4.1.8.1 – How Markets and Prices Allocate Resources
Price Mechanism Functions (RIS):
Rationing: Prices rise when demand > supply, limiting
consumption to those willing/able to pay (e.g. surge pricing).
Incentive: Higher prices encourage producers to supply more,
lower prices encourage demand.
Signalling: Prices communicate information about scarcity/surplus
to consumers & producers.
Advantages:
Efficient allocation without central planning.
Quick response to changes in demand/supply.
Promotes innovation & cost efficiency.
Disadvantages:
Impersonal – ignores equity and income distribution.
May underprovide merit goods / overprovide demerit goods.
Can fail where information is missing (market failure).
Can create undesirable markets (e.g. market for blood donors’
changes incentives).
4.1.8.2 – Meaning of Market Failure
Definition: When free markets misallocate resources and fail to maximise
welfare.
Complete Market Failure: Missing market (e.g. public goods not
provided at all).
Partial Market Failure: Market exists but misallocates resources
(e.g. pollution from production).
Causes:
Public goods
Externalities
Merit/demerit goods
Monopoly power
Factor immobility
Information failure
Inequality
4.1.8.3 – Public, Private & Quasi-Public Goods
Pure Public Goods: Non-rival (one person’s use doesn’t reduce
availability) & non-excludable (cannot stop non-payers). E.g.
national defence.
Private Goods: Rival + excludable (e.g. food, clothes).
Quasi-Public Goods: Partially rival/excludable due to technology
(e.g. toll roads, subscription TV).
Free Rider Problem: People consume without paying → under-provision.
Tragedy of the Commons: Overuse of common resources (e.g.
overfishing).
4.1.8.4 – Positive & Negative Externalities
Externalities: Occur when private costs/benefits ≠ social costs/benefits.
Price Mechanism Functions (RIS):
Rationing: Prices rise when demand > supply, limiting
consumption to those willing/able to pay (e.g. surge pricing).
Incentive: Higher prices encourage producers to supply more,
lower prices encourage demand.
Signalling: Prices communicate information about scarcity/surplus
to consumers & producers.
Advantages:
Efficient allocation without central planning.
Quick response to changes in demand/supply.
Promotes innovation & cost efficiency.
Disadvantages:
Impersonal – ignores equity and income distribution.
May underprovide merit goods / overprovide demerit goods.
Can fail where information is missing (market failure).
Can create undesirable markets (e.g. market for blood donors’
changes incentives).
4.1.8.2 – Meaning of Market Failure
Definition: When free markets misallocate resources and fail to maximise
welfare.
Complete Market Failure: Missing market (e.g. public goods not
provided at all).
Partial Market Failure: Market exists but misallocates resources
(e.g. pollution from production).
Causes:
Public goods
Externalities
Merit/demerit goods
Monopoly power
Factor immobility
Information failure
Inequality
4.1.8.3 – Public, Private & Quasi-Public Goods
Pure Public Goods: Non-rival (one person’s use doesn’t reduce
availability) & non-excludable (cannot stop non-payers). E.g.
national defence.
Private Goods: Rival + excludable (e.g. food, clothes).
Quasi-Public Goods: Partially rival/excludable due to technology
(e.g. toll roads, subscription TV).
Free Rider Problem: People consume without paying → under-provision.
Tragedy of the Commons: Overuse of common resources (e.g.
overfishing).
4.1.8.4 – Positive & Negative Externalities
Externalities: Occur when private costs/benefits ≠ social costs/benefits.
