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The workings of the Market
The workings of the Market
ObjectivesObjectives
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 ValuesPrices and Values
The “diamond / water paradox”
~£1.50 / kg ~ £40 million/ kg
Marginal ValuesMarginal 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 MarginPrice 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?Why do Prices Matter?
Ration scarce resources
Provide signals to producers
Directly affect quality of life
What Determines a Price?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
0
20
40
60
80
100
0 100 200 300 400 500 600 700 800
The determination of market equilibrium (potatoes: monthly)
The determination of market equilibrium (potatoes: monthly)
Quantity (tonnes: 000s)
E
D
C c
d
e
Supply
Demand
Pri
ce (
pen
ce p
er k
g)
Aa
Bb
The Degree of CompetitionThe 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 structuresFeatures of the four market structures
Structure conduct performance
The Behaviour of FirmsThe 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 PolicyStarting 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 drinkingObesityFirst-time buyers priced out of housing marketPetrolEnergy
Market FailureMarket 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 FailureSources of Market Failure
Imperfect Competition i.e. monopoly powerExternalitiesImperfect informationMissing markets including public goodsThe time dimensionThe principal–agent problemProtecting 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 PowerMarket Failures: Monopoly Power
Market Failures: Externalities
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
Q1
Negative externalities in productionNegative externalities in production
O
MPC = S
D = MPB= MSB
Co
sts
and
be
nef
its
Quantity
P1
Q1
Negative externalities in productionNegative externalities in production
O
MPC = S
Co
sts
and
be
nef
its
Quantity
MSC
External cost
Q2Social optimum
D = MPB= MSB
P1
P2
Market Failures: Externalities
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
P1
Q1
Co
sts
and
be
nef
its
Quantity
Positive externalities in consumptionPositive externalities in consumption
MPB = D
O
S = MSC
P1
Q1
Co
sts
and
be
nef
its
Quantity
Positive externalities in consumptionPositive externalities in consumption
MSB
External benefit
Q2
P2
Market Failures: Externalities
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
Market Failures: Public Goods
Taxes and subsidiesLaws and RegulationChanges in property rightsProvision of informationFinancial interventionDirect Provision of goods and servicesShould there be more or less intervention in the
market?
Forms of Government InterventionForms 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 careThe market for health care
