1.8 The market mechanism,
market failure and government
intervention in markets
1.8.1 How markets and prices allocate
resources
Economic systems
1. Free market economy: markets allocate resources through the price mechanism
2. Command economy: the government owns scarce resources, the state allocates
resources and sets production targets and growth rates according to its own
view of people’s wants - market prices play little or no role in resource allocation
3. Mixed economy: some resources are owned by the public sector and some by
the private sector. The state typically supplies public, quasi-public and merit
goods and intervenes in markets to correct market failure.
Advantages of free market economies
1. An efficient allocation of scarce resources – factor inputs tend to go where the
expected profit is highest, and in turn this represents the goods/services most
desired by consumers (economists often link this to idea of consumer
sovereignty).
2. Competitive prices for consumers as suppliers look to increase and then protect
their market share.
3. Competition drives innovation & invention bringing higher profits for businesses
and better products for consumers – economists often call this dynamic
efficiency
4. The profit motive stimulates investment which encourages economies of scale
(i.e. lower unit costs in production) and, in turn, lower prices for consumers.
5. Competition through trade helps to reduce domestic monopoly power and
increases choice.
1.8 The market mechanism, market failure and government intervention in markets 1
, 6. Historically, economies with a large free-market aspect to resource allocation
have grown more quickly than those with a command economy.
Disadvantages of free market economies
1. Some members of society may be unable to work e.g. the elderly, those with
disabilities or additional needs, parents with young children etc. Without
government intervention, these people will likely live n poverty. This can create
significant inequality in an economy.
2. Goods that are bad for us (often called demerit goods) may be over-produced;
these could include products such as cigarettes and alcohol. Similarly, products
that are very good for us (often called merit goods) may not be consumed in
large enough quantities; these could include healthcare and education (which
will not be provided by the government in a completely free-market system).
3. Because of the profit motive, firms may be tempted to cut costs, and so exploit
labour (e.g. paying low wages or using child labour), use environmentally-
unsound production methods etc.
4. Some firms may grow so large that they gain significant monopoly power, which
allows them to charge very high prices to consumers, which could be unfair.
Without government intervention, there may be no easy way to prevent this from
happening.
5. Public goods will not be provided. Examples include streetlights, free-to-use
roads, lighthouses, flood defences etc.
Advantages of command economies
1. There is generally a low level of inequality and a low level of unemployment.
Many command
economies have had strong gender equality.
2. Resources are allocated according to the ‘common good’ rather than according
to the ‘profit motive’. This is likely to result in universal provision of healthcare
and education, amongst other things.
3. It may be more straightforward / fast to get large-scale infrastructure projects
built.
Disadvantages of command economies
1.8 The market mechanism, market failure and government intervention in markets 2
, 1. Bureaucratic costs of central planning of resources – petty officialdom can lead
to wasteful
inefficiencies and therefore higher costs.
2. Problems in fixing prices of goods and services – planners are unlikely to be as
accurate as the market in determining suitable prices.
3. Absence of incentives for both workers (i.e. no wage ‘differentials’) and
businesses (i.e. no ‘profit motive’) can damage productivity and also lead to
large levels of over-employment.
4. Low productivity and weak incentives lead to rising losses for many state-owned
businesses. The incentive to innovate is also limited.
5. Changing consumer needs and wants are not expressed as preferences in
markets – the state is often slow to react to these
6. The state can suffer from information failures and corruption
7. State-run economies are at higher risk of mal-investment driven by political
motivations rather than market-assessed cost-benefit analysis
Adam Smiths ‘invisible hand’.
How the price mechanism works
1. A shift in demand/supply causes excess demand or excess supply - market in
disequilibrium.
2. This signals price is too high/low.
3. Incentivising to change price.
4. This rations away excess demand/supply.
5. Providing a reallocation of scarce resources at new price and quantity.
6. New market equilibrium achieved.
1.8.2 The meaning of market failure
Market failure occurs when the market mechanism leads to a misallocation of
resources (and a deadweight loss to society).
1.8 The market mechanism, market failure and government intervention in markets 3
market failure and government
intervention in markets
1.8.1 How markets and prices allocate
resources
Economic systems
1. Free market economy: markets allocate resources through the price mechanism
2. Command economy: the government owns scarce resources, the state allocates
resources and sets production targets and growth rates according to its own
view of people’s wants - market prices play little or no role in resource allocation
3. Mixed economy: some resources are owned by the public sector and some by
the private sector. The state typically supplies public, quasi-public and merit
goods and intervenes in markets to correct market failure.
Advantages of free market economies
1. An efficient allocation of scarce resources – factor inputs tend to go where the
expected profit is highest, and in turn this represents the goods/services most
desired by consumers (economists often link this to idea of consumer
sovereignty).
2. Competitive prices for consumers as suppliers look to increase and then protect
their market share.
3. Competition drives innovation & invention bringing higher profits for businesses
and better products for consumers – economists often call this dynamic
efficiency
4. The profit motive stimulates investment which encourages economies of scale
(i.e. lower unit costs in production) and, in turn, lower prices for consumers.
5. Competition through trade helps to reduce domestic monopoly power and
increases choice.
1.8 The market mechanism, market failure and government intervention in markets 1
, 6. Historically, economies with a large free-market aspect to resource allocation
have grown more quickly than those with a command economy.
Disadvantages of free market economies
1. Some members of society may be unable to work e.g. the elderly, those with
disabilities or additional needs, parents with young children etc. Without
government intervention, these people will likely live n poverty. This can create
significant inequality in an economy.
2. Goods that are bad for us (often called demerit goods) may be over-produced;
these could include products such as cigarettes and alcohol. Similarly, products
that are very good for us (often called merit goods) may not be consumed in
large enough quantities; these could include healthcare and education (which
will not be provided by the government in a completely free-market system).
3. Because of the profit motive, firms may be tempted to cut costs, and so exploit
labour (e.g. paying low wages or using child labour), use environmentally-
unsound production methods etc.
4. Some firms may grow so large that they gain significant monopoly power, which
allows them to charge very high prices to consumers, which could be unfair.
Without government intervention, there may be no easy way to prevent this from
happening.
5. Public goods will not be provided. Examples include streetlights, free-to-use
roads, lighthouses, flood defences etc.
Advantages of command economies
1. There is generally a low level of inequality and a low level of unemployment.
Many command
economies have had strong gender equality.
2. Resources are allocated according to the ‘common good’ rather than according
to the ‘profit motive’. This is likely to result in universal provision of healthcare
and education, amongst other things.
3. It may be more straightforward / fast to get large-scale infrastructure projects
built.
Disadvantages of command economies
1.8 The market mechanism, market failure and government intervention in markets 2
, 1. Bureaucratic costs of central planning of resources – petty officialdom can lead
to wasteful
inefficiencies and therefore higher costs.
2. Problems in fixing prices of goods and services – planners are unlikely to be as
accurate as the market in determining suitable prices.
3. Absence of incentives for both workers (i.e. no wage ‘differentials’) and
businesses (i.e. no ‘profit motive’) can damage productivity and also lead to
large levels of over-employment.
4. Low productivity and weak incentives lead to rising losses for many state-owned
businesses. The incentive to innovate is also limited.
5. Changing consumer needs and wants are not expressed as preferences in
markets – the state is often slow to react to these
6. The state can suffer from information failures and corruption
7. State-run economies are at higher risk of mal-investment driven by political
motivations rather than market-assessed cost-benefit analysis
Adam Smiths ‘invisible hand’.
How the price mechanism works
1. A shift in demand/supply causes excess demand or excess supply - market in
disequilibrium.
2. This signals price is too high/low.
3. Incentivising to change price.
4. This rations away excess demand/supply.
5. Providing a reallocation of scarce resources at new price and quantity.
6. New market equilibrium achieved.
1.8.2 The meaning of market failure
Market failure occurs when the market mechanism leads to a misallocation of
resources (and a deadweight loss to society).
1.8 The market mechanism, market failure and government intervention in markets 3
