Market Mechanism, Market Failure and
Government Intervention in Markets notes
4.1.8.1.—> HOW MARKET AND PRICES ALLOCATE RESOURCES
PRICE MECHANISM determines market price.
Resources are allocated through the price mechanism in a free market economy. The
problem of scarce resources is solved in this way.
Prices move resources to where they are demanded or where there is a shortage and
removes resources from where there is a surplus.
FREE MARKET ECONOMY: low tax rates, less regulation, free trade (no tari s), more
super-wealthy individuals, less public goods/ private health care, less social security such
as bene ts, low or no minimum wage, large monopolies, less taxes on demerit goods.
FUNCTIONS TO ALLOCATE RESOURCES
• RATIONING: price increases due to excess demand. This discourages demand and
rations resources.
• INCENTIVE: encourages a change in behavior of a consumer/producer. Eg. High price
would encourage rms to supply more to the market due to a higher pro t.
• SIGNALLING: price acts as a signal to consumer and new rms entering the market.
Price changes show where sources are needed in the market. HIGH PRICE signals
rms to enter the market as it pro table but encourages consumers to reduce demand
and leave the market.
ADVANTAGES OF THE PRICE MECHANISM
• Impersonal method of allocating resources.
• It signals what the cost of purchasing a good is to a consumer and signals producers to
tell them what revenue they will receive.
• Consumers gain sovereignty in the market. They are able to choose what is bought and
sold.
• Generally, it’s an e cient allocation of resources.
DISADVANTAGES OF THE PRICE MECHANISM
• There may be inequality in income and wealth. It does not consider what the distribution
of income is.
• Under-provision of public and merit goods, which requires government intervention.
• May be undesirable for some human elds of activity.
• Monopolistic industries restrict output, drive prices up.
• Prices may be incorrect.
• Unable to respond to consumer preferences.
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, 4.1.8.2 —> THE MEANING OF MARKET FAILURE
MARKET FAILURE: when the free market results in an ine cient allocation of resources.
When resources are not allocated to the best interest of society. Economic and social
welfare is not maximized.
-COMPLETE MARKET FAILURE: free market fails to provide a good. Missing market. Eg.
street lights.
-PARTIAL MARKET FAILURE: free market provides a good at an ine cient price or
quantity. Misallocation. Eg. vaccines being under-consumed.
TYPES OF MARKET FAILURE
• EXTERNALITIES: cost or bene t a third party receives from an economic transaction
outside of the market mechanism. Spill-over e ect of the production or consumption of
a good or service.
• UNDER-PROVISION OF PUBLIC GOODS: they are non-excludable and non-rival.
Underprovided in a free market due to the free-rider problem.
• INFORMATION GAPS: consumers and producers do not have perfect information when
making economic decisions so this leads to a misallocation of resources.
• MONOPOLIES: consumer has little choice where to buy goods and services o ered by
a monopoly so they are often overcharged leading to a under-consumption of the good
or service. Misallocation of resources since consumer needs and wants are not fully
met.
• INEQUALITY: inequitable distribution in income and wealth which can lead to social
externalities.
4.1.8.3 —> PUBLIC GOODS, PRIVATE GOODS AND QUASI-PUBLIC GOODS
PUBLIC GOODS —> missing from free market, but o er bene ts to society. Eg. Street
lights and ood control systems.
-NON EXCLUDABLE: by consuming the good, someone else is not prevented from
consuming the good as well.
-NON-RIVAL: the bene t other people get from the good does not diminish if more people
consume the good.
FREE RIDER PROBLEM: people who dont pay for the good, still receive bene ts from it.
This is why public goods are under-provided by the private sector, the don’t make a pro t.
They are also under-provided because it’s di cult to measure the value consumers get
from public goods, so it’s hard to put a price on the good.
Government provide public goods and have to estimate the social bene t. Funded using
tax revenue.
PRIVATE GOODS
-EXCLUDABLE: the consumption of it prevents other from consuming the good.
-RIVAL
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Government Intervention in Markets notes
4.1.8.1.—> HOW MARKET AND PRICES ALLOCATE RESOURCES
PRICE MECHANISM determines market price.
Resources are allocated through the price mechanism in a free market economy. The
problem of scarce resources is solved in this way.
Prices move resources to where they are demanded or where there is a shortage and
removes resources from where there is a surplus.
FREE MARKET ECONOMY: low tax rates, less regulation, free trade (no tari s), more
super-wealthy individuals, less public goods/ private health care, less social security such
as bene ts, low or no minimum wage, large monopolies, less taxes on demerit goods.
FUNCTIONS TO ALLOCATE RESOURCES
• RATIONING: price increases due to excess demand. This discourages demand and
rations resources.
• INCENTIVE: encourages a change in behavior of a consumer/producer. Eg. High price
would encourage rms to supply more to the market due to a higher pro t.
• SIGNALLING: price acts as a signal to consumer and new rms entering the market.
Price changes show where sources are needed in the market. HIGH PRICE signals
rms to enter the market as it pro table but encourages consumers to reduce demand
and leave the market.
ADVANTAGES OF THE PRICE MECHANISM
• Impersonal method of allocating resources.
• It signals what the cost of purchasing a good is to a consumer and signals producers to
tell them what revenue they will receive.
• Consumers gain sovereignty in the market. They are able to choose what is bought and
sold.
• Generally, it’s an e cient allocation of resources.
DISADVANTAGES OF THE PRICE MECHANISM
• There may be inequality in income and wealth. It does not consider what the distribution
of income is.
• Under-provision of public and merit goods, which requires government intervention.
• May be undesirable for some human elds of activity.
• Monopolistic industries restrict output, drive prices up.
• Prices may be incorrect.
• Unable to respond to consumer preferences.
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, 4.1.8.2 —> THE MEANING OF MARKET FAILURE
MARKET FAILURE: when the free market results in an ine cient allocation of resources.
When resources are not allocated to the best interest of society. Economic and social
welfare is not maximized.
-COMPLETE MARKET FAILURE: free market fails to provide a good. Missing market. Eg.
street lights.
-PARTIAL MARKET FAILURE: free market provides a good at an ine cient price or
quantity. Misallocation. Eg. vaccines being under-consumed.
TYPES OF MARKET FAILURE
• EXTERNALITIES: cost or bene t a third party receives from an economic transaction
outside of the market mechanism. Spill-over e ect of the production or consumption of
a good or service.
• UNDER-PROVISION OF PUBLIC GOODS: they are non-excludable and non-rival.
Underprovided in a free market due to the free-rider problem.
• INFORMATION GAPS: consumers and producers do not have perfect information when
making economic decisions so this leads to a misallocation of resources.
• MONOPOLIES: consumer has little choice where to buy goods and services o ered by
a monopoly so they are often overcharged leading to a under-consumption of the good
or service. Misallocation of resources since consumer needs and wants are not fully
met.
• INEQUALITY: inequitable distribution in income and wealth which can lead to social
externalities.
4.1.8.3 —> PUBLIC GOODS, PRIVATE GOODS AND QUASI-PUBLIC GOODS
PUBLIC GOODS —> missing from free market, but o er bene ts to society. Eg. Street
lights and ood control systems.
-NON EXCLUDABLE: by consuming the good, someone else is not prevented from
consuming the good as well.
-NON-RIVAL: the bene t other people get from the good does not diminish if more people
consume the good.
FREE RIDER PROBLEM: people who dont pay for the good, still receive bene ts from it.
This is why public goods are under-provided by the private sector, the don’t make a pro t.
They are also under-provided because it’s di cult to measure the value consumers get
from public goods, so it’s hard to put a price on the good.
Government provide public goods and have to estimate the social bene t. Funded using
tax revenue.
PRIVATE GOODS
-EXCLUDABLE: the consumption of it prevents other from consuming the good.
-RIVAL
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