Strengths and weaknesses of the market economy

Overview

How the price mechanism allocates resources and when it does so efficiently, the strengths of the market economy and competition, market failure from external costs and benefits, public goods, information failure and labour immobility, inequality, whether failure justifies intervention, and allocative efficiency.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

Each one with the model answer underneath.

1. 1

   How does the price mechanism allocate resources in a market economy?

   Model answer

   Prices signal where demand is strong, give producers the incentive to supply it, and ration the good to those willing to pay, which moves resources to their most valued use.

2. 2

   Under what condition does a market allocate resources efficiently?

   Model answer

   When the private costs and benefits facing buyers and sellers are the same as the social costs and benefits, so that no third party is affected.

3. 3

   Give two strengths of the market economy as a way of allocating resources.

   Model answer

   It responds quickly to changes in what consumers want, and competition gives firms a continual incentive to cut costs and to innovate.

4. 4

   How does competition in a market economy benefit consumers?

   Model answer

   Firms must keep prices close to costs and improve quality in order to retain customers, so consumers gain more choice at a lower price.

5. 5

   Define market failure.

   Model answer

   Market failure is the failure of a free market to allocate resources efficiently, leaving society's welfare lower than it could be.

6. 6

   Why do external costs cause market failure?

   Model answer

   The market prices only private costs, so a good that generates external costs is under-priced and over-produced relative to the socially optimal output.

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