
• Re-allocating resources either:

  • produces a better/greater output
  • obtains the same output while saving some of the resource
• Misallocation of Resources occur because of:

  • Public Goods
  • Externalities
  • Merit and Demerit Goods
  • Monopoly power
  • Other market imperfections
  • Inequalities in the distribution of income and wealth
• Complete (Missing) Market Failure - a situation in which there is no market due to the function of prices breaking down

  • Requires government intervention as firms will not receive revenue for supplying to this market
• Partial Market Failure - when a market exists but there is misallocation of resources resulting in the wrong quantity of the good or service being produced
• Externality - the cost or benefit a third party from outside the market receives from an economic transaction by economic agents
• Positive externalities - when the consumption or production of a good causes a benefit to a third party
• Negative Externalities - when the consumption or production of a good or service causes a harmful effect (cost) on the third party
• Asymmetric Information - when either the buyer or seller has more information than the other party about a good or service
• Public Good - a good that is non-excludable and non-rivalrous; these characteristics lead to market failure
• Private Good - goods or services that are supplied and sold through markets by private sector businesses and are excludable and rivalrous
• Characteristic of a Private Goods:

  • Excludability - when owners can exercise private property rights and exclude people from using a good or consuming its benefits (e.g. a shopkeeper can stop people from consuming their goods unless they're willing and able to pay)
• Characteristic of a Private Good:

  
  

  Rivalry (Diminishability) - when one person consumes a private good (e.g. a chocolate bar), the quantity available to others diminishes
• Characteristic of a Public Good:

  • Non-Excludability - when providing the benefits for one means providing the benefits for all (e.g. national defence)
• Characteristic of a Public Good:

  • Non-Rivalry - consumption of the benefits of a good/service (e.g. national defence and peace of mind) doesn't reduce the benefits available for anyone else
• Public 'Bad' - has negative effects (externalities) on people and their communities leading to a significant loss of social welfare (e.g. garbage)
• Quasi-public Good - a public good with characteristics of private goods as there is an ability to stop non-paying consumers from using it
• Pure Public Good - a public good with no likeness to private goods as free riders (non-payers) would be able to consume the good at no financial cost
• Free Rider - someone who benefits from a good or service without paying for it
• Valuation - a method used to try and estimate the worth of public goods if a consumer had to pay for it as public goods do not have a market price
• Private Costs - the internal costs incurred by producers or consumers directly involved in a transaction or economic activity
• Private Benefit - the benefit derived by an individual or firm directly involved in a transaction either as a buyer or seller
• Social Costs - the total cost of an activity to society including private costs and external costs (e.g. The social cost of tobacco to the UK was £17.5bn in 2023)
• Social Benefits - the total benefit to society from providing or consuming a good or service (e.g. “consuming” education produced better trained workers)
• Marginal Private Cost (MPC) - the additional cost to a firm of producing one more unit of a good or service
• Marginal External Cost (MEC) - the cost to third parties from the production of an extra unit of a good or service
• Marginal Social Cost - the total cost to society arising from producing an extra unit of a good or service
• Merit Good - a good that is deemed to be beneficial for society, as there is a positive externality from providing it, but is underprovided and underconsumed in the market