Market Failure and Government Intervention | 4.1.8 | Microeconomics | A-Level Economics Notes

4.1.8.1 How Markets and Prices Allocate Resources

• The price mechanism determines the market price (Adam Smith’s invisible hand).
• Rationing – higher prices ration demand.
• Incentive – prices create incentives for people to alter their economic behaviour (e.g. high prices incentivise higher supply due to the profit motive).
• Economic incentives influence what, how and for whom goods and services are produced.
• Signalling - prices provide information to buyers and sellers.
• The price mechanism is arguably an impersonal method of allocating resources.
• However, introducing the price mechanism and markets into some fields of human activity may be undesirable and is likely to affect the nature of the activity, e.g. introducing a market for blood changes the nature of the transaction and the incentives involved.
• Pros: consumer sovereignty (consumers are given the power to determine what is bought and sold in the market, and at what quantity/ price, leading to more efficient markets), no regulation, no risk of government failure.
• Cons: can widen inequality of income and wealth, consumers with the largest purchasing power always win, under-provision of public and merit goods, unemployment, and inflation.

4.1.8.2 The Meaning of Market Failure

• Market failure occurs whenever there is a misallocation of resources.
• Complete market failure occurs when there is a resulting missing market.
• Partial market failure occurs where a market exists but contributes to a misallocation of resources.
• Externalities occur when production or consumption of goods and services impose external costs or benefits on third parties outside of the market, without these being reflected in market prices. They are the difference between social and private costs/ benefits.
• Externalities can lead to market failure if there is under-provision and under-consumption of merit goods, or over-provision or over-consumption of demerit goods.
• An under-provision of public goods is another cause of market failure.
• Monopoly markets can lead to higher prices and lower outputs, leading to a misallocation of resources.
• Market imperfections and information failure are also causes of market failure.
• Inequalities in the distribution of income and wealth can lead to market failure.

4.1.8.3 Public Goods, Private Goods and Quasi-Public Goods

• Pure public goods are non-rival and non-excludable.
• Private goods are excludable and rival.
• Non-excludability: if a good is provided for one person, it is provided for all.
• Non-rivalry: when a good is consumed by one person, it does not reduce benefits others can gain from it.
• Non-rejectability: if a public good is provided, it is impossible for a person to opt-out and not gain its benefits.
• A public good may take on some characteristics of a private good and become a quasi-public good (e.g. toll roads).
• Technological change is significant (e.g. television broadcast is now excludable).
• The free-rider problem occurs when non-excludability leads to a situation in which not enough customers choose to pay for a good, preferring to free ride instead. As a result, the incentive to provide that good through the market disappears, leading to a missing market.
• The tragedy of the commons is a situation where there is overconsumption of a particular product / service because rational individual decisions lead to an outcome that is damaging to the overall social welfare (e.g. overfishing).
• The tragedy of the commons is particularly relevant to environmental market failures.

4.1.8.4 Positive and Negative Externalities in Consumption and Production

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• Externalities exist when there is a divergence between private and social costs and benefits.
• Negative externalities are likely to result in over-production because the external costs, often associated with demerit goods, are ignored by the market mechanism.
• Similarly, positive externalities are likely to result in under-production as the external benefits, often seen with merit goods, are ignored by the free market.
• The absence of property rights leads to externalities in both production and consumption and hence market failures. For example, the non-excludable nature of public goods leads to the free-rider problem.
• Diagrams

4.1.8.5 Merit and Demerit Goods

• The classification of merit and demerit goods depends upon a value judgement.
• Some products may be subject to positive and negative externalities in consumption.
• The under-provision of merit goods and over-provision of demerit goods is likely to result from imperfect information (about the long-run implications of consuming the good).
• Not all products that result in positive or negative externalities are either merit or demerit goods.
• Merit goods are those for which the social benefits of consumption exceed the private benefits and for which the long-term private benefits of consumption are greater than the short-term private benefits.
• Demerit goods are goods for which the private benefits of consumption are greater than the social benefits for consumption and for which the long-term private benefits are less than the short-term private benefits.

3.1.5.6 Market Imperfections

• Imperfect and asymmetric information can lead to market failure.
• Symmetric information means that consumers and producer have equal knowledge of the goods or services being sold.
• Imperfect or asymmetric information can lead to uninformed decisions being made. This can lead to a misallocation of resources.
• Monopoly and monopoly power can also lead to market failure.
• The immobility of factors of production can also lead to market failure.
• Occupational mobility of labour is the ability of workers to switch between jobs. Obstacles such as a lack of training or skills can cause structural unemployment.
• Geographical mobility of labour is the ability for workers to relocate to work. Obstacles such as family or living costs can cause frictional or structural unemployment.

4.1.8.7 Competition Policy (A Level Only)

• Within the EU, competition policy is overseen by the European Competition Commission and in the UK by the Competition and Markets Authority.
• Competition policy ensures the quality and standards of services are maintained, and that the public interest is protected against monopoly power.
• These policies are relied on when antitrust and cartel agreements take place, or when we see mergers or concentrated markets.
• Price regulation: ensures prices don’t change too much
• Quality control: performance targets are set (e.g. for train delays/ number of patients seen).
• Profit Control: monopolies can be investigated and windfall taxes can be applied. These are taxes on profits.
• State ownership of monopolies, or even privatisation of monopolies depending on previous outcomes.
• As mentioned, competition policy can lead to competitive outcomes such as lower prices and better quality of services.
• However, competition policy can also cause unintended consequences. There may be imperfect or asymmetric information (particularly with monopolies in terms of their profits). Also, some policies may incentivise monopolies to raise costs or over-employ capital. Profit control can also be seen as an entry barrier, and can lead to tax evasion from incumbent firms and less innovation.

4.1.8.8 Public Ownership, Privatisation, Regulation and Deregulation of Markets (A Level Only)

• Nationalisation is the public ownership of industries or firms.
• The main argument for nationalisation is that the state has a better understanding of consumers wants, leading to more allocatively efficient outcomes.
• On the other hand, nationalisation can lead to economies, but then also diseconomies of scale due to their large scales of work. Also, governments will have political priorities over commercial issues, leading to a lack of focus, complacency and a waste of resources. Lastly, there can be higher prices due to a lack of competition and incentives, and this will be a burden on the taxpayer.
• Moral hazard is the tendency of firms and individuals, once insured against some contingency, to behave so as to make that contingency more likely.
• Privatisation is the selling of previously state-owned assets to the private sector.
• The profit motive and competition will raise productive efficiency, and also lead to lower prices and consumer surplus gains (allocative efficiency). Privatisation is also an instant source of government revenue.
• There will still be a risk of monopoly abuse, so privatisation should occur hand-in-hand with regulation/ competition policy.
• Regulation is the imposition of rules and constraints which restrict the freedom of economic action, and deregulation is the removal of previously imposed regulations.
• Deregulation promotes competition and market contestability through the removal of artificial barriers to entry, as well as the removal of red tape and bureaucracy.

4.1.8.9 Government Intervention in Markets

• The existence of market failure, in its various forms, provides an argument for government intervention in markets.
• Governments influence the allocation of resources in a variety of ways, including through public expenditure, taxation and regulation.
• Governments have a range of objectives and these affect how they intervene in a mixed economy to influence the allocation of resources.
• Taxation: indirect taxes are taxes on expenditure. They are costs of production that cause supply to decrease, and are generally imposed on demerit goods.
• Subsidies are payments made by the government to producers to lower their costs of production, leading to a rightward shift in supply.
• Maximum prices (price ceilings) are prices set below the free market price, above which it is illegal to trade.
• Minimum prices are prices set above the free market price, below which it is illegal to trade.
• State provision of public goods: the government can provide goods to solve the problem of a missing market.
• The extension of property rights allows an exclusive authority to determine how a resource is used further. For example, the owner of a bar of chocolate in a sweet shop has the right to prevent people from consuming the bar unless they pay a given price. E.g. The National Rivers Authority, part of the Environmental Agency, was given the power to act as if it owned the UK’s rivers.
• Pollution permits can ensure quotas are put on carbon emissions, allowing small firms to make revenue trading their excess pollution permits.

4.1.8.10 Government Failure

• Government failure occurs when government intervention in the economy leads to a misallocation of resources.
• Inadequate information, conflicting objectives and excessive administrative costs are possible sources of government failure.
• For example, governments may create, rather than remove, market distortions.
• Government intervention can also lead to unintended consequences.
• Government failure means that, even when there is market failure, government intervention will not necessarily improve economic welfare