Market mechanism, market failure and government intervention in markets
How markets and prices allocate resources
The Price Mechanism Functions:
The price mechanism determines the market price. Resources are allocated through the price mechanism in a
free market economy. The economic problem of scarce resources is solved. The price moves resources to
where they are demanded or there is a shortage + removes resources from surpluses.
3 main functions to allocate resources:
Rationing
● When resources are scarce, price increases due to demand
● This discourages demand + rations resources e.g. plane tickets
Incentive
● This encourages a change in behaviour e.g. high prices encourage firms to supply more as it is
profitable
Signalling
● The price changes show where resources are needed in the market. A high price signals profitability
- new entrants - but encourages consumers to reduce demand and leave
The price mechanism is the way in which the basic economic problem is resolved in a market economy.
Advantages
● The invisible hand can signal costs and revenue for consumers + producers
● It allows consumers to gain sovereignty in the market. They have ‘spending votes’ in the market, to
choose what is bought and sold
● Generally the free market allows efficient allocation of resources
Disadvantages
● Impersonal method of allocating resources
● Introducing price mechanism into some fields could be undesirable
● The price mechanism and the free market ignore equality + income distribution - may vary between
capitalist societies
● In a free market, there is the under-provision of public and merit goods, which requires government
intervention.
The meaning of market failure
Market failure occurs whenever a market leads to a misallocation of resources - not allocated in the best
interests of society. More output is achievable.
Economic and social welfare is not maximised where there is market failure.
Types of market failure:
Externalities
● The cost or benefit a third party receives from an economic transaction outside of the market
mechanism
, ● The spill-over effect of production or consumption of a good or service
● Negative externalities are caused by the consumption of demerit goods e.g. cigarettes
● Positive externalities are caused by the consumption of merit goods e.g. recycling schemes
The under-provision of public goods
● Public goods are non-excludable and non-rival, and they are underprovided in a free market because
of the free-rider problem
Informationgaps
● It is assumed that consumers and producers have perfect information when making economic
decisions
● This is rarely the case, and this imperfect information leads to a misallocation of resources
Monopolies
● Since choice is limited, they are often overcharged
● Leads to the under-consumption of the good or service - misallocation of resources, as needs +
wants are not fully met
Inequalities in the distribution of income and wealth
● There is an unequitable distribution in income and wealth. Income refers to a flow of money, whilst
wealth refers to a stock of assets
● Leads to negative externalities e.g. social unrest
Complete market failure
● When there is a missing market. The market doesn’t supply the products at all
Partial market failure
● When the market produces at the wrong quantity or price
● Resources are misallocated
Public goods, private goods and quasi-public goods
Public goods
Missing from the free market, but offer benefits to society e.g. street lights.
● They are non-excludable so by consuming the good, someone else is not prevented from consuming
the good as well - non-rival
● This gives rise to the free-rider problem - people who don’t pay still receive benefits
● This is why public goods are underprovided by the private sector - don’t make a profit
● It is difficult to measure the value consumers get from public goods, so it is hard to set a price
● Governments provide public goods, and they have to estimate the social benefit - funded using tax
revenue
Private goods
They are rival and excludable e.g. a chocolate bar has only one consumer. Moreover, private property rights
can be used to prevent others from consuming the good.
Quasi (non-pure) public goods
How markets and prices allocate resources
The Price Mechanism Functions:
The price mechanism determines the market price. Resources are allocated through the price mechanism in a
free market economy. The economic problem of scarce resources is solved. The price moves resources to
where they are demanded or there is a shortage + removes resources from surpluses.
3 main functions to allocate resources:
Rationing
● When resources are scarce, price increases due to demand
● This discourages demand + rations resources e.g. plane tickets
Incentive
● This encourages a change in behaviour e.g. high prices encourage firms to supply more as it is
profitable
Signalling
● The price changes show where resources are needed in the market. A high price signals profitability
- new entrants - but encourages consumers to reduce demand and leave
The price mechanism is the way in which the basic economic problem is resolved in a market economy.
Advantages
● The invisible hand can signal costs and revenue for consumers + producers
● It allows consumers to gain sovereignty in the market. They have ‘spending votes’ in the market, to
choose what is bought and sold
● Generally the free market allows efficient allocation of resources
Disadvantages
● Impersonal method of allocating resources
● Introducing price mechanism into some fields could be undesirable
● The price mechanism and the free market ignore equality + income distribution - may vary between
capitalist societies
● In a free market, there is the under-provision of public and merit goods, which requires government
intervention.
The meaning of market failure
Market failure occurs whenever a market leads to a misallocation of resources - not allocated in the best
interests of society. More output is achievable.
Economic and social welfare is not maximised where there is market failure.
Types of market failure:
Externalities
● The cost or benefit a third party receives from an economic transaction outside of the market
mechanism
, ● The spill-over effect of production or consumption of a good or service
● Negative externalities are caused by the consumption of demerit goods e.g. cigarettes
● Positive externalities are caused by the consumption of merit goods e.g. recycling schemes
The under-provision of public goods
● Public goods are non-excludable and non-rival, and they are underprovided in a free market because
of the free-rider problem
Informationgaps
● It is assumed that consumers and producers have perfect information when making economic
decisions
● This is rarely the case, and this imperfect information leads to a misallocation of resources
Monopolies
● Since choice is limited, they are often overcharged
● Leads to the under-consumption of the good or service - misallocation of resources, as needs +
wants are not fully met
Inequalities in the distribution of income and wealth
● There is an unequitable distribution in income and wealth. Income refers to a flow of money, whilst
wealth refers to a stock of assets
● Leads to negative externalities e.g. social unrest
Complete market failure
● When there is a missing market. The market doesn’t supply the products at all
Partial market failure
● When the market produces at the wrong quantity or price
● Resources are misallocated
Public goods, private goods and quasi-public goods
Public goods
Missing from the free market, but offer benefits to society e.g. street lights.
● They are non-excludable so by consuming the good, someone else is not prevented from consuming
the good as well - non-rival
● This gives rise to the free-rider problem - people who don’t pay still receive benefits
● This is why public goods are underprovided by the private sector - don’t make a profit
● It is difficult to measure the value consumers get from public goods, so it is hard to set a price
● Governments provide public goods, and they have to estimate the social benefit - funded using tax
revenue
Private goods
They are rival and excludable e.g. a chocolate bar has only one consumer. Moreover, private property rights
can be used to prevent others from consuming the good.
Quasi (non-pure) public goods
