The benefits of competition, monopoly and market power, the causes of market failure including externalities, merit and demerit goods and public goods, and how government intervenes to correct it.

What this dot point is asking

AQA wants you to explain the benefits of competition, the problems of monopoly and market power, the main causes of market failure (externalities, merit and demerit goods, public goods), and how the government intervenes to correct market failure. Market failure questions are a rich source of 9 mark "analyse" and "discuss" items, so practise the chains of reasoning from cause to policy.

The benefits of competition

When many firms compete, consumers tend to gain:

• Lower prices, as firms fight for customers and cannot charge above the market rate.
• More choice of products and suppliers.
• Better quality and customer service, as firms try to stand out.
• Innovation, as firms invent new and better products to win market share.

Competition also forces firms to be efficient and keep costs down, because a wasteful firm will be undercut by rivals.

Monopoly and market power

Monopoly is not always bad: a large firm may gain economies of scale (lower average costs from producing in bulk) or fund expensive research and development. But the risks are higher prices, lower output, less choice and weaker incentives to innovate, which is why governments regulate monopolies.

Market failure

Externalities

With a negative externality, the social cost is greater than the private cost paid by the producer, so too much is produced. With a positive externality, the social benefit exceeds the private benefit, so too little is produced. Government policy aims to make people face the full social cost or benefit.

Merit, demerit and public goods

• Merit goods (such as education and healthcare) are under-consumed because people undervalue their long-term benefits, so the government encourages or provides them.
• Demerit goods (such as cigarettes and alcohol) are over-consumed because people ignore or discount the harm they cause.
• Public goods (such as street lighting and national defence) are non-excludable and non-rival, so the free market under-provides them due to the free-rider problem.

How the government intervenes

Governments correct market failure using:

• Indirect taxes to discourage demerit goods and negative externalities (raising the price towards the social cost).
• Subsidies to encourage merit goods and positive externalities (lowering the price).
• Regulation and bans to limit harmful activity directly.
• Information campaigns to change behaviour and correct ignorance.
• Direct provision of public and merit goods, funded by taxation.

Each policy has drawbacks: taxes can be hard to set at the right level, regulation needs enforcing, and government can itself fail (government failure) if it intervenes badly.

Worked example

Try this

Q1. Define a negative externality. [2 marks]

• Cue. A cost imposed on a third party not involved in the transaction, such as pollution.

Q2. Explain one way the government could encourage the consumption of a merit good. [3 marks]

• Cue. A subsidy lowers the price, raising demand, for example funding free vaccinations.