Market Mechanism, Market Failure and Government Intervention in Markets
8.1 How markets and prices allocate resources
The Price Mechanism:
Functions
● The price mechanism determines the market price. Adam Smith called this “the
invisible hand of the market”.
● Resources are allocated through the price mechanism in a free market economy.
The economic problem of scarce resources is solved through this mechanism. The
price moves resources to where they are demanded or where there is a shortage,
and removes resources from where there is a surplus
● The price mechanism uses three main functions to allocate resources:
- Rationing: when there are scarce resources, price increases due to the
ecuess of demand. The increase in price discourages demand and
consequently rations resources. For example, plane tickets might rise as
seats are sold because space is running out. This is disincentive to some
consumers to purchase the tickets, which rations the tickets.
- Incentive: this encourages a change in behaviour of consumer or producer.
For example, high price would encourage firms to supply more to the market
because it is more profitable to do so
- Signalling: the price acts as a signal to consumers and new firms entering
the market. The price changes show where resources are needed in the
market. A high price signals firms to enter the market because it is profitable.
However, this encourages consumers to reduce demand and therefore leave
the market. This shifts the demand and supply curves.
, ● The price mechanism is the way in which the basic economic problem is resolved in
a market economy.
The Advantages and Disadvantages of the Price Mechanism and of Extending its use into
new areas of activity:
● The price mechanism is an impersonal method of allocating resources
● Introducing the price mechanism into some fields of human activity could be
undesirable
● In the price mechanism the invisible hand can signal what the cost of purchasing a
good is to a consumer. It also acts as a signal to producers to tell them what revenue
they will receive.
● The price mechanisms allow the consumer to gain sovereignty in the market. They
have “spending votes” in the market, which enables them to choose what is bought
and sold.
● Generally the free market allows for an efficient allocation of resources
● However, there may be inequality in income and wealth with the price mechanism. It
does not consider what the distribution of income is. Those with money have buying
power whilst those without money are left out.
● Essentially, the price mechanism and the free market ignore equality. To evaluate, it
can be argued that inequality exists but the degree of inequality may vary between
capitalist societies.
● In a free market, there is the under provision of public and merit goods, which
requires government intervention
8.2 The meaning of Market Failure
➔ Market failure occurs whenever a market leads to a misallocation of resources.
➔ A misallocation of resources is when resources are not allocated to the best interests
of society. There could be more output in the form of goods and services if the
resources were used in a different way
➔ Economic and social welfare is not maximised where there is market failure
Types of Market Failure:
● Externalities:
An externality is the cost or benefit a third party receives from an economic
transaction outside of the market mechanism. In other words, it is the spillover effect
of the production or consumption of a good or service. Negative externalities are
caused by the consumption of demerit goods such as cigarettes and positive
, externalities are caused by the consumption of merit goods, such as recycling
schemes.
● The Under-Provision of Public Goods:
Public goods are nonexcludable and nonrival and they are underprovided in a free
market because of the free rider problem.
● Information gaps:
It is assumed that consumers and producers have perfect information when making
economic decisions. However, this is rarely the case, and this imperfect information
leads to a misallocation of resources.
● Monopolies:
Since the consumer has very little choice where to buy the goods and services
offered by a monopoly, they are often overcharged. This leads to the under
consumption of the good or service and therefore there is a misallocation of
resources since consumer needs and wants are not fully met
● Inequalities in the Distribution of Income and Wealth:
There is an inequitable distribution in income and wealth, Income refers to a flow of
money, whistles wealth refers to a stock of assets. This can lead to negative
externalities such as social unrest.
Complete and Partial Market Failure:
● Complete market failure occurs when there is a missing market. The market does not
supply the products at all.
● Partial market failure occurs when the market produces a good, but it is the wrong
quantity or wrong price. Resources are misallocated where there is partial market
failure.
8.3 Public goods, private goods and quasi-public goods
● Public goods are missing from the free market but they offer benefits to society. For
example street lights and flood control systems are public goods.
● They are non-excludable so by consuming the good, someone else is not prevented
from consuming the good as well, and they are non-rival, so the benefit other people
get from the good does not diminish if more people consume the good
● The non-excludable nature of public goods gives rise to the free rider problem.
Therefore people who do not oat for the good still receive benefits from it, in the
same way people who pay or the good do. This is why public goods are
underprovided by the private sector: they do not make a profit from providing the
8.1 How markets and prices allocate resources
The Price Mechanism:
Functions
● The price mechanism determines the market price. Adam Smith called this “the
invisible hand of the market”.
● Resources are allocated through the price mechanism in a free market economy.
The economic problem of scarce resources is solved through this mechanism. The
price moves resources to where they are demanded or where there is a shortage,
and removes resources from where there is a surplus
● The price mechanism uses three main functions to allocate resources:
- Rationing: when there are scarce resources, price increases due to the
ecuess of demand. The increase in price discourages demand and
consequently rations resources. For example, plane tickets might rise as
seats are sold because space is running out. This is disincentive to some
consumers to purchase the tickets, which rations the tickets.
- Incentive: this encourages a change in behaviour of consumer or producer.
For example, high price would encourage firms to supply more to the market
because it is more profitable to do so
- Signalling: the price acts as a signal to consumers and new firms entering
the market. The price changes show where resources are needed in the
market. A high price signals firms to enter the market because it is profitable.
However, this encourages consumers to reduce demand and therefore leave
the market. This shifts the demand and supply curves.
, ● The price mechanism is the way in which the basic economic problem is resolved in
a market economy.
The Advantages and Disadvantages of the Price Mechanism and of Extending its use into
new areas of activity:
● The price mechanism is an impersonal method of allocating resources
● Introducing the price mechanism into some fields of human activity could be
undesirable
● In the price mechanism the invisible hand can signal what the cost of purchasing a
good is to a consumer. It also acts as a signal to producers to tell them what revenue
they will receive.
● The price mechanisms allow the consumer to gain sovereignty in the market. They
have “spending votes” in the market, which enables them to choose what is bought
and sold.
● Generally the free market allows for an efficient allocation of resources
● However, there may be inequality in income and wealth with the price mechanism. It
does not consider what the distribution of income is. Those with money have buying
power whilst those without money are left out.
● Essentially, the price mechanism and the free market ignore equality. To evaluate, it
can be argued that inequality exists but the degree of inequality may vary between
capitalist societies.
● In a free market, there is the under provision of public and merit goods, which
requires government intervention
8.2 The meaning of Market Failure
➔ Market failure occurs whenever a market leads to a misallocation of resources.
➔ A misallocation of resources is when resources are not allocated to the best interests
of society. There could be more output in the form of goods and services if the
resources were used in a different way
➔ Economic and social welfare is not maximised where there is market failure
Types of Market Failure:
● Externalities:
An externality is the cost or benefit a third party receives from an economic
transaction outside of the market mechanism. In other words, it is the spillover effect
of the production or consumption of a good or service. Negative externalities are
caused by the consumption of demerit goods such as cigarettes and positive
, externalities are caused by the consumption of merit goods, such as recycling
schemes.
● The Under-Provision of Public Goods:
Public goods are nonexcludable and nonrival and they are underprovided in a free
market because of the free rider problem.
● Information gaps:
It is assumed that consumers and producers have perfect information when making
economic decisions. However, this is rarely the case, and this imperfect information
leads to a misallocation of resources.
● Monopolies:
Since the consumer has very little choice where to buy the goods and services
offered by a monopoly, they are often overcharged. This leads to the under
consumption of the good or service and therefore there is a misallocation of
resources since consumer needs and wants are not fully met
● Inequalities in the Distribution of Income and Wealth:
There is an inequitable distribution in income and wealth, Income refers to a flow of
money, whistles wealth refers to a stock of assets. This can lead to negative
externalities such as social unrest.
Complete and Partial Market Failure:
● Complete market failure occurs when there is a missing market. The market does not
supply the products at all.
● Partial market failure occurs when the market produces a good, but it is the wrong
quantity or wrong price. Resources are misallocated where there is partial market
failure.
8.3 Public goods, private goods and quasi-public goods
● Public goods are missing from the free market but they offer benefits to society. For
example street lights and flood control systems are public goods.
● They are non-excludable so by consuming the good, someone else is not prevented
from consuming the good as well, and they are non-rival, so the benefit other people
get from the good does not diminish if more people consume the good
● The non-excludable nature of public goods gives rise to the free rider problem.
Therefore people who do not oat for the good still receive benefits from it, in the
same way people who pay or the good do. This is why public goods are
underprovided by the private sector: they do not make a profit from providing the
