CAIE A-Level Economics 7.4.4 Consumption and Production Externalities

Market Economies

From Adam Smith onwards, most economists have regarded competitive markets as the main mechanism of economic activity. They argue that the interaction between producers and consumers can lead to both allocative efficiency and productive efficiency.

It can, however, be questioned whether the market automatically produces the best solution. Sometimes there are significant reasons for governments to intervene in a market in order to produce a better outcome than market forces alone. These situations are market failures.

When producing goods and services firms consider the private costs they pay and private benefits they receive. For example, a steel producer accounts for the cost of iron ore, fuel, labour and administration. It offsets these costs against the revenue from selling the steel. However, those people who live near the steelworks suffer the consequences of the noise, dirt and polluted air generated as part of the production process. Similarly, in many areas the extraction of iron ore can lead to environmental destruction such as the degradation of ground water for domestic consumption and a reduction in the variety of wildlife and flowers.

Competitive markets as envisaged by economists, however, may not exist. Firms may integrate to gain the benefits of economies of scale, to realise their ambition to rule the market or to increase their market share. Such integration might lead to the development of a monopoly market structure. Many believe that a monopoly always operates against the interests of the consumer because of its lack of efficiency. As a result, governments often restrict the operation of monopolies.