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)
E
e
100
Price (pence per kg)
Supply
d
D
80
Cc
60
b
40
B
a
20
A
Demand
0
0
100
200
300
400
500
Quantity (tonnes: 000s)
600
700
800
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
Type of
market
Number
of firms
Perfect
competition
Very
many
Monopolistic
competition
Many /
several
Freedom of
entry
Nature of
product
Unrestricted
Homogeneous
(undifferentiated)
Unrestricted
Examples
Differentiated
Undifferentiated
Oligopoly
Monopoly
Few
One
Restricted
Restricted or
completely
blocked
or differentiated
Unique
Structure  conduct  performance
Outcomes on price
and output
Price set = MC. Q
where MB=MC
Price > MC Q below
point where
MB=MC. (Not v
below)
Varies depending
on the type of
competition
Monopoly power
results in P>> MC
and Q lower than
optimal output
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
Market Failures: Monopoly Power
 Why is a monopoly ‘bad’?
 What can governments do if a monopoly exists?
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
Negative externalities in production
Costs and benefits
MPC = S
P1
D = MPB
= MSB
O
Q1
Quantity
Negative externalities in production
Costs and benefits
MSC
MPC = S
P2
P1
External cost
D = MPB
= MSB
O
Social optimum
Q2
Quantity
Q1
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
Positive externalities in consumption
Costs and benefits
S = MSC
P1
MPB = D
O
Q1
Quantity
Positive externalities in consumption
Costs and benefits
External benefit
S = MSC
P2
P1
MSB
MPB = D
O
Q1
Q2
Quantity
Market Failures:
Externalities
 How might a government intervene if faced with an
externality?
Market Failures:
Public Goods
 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
Forms of Government Intervention
 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?
The market for health care
 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