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The price mechanism determines the market price (Adam Smith called this the invisible hand of the market). The
price mechanism distributes the scares resources between alternative uses and allocates these scares resources
between competing uses, and rations the demand for goods and services, moving the resources to where they
are demanded or where there is a shortage, and removes resources from where there is a surplus.
Signalling (Prices signal information):
Signalling is when the prices provide information that allows buyers and sellers in a market to plan and
coordinate their economic activities – this means the price acts as a signal to consumers and new firms entering
the market. This also means that the price changes show where resources are needed in a market. E.g. A high
price signals firms to enter the market as it is profitable, however, this encourages consumers to reduce demand
and therefore, leave the market – this shifts the demand and supply curves.
Incentive (Prices create incentive):
The incentive function is when information signalled by the prices creates incentives for consumers/producers
to alter their economic behaviour. E.g. A higher price in a market creates incentives for producers to supply more
of a good/service because it may be more profitable to do so. Whereas, in a labour market, rising wages create
an incentive for people to acquire new skills and supply their labour services while falling wages reduce these
incentives.
Rationing (The rationing function of prices):
The rationing function distributes scares goods to those consumers who value them the most. For example, if
there was excess demand, firms will increase the price which may deter people from buying it as it is more
expensive, thus reducing the excess demand, however, there will still be a demand and this reflects the strength
of consumer preferences and consumers’ ability to pay, rations demand for the good (people who need it the
most will continue buying it regardless of the increased prices). Likewise, when there is an excess of supply, firms
will reduce the prices, which means consumers will buy more of the good, and this will reduce the excess supply
of the good. Similarly, rising wages in a labour market ration firms’ demand for labour. The rationing function of
prices is depicted by a contraction of demand along the demand curve.
Allocative (Prices and resource allocation):
The allocative function directs resources between markets, away from the markets in which prices are too high
and in which there is excess supply, towards the markets where there is excess demand and price is too low. Part
of the allocating function is determined which particular resources will be used to produce the desired goods.
E.g. A higher price of good X is a signal that the market desires more output of Good X so producers are given an
incentive to hire more resources to produce Good X. Whereas, a lower price for Good X will signal them to devote
fewer resources to the production of Good X.
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The price mechanism is how the basic economic problem is resolved in a market economy.
Market failure occurs whenever the market/price mechanism (forces of supply and demand) performs badly or
fails to perform at all, therefore fails to allocate scarce resources efficiently and society suffers – this is known as
a misallocation of resources (there could be more output in the form of goods and services if the resources were
used differently). When there is market failure, economic and social welfare is not maximised and usually, the
government have to intervene to prevent it.
Market failure can be complete or partial.
➔ Complete Market Failure: This occurs where no market exists – this is known as a missing market. The
market does not supply the products at all. National defence is an example of a missing market as there’s
no market which allocates national defence. This means that governments need to intervene and provide
it.
➔ Partial market failure: is when the market function, but either the price or quantity supplied of the
good/service is wrong. Resources are misallocated. The provision of health care. If left completely to
market forces, is an example of partial market failure. If health care was left to market forces, then some
people wouldn’t be able to afford the treatment they needed. As a result, governments might intervene
and provide free health care.
When all the price mechanism functions perform well, markets will work well and market failure is non-existent.
However, when one or more of the four functions of prices breaks down, market failure occurs. Market failure
also occurs in the case of pure public goods and externalities; the price mechanism breaks down completely. If
an alternative method of provision does not exist, complete market breakdown means that markets fail
completely and none of the public good is produced, the useful service is not provided and hence there is market
failure. In the case of an externality such as pollution, firms that generate pollution simply dump it on other
people (known as third parties). There is no market in which the unwilling consumers of pollution can charge
producers for the discomfort they suffer. The lack of a market means there is no incentive for the polluter to
pollute less, and so there is market failure.
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Pure Public goods
Public goods have two main characteristics, and it is these that lead to market failure:
➔ Non-excludability – This means by consuming the good, someone else is not prevented from consuming
the good as well.
➔ Non-rivalry – one person benefiting from the good doesn’t stop other also benefiting (e.g. more people
benefiting from flood defence doesn’t reduce the benefit to the first person to benefit.
Examples of public goods are flood defence, street lighting, firework displays and lighthouses.
Public goods are under-provided by the free market:
- The non-excludability of public goods leads to the free-rider problem. The free-rider problem means that
once a public good is provided it’s impossible to stop someone else from benefiting from it, even if they
haven’t paid towards it – the people who do not pay, still receive the benefits from it, in the same way,
people who do pay for the good do (e.g. a firm providing street cleaning cannot stop a free rider, who has
refused to pay for street cleaning, benefiting from a clean street).
- The price mechanism cannot work if there are free-riders. Consumers won’t choose to pay for a public
good that they can get for free because other consumers have paid for it.
- Hence, public goods are underprovided by the private sector as they do not make a profit from providing
the good since consumers do not see a reason to pay for the good if they still receive the benefit without
paying. It is often impossible to collect enough revenue to cover costs. Profits cannot be made and the
incentive to provide the service through the market disappears. The market thus fails to provide a service
for which there is an obvious need. The result is a missing market.
- Public goods are also underprovided because it is difficult to measure the value consumers get from
public goods, so it is hard to put a price on the good. Consumers will undervalue the benefit, so they pay
less, whilst producers will overvalue it, so they can charge more.
- These problems mean that firms are reluctant to supply public goods, and the problems will cause market
failure.
- Governments have to intervene to provide the public goods, and so they have to estimate what the social
benefit of the public good is when deciding what output of the good to provide – these are funded using
tax revenue, but the quantity provided will be less than the socially optimum quantity.
Positive externalities are a form of a public good. They’re consumed by those who don’t pay for them, so they’re
an example of the free-rider problem/ No market exists for externalities, so they’re an example of a missing
market.
Private goods
Private goods are the opposite of public goods and have two main characteristics:
➔ Excludability – owners can exercise private property rights, preventing other people from using the good
or consuming their benefits.
➔ Rivalry – When one person consumes a private good, such as a sweet or a banana, the quantity available
to others diminishes (e.g. if you eat a bar of chocolate, other people cannot eat it and gain its benefits, in
this sense people are rivals).
People also have a choice whether or not to consume private goods.
–
The price mechanism determines the market price (Adam Smith called this the invisible hand of the market). The
price mechanism distributes the scares resources between alternative uses and allocates these scares resources
between competing uses, and rations the demand for goods and services, moving the resources to where they
are demanded or where there is a shortage, and removes resources from where there is a surplus.
Signalling (Prices signal information):
Signalling is when the prices provide information that allows buyers and sellers in a market to plan and
coordinate their economic activities – this means the price acts as a signal to consumers and new firms entering
the market. This also means that the price changes show where resources are needed in a market. E.g. A high
price signals firms to enter the market as it is profitable, however, this encourages consumers to reduce demand
and therefore, leave the market – this shifts the demand and supply curves.
Incentive (Prices create incentive):
The incentive function is when information signalled by the prices creates incentives for consumers/producers
to alter their economic behaviour. E.g. A higher price in a market creates incentives for producers to supply more
of a good/service because it may be more profitable to do so. Whereas, in a labour market, rising wages create
an incentive for people to acquire new skills and supply their labour services while falling wages reduce these
incentives.
Rationing (The rationing function of prices):
The rationing function distributes scares goods to those consumers who value them the most. For example, if
there was excess demand, firms will increase the price which may deter people from buying it as it is more
expensive, thus reducing the excess demand, however, there will still be a demand and this reflects the strength
of consumer preferences and consumers’ ability to pay, rations demand for the good (people who need it the
most will continue buying it regardless of the increased prices). Likewise, when there is an excess of supply, firms
will reduce the prices, which means consumers will buy more of the good, and this will reduce the excess supply
of the good. Similarly, rising wages in a labour market ration firms’ demand for labour. The rationing function of
prices is depicted by a contraction of demand along the demand curve.
Allocative (Prices and resource allocation):
The allocative function directs resources between markets, away from the markets in which prices are too high
and in which there is excess supply, towards the markets where there is excess demand and price is too low. Part
of the allocating function is determined which particular resources will be used to produce the desired goods.
E.g. A higher price of good X is a signal that the market desires more output of Good X so producers are given an
incentive to hire more resources to produce Good X. Whereas, a lower price for Good X will signal them to devote
fewer resources to the production of Good X.
,2|Page
The price mechanism is how the basic economic problem is resolved in a market economy.
Market failure occurs whenever the market/price mechanism (forces of supply and demand) performs badly or
fails to perform at all, therefore fails to allocate scarce resources efficiently and society suffers – this is known as
a misallocation of resources (there could be more output in the form of goods and services if the resources were
used differently). When there is market failure, economic and social welfare is not maximised and usually, the
government have to intervene to prevent it.
Market failure can be complete or partial.
➔ Complete Market Failure: This occurs where no market exists – this is known as a missing market. The
market does not supply the products at all. National defence is an example of a missing market as there’s
no market which allocates national defence. This means that governments need to intervene and provide
it.
➔ Partial market failure: is when the market function, but either the price or quantity supplied of the
good/service is wrong. Resources are misallocated. The provision of health care. If left completely to
market forces, is an example of partial market failure. If health care was left to market forces, then some
people wouldn’t be able to afford the treatment they needed. As a result, governments might intervene
and provide free health care.
When all the price mechanism functions perform well, markets will work well and market failure is non-existent.
However, when one or more of the four functions of prices breaks down, market failure occurs. Market failure
also occurs in the case of pure public goods and externalities; the price mechanism breaks down completely. If
an alternative method of provision does not exist, complete market breakdown means that markets fail
completely and none of the public good is produced, the useful service is not provided and hence there is market
failure. In the case of an externality such as pollution, firms that generate pollution simply dump it on other
people (known as third parties). There is no market in which the unwilling consumers of pollution can charge
producers for the discomfort they suffer. The lack of a market means there is no incentive for the polluter to
pollute less, and so there is market failure.
, 3|Page
Pure Public goods
Public goods have two main characteristics, and it is these that lead to market failure:
➔ Non-excludability – This means by consuming the good, someone else is not prevented from consuming
the good as well.
➔ Non-rivalry – one person benefiting from the good doesn’t stop other also benefiting (e.g. more people
benefiting from flood defence doesn’t reduce the benefit to the first person to benefit.
Examples of public goods are flood defence, street lighting, firework displays and lighthouses.
Public goods are under-provided by the free market:
- The non-excludability of public goods leads to the free-rider problem. The free-rider problem means that
once a public good is provided it’s impossible to stop someone else from benefiting from it, even if they
haven’t paid towards it – the people who do not pay, still receive the benefits from it, in the same way,
people who do pay for the good do (e.g. a firm providing street cleaning cannot stop a free rider, who has
refused to pay for street cleaning, benefiting from a clean street).
- The price mechanism cannot work if there are free-riders. Consumers won’t choose to pay for a public
good that they can get for free because other consumers have paid for it.
- Hence, public goods are underprovided by the private sector as they do not make a profit from providing
the good since consumers do not see a reason to pay for the good if they still receive the benefit without
paying. It is often impossible to collect enough revenue to cover costs. Profits cannot be made and the
incentive to provide the service through the market disappears. The market thus fails to provide a service
for which there is an obvious need. The result is a missing market.
- Public goods are also underprovided because it is difficult to measure the value consumers get from
public goods, so it is hard to put a price on the good. Consumers will undervalue the benefit, so they pay
less, whilst producers will overvalue it, so they can charge more.
- These problems mean that firms are reluctant to supply public goods, and the problems will cause market
failure.
- Governments have to intervene to provide the public goods, and so they have to estimate what the social
benefit of the public good is when deciding what output of the good to provide – these are funded using
tax revenue, but the quantity provided will be less than the socially optimum quantity.
Positive externalities are a form of a public good. They’re consumed by those who don’t pay for them, so they’re
an example of the free-rider problem/ No market exists for externalities, so they’re an example of a missing
market.
Private goods
Private goods are the opposite of public goods and have two main characteristics:
➔ Excludability – owners can exercise private property rights, preventing other people from using the good
or consuming their benefits.
➔ Rivalry – When one person consumes a private good, such as a sweet or a banana, the quantity available
to others diminishes (e.g. if you eat a bar of chocolate, other people cannot eat it and gain its benefits, in
this sense people are rivals).
People also have a choice whether or not to consume private goods.
