1.5. The MM, MF and GI in Markets

• The rationing, incentive and signalling functions of price are used in allocating resources and coordinating the decisions of buyers and sellers in a market economy
• rationing function:

  1. Resources limited
  2. Price goes up
  3. Less people are willing to pay
  4. Resource is only allocated to those willing to pay
• Incentive function:

  1. price rises
  2. producers are incentivised to raise output
  3. greater output = greater profit
• Signalling function:

  1. Price increases
  2. signal to producers to increase supply (more profit)
  3. signals consumers to reduce demand
  4. signals producers to decrease supply
• If prices increase, producers want to increase supply to break-even quicker

  BEP= FC/ (SP-VC)

  SP-VC = Contribution: which is the money available to pay for fixed costs
• the price mechanism is the way in which the basic economic problem (scarcity) is resolved in a market economy, as price mechanisms save resources
• economic incentives influence what, how and for whom goods and services are produced:

  • what goods and services produced are whichever are in highest demand
  • how goods and services are produced might be whichever way is most cost-efficient
  • for whom could be those who are willing to pay
• Market Failure occurs whenever a market leads to a misallocation of resources, leading to goods being under/oversupplied by a market
• missallocation of resources means an economy's resources are used incorrectly
• • Complete market failure results in a missing market
  • Partial market failure arise where a market exists but contributes to resource misallocation
• Market failure can be caused by:

  • public goods
  • positive and negative externality
  • merit and demerit goods
  • monopoly and other market imperfections
  • inequalities in the distribution of income and wealth
• the role of the government is to try to eliminate market failure through government intervention
• pure public goods are:

  • non-rival (supply doesn't diminish with use)
  • non-excludable (consumption of the good cannot be prevented)

  private goods are:

  • rival (supply diminishes with use)
  • excludable (consumption can be prevented)
• when a public good takes on some of the characteristics of a private good, it can become a quasi-public good, e.g. road networks:

  • public as it can be used freely by anyone
  • private as road-use can be restricted (excludable) and congestion may diminish supply (rivalrous)
• technological change make public goods become private:

  • e.g. television broadcasting is now excludable
• the free-rider problem is when those who do not pay for a good still use it and mainly affect public goods
• Private:

  • costs - costs to economic agents who are involved in economic activity
  • benefits - benefits only to economic agents

  Social:

  • costs - costs to economic agents and a third party (negative externalities)
  • benefits - benefits to economic agents and a third party (positive externalities)
• a negative externality is when a third party is harmed by the consumption or production of a good or service
• negative externalities likely result in over-production. This is because the amount that should be produced (to satisfy society's wants) is less than the amount that is actually produced.
• positive externalities likely result in under-production. This is because the amount that should be produced is more than the amount actually produced due to its benefits to others
• Positive consumption externality:

  • demand curve shifts to the right as there are benefits to society
  • therefore resources are underconsumed which leads to market failure

  A) Costs and benefits

  B) quantity

  C) MPB

  D) MPC=MSC

  E) MSB

  F) Deadweight welfare loss

  
• negative consumption externality:

  • demand curve shifts to the left as society is harmed by the consumption of the good/service
  • therefore resources are overconsumed, leading to market failure

  A) costs and benefits

  B) Quantity

  C) MPB

  D) MPC=MSC

  E) MSB

  F) deadweight welfare loss

  
• Positive production externality:

  • supply curve shifts to the right due to benefits of production to society
  • therefore goods are underproduced, leading to market failure

  A) costs and benefits

  B) quantity

  C) MPB=MSB

  D) MPC

  E) MSC

  F) Deadweight welfare loss

  
• negative production externality:

  • supply curve shifts to the left as production harms society
  • therefore resources are overproduced, leading to market failure

  A) costs and benefits

  B) quantity

  C) MPB=MSB

  D) MPC

  E) MSC

  F) Deadweight welfare loss

  G) socially optimum level of production

  
• • Merit goods are goods which are beneficial to society but are underprovided and underconsumed (e.g. education, staff training)
  • Demerit goods are goods which are harmful to society but are overprovided and overconsumed (e.g. cigarettes, pollution)

  Merit goods have positive externalities but demerit goods have negative externalities

  The classification of merit and demerit goods depends upon a value judgement
• consumers lack perfect information about merit and demerit goods, which may cause them to be under or over consumed
• • Merit goods have a positive consumption externality
  • Demerit goods have a negative consumption externality
  • the misallocation of resources resulting from the consumption of merit and demerit goods can be illustrated with externality diagrams.
• Market failure can be caused by imperfect and asymmetric information as:

  • without having full information about a product (benefits and costs), it is difficult for consumers and producers to make decisions on buying and selling
  • this leads to the misallocation of resources
• Market failure can be caused by;

  • imperfect and asymmetric information
  • monopoly and monopoly power
  • the immobility of factors of production
• Market failure can be caused by the existence of monopoly and monopoly power as:

  • prices of the good may be too high, causing underconsumption
  • output may be restricted to maximise profits
• Market failure can be caused by factor immobility as it is difficult for factors of production to be put to alternative use. This leads to the misallocation of resources which leads to market failure

  Examples are:

  • labour immobility caused by geographical or occupational immobility
  • capital immobility caused by rapid technological change or a structural change in the economy
  • land immobility from the inability to change the use of land
• • Income is a flow concept, measured by the flow of earning of individuals or households (e.g. interest, dividends, rent)
  • Wealth is a stock concept, measured by the stock of financial assets (e.g. savings, shares, property)
• in the absence of government intervention, the market mechanism is likely to result in a very unequal and inequitable distribution of income and wealth due to gender, location, occupation, etc.

  
  

  progressive taxes and government spending are used to reduce inequality
• in a market economy, an individual's ability to consume goods and services depend on their income and wealth. An inequitable distribution of this is likely to lead to a misallocation of resources, and therefore market failure