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The Market Mechanism

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Economics

Imagine you have a new idea for a product. How do you know if people want to buy it? How much would you supply to the market and at what price? Fortunately, you don't have to worry about any of this! All this is done through the market mechanism and its functions. In this explanation, you will learn how the market mechanism works, its functions, and its advantages and disadvantages.

What is the market mechanism?

The market mechanism links the actions of the three economic agents: consumers, producers, and owners of the factors of production.

The market mechanism is also called the free market system. It is the situation where decisions on price and quantity in a market are made based on demand and supply alone. We also refer to this as the price mechanism.

The functions of the market mechanism

The functions of the market mechanism spring into action when there is a disequilibrium in the market.

Disequilibrium in the market occurs when the market fails to find its equilibrium point.

Disequilibrium in the market happens when demand is greater than supply (excess demand) or supply is greater than demand (excess supply).

The market mechanism has three functions: the signalling, incentive, and rationing functions.

The signalling function

The signalling function relates to the price.

The signalling function is when a change in price provides information to consumers and producers.

When prices are high, this would signal to producers to produce more and would also signal a need for new producers to enter the market.

On the other hand, if prices fell, this would signal consumers to buy more.

The incentives function

The incentive function applies to producers.

The incentive function happens when a change in prices encourages firms to provide more goods or services.

In colder periods, the demand for warmer clothes such as winter jackets increases. Thus, there is an incentive for producers to make and sell winter jackets as there is a greater guarantee that people are willing and able to buy them.

The rationing function

The rationing function applies to consumers.

The rationing function is when a change in price limits consumer demand.

In recent times, there has been a shortage of fuel in the UK. Due to limited supply, the price for fuel increases, and demand falls. This has limited consumer demand. Instead of driving to work/school, people opt for public transport instead.

One of the fundamental economic problems is scarcity. Any change in price causes demand to be affected and resources to be rationed amongst the people who are willing and able to pay.

The market mechanism diagram

We can graphically show the functions of the market mechanism at work through two diagrams.

In Figure 1, we assume the prices are low in a particular market.

The market mechanism Functions of the market mechanism with a low price StudySmarterFigure 1. Functions of the market mechanism with a low price - StudySmarter.

As you can see in the figure above, the quantity demanded far exceeds the quantity supplied. The signalling function tells producers to supply more of that particular good or service to the market. Producers also have a profit incentive, so as they supply more, the price in the market starts to increase and they can make more profit. This sends consumers a signal to stop buying the good or service because it's becoming more expensive. The increase in price limits consumer demand and they now leave that particular market.

Figure 2 illustrates the situation when the quantity supplied far exceeds the quantity demanded. This occurs when prices in a particular market are high.

The market mechanism Functions of the market mechanism with a high price StudySmarterFigure 2. Functions of the market mechanism with a high price - StudySmarter.

As we can see in the figure above, the quantity supplied far exceeds the quantity demanded. Because there is excess supply, producers aren't selling much and this impacts their profits. The signalling function tells producers to reduce the supply of that good or service. The reduction in price signals consumers to buy more and other consumers now enter into this market.

Allocation of resources and the market mechanism

What we have essentially been looking at which the help of the two diagrams, is how resources are allocated in a market.

The relationship between supply and demand plays a very important role in deciding how scarce resources are allocated.

When there is excess supply, it's not rational for scarce resources to be used for this good or service if there isn't much demand for it. When there is excess demand, it's rational to use scarce resources for this good or service because consumers want and are willing to pay for it.

Each time there is a disequilibrium, this mechanism allows the market to move to a new equilibrium point. The reallocation of resources that takes place with the market mechanism is done by the invisible hand (without involvement by the government).

The invisible hand refers to the unobservable market force that helps the demand and supply of goods in the free market reach equilibrium automatically.

Advantages and disadvantages of the market mechanism

Like all microeconomics theories, there are both advantages and disadvantages. The market mechanism is no exception to this.

Advantages

Some advantages of the market mechanism are:

  • Allocative efficient. The market mechanism allows the free market to distribute goods and services efficiently without much waste and it benefits society as a whole.
  • Signals to investment. The market mechanism signals to firms and investors which goods and services are profitable and thus where they should invest and where they shouldn't.
  • No government intervention. Good and services are provided based on the invisible hand. Producers are free to produce whatever they want and consumers are free to buy whatever they want without the need for government intervention.

Disadvantages

Some disadvantages of the market mechanism are:

  • Market failure. Where there is no profit incentive to produce a particular good or service like healthcare or education, producers will not produce it, even if there is a necessity for it or high demand. Because of this, many vital goods and services are underproduced by the free market thus leading to market failure.
  • Monopoly. In the real world, there is sometimes only one seller of a good or service. Because of the lack of competition, they control the prices and supply of that good or service. Especially if this is a necessary good or service, consumers still have to buy it even if the price is too high.
  • Wastage of resources. In theory, there should be little to no wastage of resources as they are efficiently distributed, but in the real world that isn't always the case. Most firms value profits over efficient processes and this results in waste of resources.

Market mechanisms: market failure and government intervention

As we have said before, the main actors in the market are consumers, the firms (producers), and the owners of the factors of production.

The market functions affect demand and supply. This interaction between supply and demand ensures efficient allocation of resources while helping achieve market equilibrium. This is why we can say that the market (forces of supply and demand) determines the best price and best quantity for both the producers and consumers.

However, one disadvantage of the market mechanism, is that it can lead to market failure.

Market failure is when there is an inefficient distribution of goods and services in the free market.

When this occurs, government intervention is important. It enables the correction of market failure and the achievement of social and economic goals both as an economy and on a personal level.

However, government intervention can also have negative effects on the market. This is known as government failure.

Government failure is a situation where government intervention in the economy creates inefficiency and leads to the misallocation of resources.

Market Failure, Government Intervention, and Government Failure are key concepts that link to the market mechanism. Check out our explanations for each topic!

The Market Mechanism - Key takeaways

  • The market mechanism is a system of the market where the forces of demand and supply determine the price and quantity of goods and services traded.
  • The market mechanism relies on the invisible hand to fix market malfunctions.
  • The market mechanism has three functions: signalling, giving incentives, and rationing.
  • The market mechanism allows the market to move to an equilibrium point and distributes resources efficiently.
  • The market mechanism has some advantages: allocative efficiency, signals investment, and no government intervention. It also has some disadvantages: market failure, monopoly, waste of resources.
  • Government intervention is used when the market mechanism fails to correct market failure.

The Market Mechanism

The market mechanism is a system of the market where the forces of demand and supply determine the price and quantity of goods and services. 

  • Signals whether prices are too high or too low.
  • Incentivises to change the price of goods and services. 
  • Rations excess demands and supply.
  • Helps with the allocation of scarce resources.

The market mechanism is also referred to as the 'Price Mechanism'.

  • Helps ration goods and resources.
  • Gives a signal to producers on what to and not to invest in.
  • Determines income distribution amongst input owners. 
  • Gives producers complete freedom to decide what to produce.

Final The Market Mechanism Quiz

Question

Define government intervention.

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Answer

Government intervention is when a government is involved in the marketplace.

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Why do governments intervene in the marketplace?


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Answer

To overcome market failure.

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What are the types of government intervention?


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Taxes 

Subsidies 

Minimum and maximum prices 

Regulations

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What are subsidies?


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Answer

Subsidies are financial support to products with positive externalities.

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What are minimum prices?


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Answer

Setting a lower limit for prices by the government.

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What are the disadvantages of setting minimum prices?


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Answer

It can be costly for the government and force it to put tariffs on cheap imports – which damages the welfare of farmers in other countries.

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Give an example of maximum prices.


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Answer

The price for bread cannot be higher than 80p/100g.

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What can create a shortage?


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maximum prices

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What are regulations?


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Answer

Regulations include non-market based ways of intervention in markets.

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Give an example of regulations.


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Minimum age laws on alcohol, maximum CO2 emissions for vehicles, ban on diesel cars.

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What are the advantages of government intervention?


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The advantages of government intervention are equality, fighting monopolies, public goods, consumer behaviour and environmental protection.

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What are the disadvantages of government intervention?


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The disadvantages of government intervention are worsening the situation, limited choice of products, pressure and dicrimination.

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What are public goods?


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Some goods and services are not provided in a free market because they do not give any financial benefits. Instead, they can be provided by the government.

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What is government failure?


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Government failure is an economic inefficiency caused by government intervention. It is when the government intervenes in the market with good intentions, but in result, creates even more problems by either deepening the market failure or causing a new failure.

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 What is the definition of market failure?

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Market failure is an economic term that describes the situation in which the markets perform inequitably (unfairly or unjustly) or inefficiently.

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What causes market failure?

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Market failure is caused by an inefficient allocation of resources which prevents supply and demand curves from meeting at the equilibrium point.

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Give an example of a market failure.

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The free-rider problem. This occurs when there are too many non-paying consumers using goods and services. For example, if too many non-paying consumers listen to the public radio station without giving a donation, the radio station should rely on other funds such as the government, to survive. 

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What does non-rival goods mean?


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The non-rival goods category means that if one person consumes this good it does not prevent another person from consuming it.

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What is the difference between exclusive and non-exclusive goods?


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Exclusive goods prevent non-paying customers from consuming this good. Non-exclusive goods do not prevent non-paying customers from consuming this good or service.

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What is the difference between pure and impure public goods?


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Pure public goods have both characteristics non-rival and non-exclusive while impure public goods have only one of those characteristics.

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What are the main types of market failure?


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  • Complete
  • Partial


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What does complete market failure mean?


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Complete market failure means that there are no goods supplied in the market at all.

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Give an example of a 'missing market'.


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If consumers would like to buy pink shoes, but there are no businesses that supply them. These results in missing markets for this good.

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What does a partial market failure mean?


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In this situation, the market still functions. However, the number of goods demanded does not equal the supply. This results in a shortage or excess supply and inefficient pricing of the goods.

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What are the main causes of market failure?


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  • Public goods

  • Negative externalities

  • Positive externalities 

  • Merit goods

  • Demerit goods

  • monopoly

  • Inequalities in the distribution of income and wealth 

  • Environmental concerns

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Give an example of how negative externalities cause market failure.

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Answer

Negative externalities are referred to as indirect costs to individuals. For example, production factories may be releasing dangerous chemicals into the air that may be harmful to people's health to lower the cost of production. This will cause market failure as due to lower production costs there will be excessive production that does not reflect the true product's price and an over-polluted environment.

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Give an example of how demerit goods cause a market failure.

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Demerit goods are harmful to society, such as alcohol and cigarettes. Market failure happens as smokers do not realize the effect that they have on society such as passing the smell and negatively impacting second-hand smokers. They can also cause long-term health problems for themselves and for others. This is all due to overconsumption of this demerit good.

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What does monopoly mean?


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Monopoly means that there is a single or only a few producers in the market which own a vast majority of the market share.


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Give an example of how unequal distribution of income and wealth causes market failure.


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The market failure can be caused by the unequal allocation of income and wealth. For example, due to technology someone receives an extremely high salary in comparison to average workers.

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How does the government attempt to correct complete market failure?


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Government attempts to correct the complete market failure by providing goods in a missing market.

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How do governments attempt to correct inefficient pricing?


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To correct inefficient pricing government makes maximum pricing (price ceilings) and minimum pricing (price floors) laws.

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What does government failure mean?


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Government failure is the situation when the government's interventions bring more social costs than benefits into the market.  

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What is a merit good?

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Merit goods are goods for which the social benefits of consumption outweigh private benefits.

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Name an example of a merit good.

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Answer

Healthcare.

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Why do merit goods cause partial market failure?

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Because merit goods are under-provided in the market.

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Describe why education is a merit good.

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Education is provided by the market, but in quantities that are not optimal.

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Merit goods lead to _________ .

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positive externalities

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What is the privately optimal level of consumption of a merit good?

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Where demand and supply for a merit good which is not subsidised are in equilibrium.

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What is the socially optimal level of consumption of a merit good?

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The level of consumption that is possible when merit goods are subsidised.

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Why would the government want to subsidise education?

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To reach the socially optimal level of education.

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Why do customers often ignore the full benefit of merit goods?

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Due to imperfect information.

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What is a demerit good?

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A demerit good is a good for which the societal costs of consumption outweigh private costs.

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Name an example of a demerit good.

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Tobacco.

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What are the private costs of a demerit good?

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Private costs include the costs incurred by the individual for purchasing the good and the negative impact of the good on the individual.

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What are the social costs of a demerit good?

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Social costs include the negative externalities that occur during the consumption of the good.

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How do governments try to discourage the consumption of demerit goods?

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By introducing/increasing taxes on demerit goods.

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What are value judgements?

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Value judgements are personal opinions, which characterise what a particular person finds desirable or not.

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What is public ownership?

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It's when the local or central government owns industries, firms, and other assets such as housing, railways, or coal plants.

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What is private ownership?

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It's when an individual or private organisation own industries, firms, and other assets such as housing, railways, or coal plants rather than the state.

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Question

What industry did the UK partially nationalise during the 2008 financial crisis?

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The banking industry. 

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