Frequently Asked Questions - How Market Works

FAQs - How Market Works

Advantages of a market system

  • resources are allocated through the price mechanism (‘invisible hand’)
  • consumers said to be sovereign
  • economy is very responsive to changes in consumer demand
  • choice is provided for
  • competition and the profit motive promote efficiency
  • incentive for entrepreneurs to produce.

Causes of market failure: 

  • merit goods under-consumed (don’t need to use that term)
  • demerit goods over-consumed (don’t need to use that term) 
  • public goods not provided (don’t need to use that term) 
  • information failure 
  • existence of externalities
  • some people have more influence in a market than others
  • existence of monopolies.

This requires a balanced response in which both the advantages and disadvantages of government interventions must be discussed. One sided answer will lead to maximum half the marks.

Advantages of government intervention: 

  • indirect taxes to discourage consumption of demerit goods
  • subsidies to encourage consumption of merit goods 
  • taxation to finance expenditure on public goods  
  • regulations to control private producers, e.g. on pollution and monopolies having market dominance. 

Limitations of government intervention:

  • consumption of demerit goods might be discouraged, but unlikely to end completely given inelastic demand, e.g. for cigarettes and alcohol 
  • consumption of merit goods might be encouraged, but still a limit to extent of increase in consumption 
  • available finance to provide public goods  might be limited/restricted, especially if a large budget deficit 
  • regulations may not be adequately policed/enforced. 

 

Possible explanation could include:

  • goods and services are freely exchanged through a market without the need for government intervention.
  • an equilibrium price and quantity will be established in the market through the interaction of the buyers and sellers.
  • This will determine the allocation of the scarce resources.
  • Price mechanism signals preferences.
  • Profits encourage switching/reallocation of resources and thus an optimum level of efficiency is achieved.

Broadly speaking, an explanation of how market system works on its own through the dynamics of demand and supply in the market.

A subsidy is: 

a payment made to a producer, e.g. by a government to help reduce the costs of production as a result producers will want to increase supply at every given price. Consumption is therefore encouraged although this could mean supporting an inefficient producer and so distort competition.

TAGS: subsidy

Note:

Marks are usually allocated on the following criteria:

That axes are correctly labelled P and Q and curves are correctly labelled D and S or S and S-subsidy (1) 

Show the supply curve shifts to the right (1) 

Equilibrium price falls and equilibrium quantity increases (1). 

Explanation of the effect of a subsidy on equilibrium price and quantity {will get upto 3 marks}

 

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  • the price of the product 
  • the price of substitute goods/services 
  • the price of complementary goods/services 
  • changes in income 
  • changes in tastes and preferences of consumers 
  • the impact of an advertising campaign. 

Please note:

A brief description is required for each point in order to gain full marks. You might lose marks if only points are listed without explanation.

Definition and explanation

PED is the percentage change in the quantity demanded of a product divided by the percentage change in its price

Or 

PED is the responsiveness of demand to a change in price. 

 

Its value can range from perfectly inelastic to perfectly elastic. inelastic demand has a value of less than 1 while elastic demand has a value of more than 1 and it is usually a minus figure varies along the demand curve.

A brief explanation is required to get full marks.

  • there will be elements of a market economy where equilibrium price and quantity are determined  by  forces  of  demand  and  supply  without  the  need  for  government intervention
  • changes in demand and supply bring about changes in price and quantity 
  • the allocation of resources is, therefore, determined by the profit motive 
  • bringing together the preferences of the producers and the consumers 
  • there will also be elements of government intervention either through direct government control and ownership or through influences on the private sector, such as through laws and regulations

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