AQA A-level Economics: The price mechanism and the meaning of market failure (7136)

This guide covers two sub-sections of AQA A-level Economics (7136), from the AQA AS and A-level Economics specification, version 1.3, 29 June 2022: How markets and prices allocate resources and The meaning of market failure. They are numbered 3.1.8.1 and 3.1.8.2 on the AQA website; the combined specification PDF prints them as 4.1.8.1 and 4.1.8.2. The specification states no AS-only or A-level-only labels for this content. Every figure below is invented and illustrative.

Next, use the revision notes and the practice set. For supply, demand and equilibrium see the supply guide, and for the wider unit see Individuals, firms, markets and market failure. Also use the course hub, the checklist and the free diagnostics.

What you must be able to do

Specification content	You must be able to
Rationing, incentive and signalling functions of prices	Explain each function and how prices coordinate buyers and sellers
What, how and for whom	Show how incentives shape what is produced, how and for whom
Advantages and disadvantages of the price mechanism	Weigh them, including when it is extended into new activities
Impersonal allocation	Assess the view that the price mechanism is impersonal
Markets in new fields, for example blood	Assess whether a market changes the nature of the activity
Meaning of market failure	Define it as a misallocation of resources
Complete and partial failure	Distinguish a missing market from a market that exists but misallocates
Causes, with examples	Link public goods, externalities, merit and demerit goods, monopoly and other imperfections, and inequality to failure

The three functions of prices

In a market economy no one plans the whole system. Prices pass information and push decisions into line.

• Rationing: when demand exceeds supply, a higher price discourages some buyers, so the limited stock goes to those willing and able to pay.
• Incentive: a higher price raises the reward to producers, so they supply more. Higher profits also attract new firms.
• Signalling: a price change tells buyers and sellers that conditions have changed, without anyone explaining why.

Worked example 1 (invented market for sourdough loaves in Town Z). Qd = 600 − 50P and Qs = 100P, where P is in pounds.

1. Equilibrium: 600 − 50P = 100P, so 150P = 600, P = £4 and Q = 400 loaves.
2. Demand rises by 150 at every price (a new fashion for sourdough): Qd = 750 − 50P.
3. At the old price of £4: Qd = 750 − 200 = 550 and Qs = 400. There is a shortage of 150.
4. The new equilibrium: 750 − 50P = 100P, so P = £5 and Q = 500.

Read the chain. The shortage lets bakers raise price (signal). Buyers on the margin drop out as quantity demanded falls from 550 to 500 (rationing). The extra £1 per loaf pulls quantity supplied up from 400 to 500 (incentive). If demand had instead fallen to Qd = 450 − 50P, the equilibrium would be £3 and 300 loaves. At £4 there would be a surplus of 150 (Qd = 250, Qs = 400) and the falling price would tell bakers to cut back.

What, how and for whom

• What: resources move towards goods whose prices and profits are rising, and away from goods whose prices fall.
• How: firms choose the cheapest method at current input prices.
• For whom: goods go to those with the ability, as well as the willingness, to pay. Income decides the share each person gets.

Worked example 2 (how). A firm can make the same output by method L (8 workers, 1 machine per day) or method C (3 workers, 3 machines). A machine costs £200 a day.

• Wage £120: L = 8 × 120 + 200 = £1,160; C = 3 × 120 + 600 = £960. Choose C.
• Wage £60: L = 8 × 60 + 200 = £680; C = 3 × 60 + 600 = £780. Choose L.

The relative price of inputs changed the method. No instruction was needed.

Advantages and disadvantages of the price mechanism

Advantages	Disadvantages
Decisions are decentralised, so no planner needs all the information	Ignores people without purchasing power
Profit and prices give firms an incentive to be efficient and respond quickly	Prices may leave out external costs and benefits
Consumers’ choices direct production (consumer sovereignty)	No provision of public goods
Competition tends to hold prices down and encourage innovation	Monopoly power can distort prices
Low administration cost compared with central allocation	Merit goods may be under-consumed and demerit goods over-consumed

Assessing the view that the price mechanism is impersonal

Price allocation does not ask who you are, why you want the good or how badly you need it. That is a strength and a weakness.

• For: it treats buyers equally, avoids favouritism and bribery and needs no official to judge need.
• Against: it responds to purchasing power, not need.

Worked example 3 (invented). Two units of a scarce good are on sale. Four households have these maximum prices and monthly incomes.

Household	Willingness to pay (£)	Monthly income (£)
H1	40	3,000
H2	34	1,200
H3	26	1,500
H4	15	600

A price of £30 clears the market. H1 and H2 buy; revenue is £60 and consumer surplus is (40 − 30) + (34 − 30) = £14. The price is 1% of H1’s income but 5% of H4’s. H4’s low willingness to pay may reflect low income, not low need. So the market allocates efficiently in its own terms but not necessarily fairly.

Evaluation: the criticism is strongest for necessities with no substitutes, and weaker where income differences are small or the government can adjust incomes. Whether a result is “unfair” is a normative judgement.

Extending the price mechanism into new areas

Some activities have traditionally relied on gifts, queues or public provision. Arguments for extending the market are better supply, shorter queues and a clear price signal. Arguments against are that payment can change motives and the meaning of the activity.

Worked example 4 (a market for blood, invented Country B). Voluntary donors: 10,000, with 2% of donations rejected. Payment of £20 is introduced. Donors rise to 12,000 but rejections rise to 6%, because some donors now hide risks. Screening costs £15 per donor.

• Usable units before: 10,000 × 0.98 = 9,800. After: 12,000 × 0.94 = 11,280, a 15.1% rise.
• Cost before: 10,000 × 15 = £150,000, or £15.31 per usable unit.
• Cost after: 12,000 × (15 + 20) = £420,000, or £37.23 per usable unit.

The market raises quantity but cost per usable unit more than doubles. The specification point is that payment changes the nature of the transaction and the incentives. People who gave from a sense of duty may stop when giving becomes a sale (crowding out of intrinsic motives), and extrinsic rewards may attract donors with the most reason to hide their health. Judge by weighing the extra supply against quality, cost and the meaning attached to giving. Other examples include charging for road space or charging for school places.

The meaning of market failure

Market failure occurs whenever a market leads to a misallocation of resources. The market outcome differs from the one that would maximise social welfare. Compare with the ideal where marginal social benefit equals marginal social cost.

Complete and partial failure

• Complete failure (missing market): the market does not exist at all, so nothing is produced although it would be worthwhile.
• Partial failure: the market exists but produces the wrong quantity or price.

Worked example 5 (missing market, invented). Three neighbours would pay £10, £8 and £6 a month for a street light. It costs £15 a month.

1. Total willingness to pay is 10 + 8 + 6 = £24, which exceeds the cost of £15.
2. Net benefit if provided = 24 − 15 = £9.
3. If the light is provided, nobody can be stopped from using it, so each neighbour hopes the others will pay. A private firm cannot collect revenue, so no market forms and the £9 of net benefit is lost.

Worked example 6 (partial failure, invented). Marginal private benefit is 20 − 0.05Q. Marginal private cost is 4 + 0.03Q. Each unit also imposes an external cost of £2, so marginal social cost is 6 + 0.03Q.

1. Market: 20 − 0.05Q = 4 + 0.03Q, so Q = 200 and P = £10.
2. Social optimum: 20 − 0.05Q = 6 + 0.03Q, so Q = 175 and P = £11.25.
3. The market overproduces by 25 units. The welfare loss is a triangle: ½ × £2 × 25 = £25.

The market exists, but it misallocates. Detailed treatment is left to the guides on public goods, externalities and policy.

Overview of causes

Cause	Why resources are misallocated	Type	Example
Public goods	Non-excludability means no payment	Complete	Street lighting
Negative externality	Third-party costs ignored	Partial	Factory smoke
Positive externality	Third-party benefits ignored	Partial	Vaccination
Merit goods	Benefits underestimated	Partial	Education
Demerit goods	Harms underestimated	Partial	Tobacco
Monopoly and other imperfections	Price above marginal cost, immobile resources, poor information	Partial	A sole supplier
Inequality	Allocation follows income, not need	Partial	Unaffordable essentials

Common errors

• Writing “price rises, demand falls” with no link to rationing or signalling. Name the function and give the chain.
• Calling any unfairness market failure. Show that resources are misallocated or that society would gain from change.
• Mixing up a missing market with a market that is merely small.
• Listing disadvantages of the price mechanism without examples.
• Treating a blood market as good or bad without weighing motives, safety and cost.

Official syllabus

AQA, AS and A-level Economics (7135 and 7136), specification version 1.3, 29 June 2022, sections 4.1.8.1 and 4.1.8.2 as printed in the combined PDF; for first teaching from September 2015.