The workings of the Market

Objectives Understand the way in which markets and function and how this helps us to allocate scarce resources Understand how prices are determined in competitive markets Start thinking put how we can apply the principles of demand and supply to policy issues Consider why some markets work more effectively than others Assess the effectiveness of government policy

Prices and Values The “diamond / water paradox” ~£1.50 / kg~ £40 million/ kg

Marginal Values The extra benefit you get from one more unit of something is called its marginal utility Think of beer / wine / chocolate / pizza...

Price and the Concept of the Margin The concept of the ‘margin’ is a central concept in economics A consumer will be willing to pay a price up to the marginal benefit that they get from a product A producer will be willing to supply something up to the point where producing an extra (marginal) unit makes them no extra profit

Why do Prices Matter? Ration scarce resources Provide signals to producers Directly affect quality of life

What Determines a Price? Consider the market for alcohol:  Which factors determine the price? What about the housing market? Or the market for petrol? Economists use a model of demand and supply to explain the functioning of a market and the factors that cause prices to rise and fall

The determination of market equilibrium (potatoes: monthly) Quantity (tonnes: 000s) E D C c d e Supply Demand Price (pence per kg) A a B b

The Degree of Competition Classifying markets  number of firms  freedom of entry to industry  nature of product  nature of demand curve The four market structures  perfect competition  monopoly  monopolistic competition  oligopoly

Features of the four market structures Structure  conduct  performance

The Behaviour of Firms How do firms actually set prices? What are the objectives of firms?  The Divorce of ownership from control How can we assess whether firms are acting in the public interest? Is there a role for the government?

Starting to Think About Policy For one of the policy areas below, identify:  why government might be concerned about prices  what the main drivers of prices are in the market (both demand and supply)  what government policy could do to tackle the issues  what might be some unintended consequences and political trade-offs? Binge drinking Obesity First-time buyers priced out of housing market Petrol Energy

Market Failure When markets allocate resources efficiently, there may be no need for governments to intervene When we make decisions, we normally take into account the costs and benefits to ourselves  We ignore the costs and benefits to society Social Efficiency: allocative efficiency  marginal social costs and benefits social efficiency achieved where MSB = MSC If the ‘wrong’ amount is produced or consumed, there is justification for government intervention

Sources of Market Failure Imperfect Competition i.e. monopoly power Externalities Imperfect information Missing markets including public goods The time dimension The principal–agent problem Protecting people's interests  dependants  poor economic decision making by people  merit goods and demerit goods

Why is a monopoly ‘bad’? What can governments do if a monopoly exists? Market Failures: Monopoly Power

Market Failures: Externalities Externalities arise where there are costs/benefits that are not accounted for in the market mechanism Externalities may be negative or positive Externalities may be associated with production or with consumption  Production  MSC > MPC

Q1Q1 Negative externalities in production O MPC = S D = MPB = MSB Costs and benefits Quantity P1P1

Q1Q1 Negative externalities in production O MPC = S Costs and benefits Quantity MSC External cost Q2Q2 Social optimum D = MPB = MSB P1P1 P2P2

Market Failures: Externalities Externalities arise where there are costs/benefits that are not accounted for in the market mechanism Externalities may be negative or positive Externalities may be associated with production or with consumption  Consumption  MSB > MPB

MPB = D O S = MSC P1P1 Q1Q1 Costs and benefits Quantity Positive externalities in consumption

MPB = D O S = MSC P1P1 Q1Q1 Costs and benefits Quantity Positive externalities in consumption MSB External benefit Q2Q2 P2P2

Market Failures: Externalities How might a government intervene if faced with an externality?

 Public goods are defined as goods with the following characteristics:  non rivalry  non-excludability  What is the problem with a public good and why is there a role for government?  Can you relate this back to the topic of game theory and the Nash equilibrium?  Why do we have a tax system that redistributes from rich to poor?  The Warm Glow Effect Market Failures: Public Goods

Taxes and subsidies Laws and Regulation Changes in property rights Provision of information Financial intervention Direct Provision of goods and services Should there be more or less intervention in the market? Forms of Government Intervention

How well would this market function if there was no government intervention?  Would there be justification for intervention based on efficiency grounds?  Would there be a justification for the government to intervene because of equity? What type of intervention would be the most effective? Comparing different healthcare systems The market for health care