Chapter 6

The role of markets in allocating resources

 Learning objectives
By the end of this chapter you will be able to:
explain the key allocation decisions
describe the nature of the market system
analyse how the price mechanism provides
answers to the key allocation decisions
 6.1 The three key allocation decisions
•
All economies are changing and they all have
to answer three fundamental economic
questions:
• What to produce
• How to produce
• Who is to receive the products produced?
 Method of production
• There are two method of productions
• 1 labour intensive method
• A method of production in which more labour
is used compare to machinery.
• 2 Capital intensive method
• A method of production in which more capital
is used compare to labour.
 Basic economic problem
• These questions arise because of the basic
economic problem of unlimited wants exceeding
finite resources .A decision has to be made as to
how the economy’s resources are to be allocated.
For example, how many resources should be
devoted to healthcare, how many to leisure
goods and services and how many to defence.
 Basic economic problem
• Once this decision has been taken, an economy has to
decide on how the products are to be produced. for
example whether a large number of workers should be
used in agriculture or more reliance be placed on capital
equipment. Finally, because as many goods and services
cannot be produced as are required to satisfy the needs
of everyone, a decision has to be reached as to how the
products should be distributed Should products be
distributed to people according to their needs or their
ability to earn a high income.
 How to Produce
• There are two methods to produce goods and
services these are Labour intensive and capital
intensive
• Labour intensive is When more Labour is used
compared to capital
• Capital intensive is when more capital is used
compared to Labour .
 Basic economic problem
• The answers to the above questions differ in
different economic systems. An economic
system covers the institutions, organisations
and mechanisms in a country that influence
economic behaviour and determine how
resources are allocated
 6.2 Different economic systems
There are three main economic systems. One is a planned economic
system. An economy which operates a planned economic system is
called a planned, centrally planned, command or collectivist economy. It
is an economy in which the state (government) makes the decisions
about what to produce, how to produce it and who receives it. The state
owns all, or at least most, of the land and capital, and employs workers.
The state gives instructions, sometimes called directives to state-owned
enterprises (SOEs) on what to produce and how to produce it. The state
determines who gets the products made, both by deciding on the
remuneration paid to the workers and by controlling prices. It will
usually provide basic necessities and important products such as
housing. transport and education free of cost or at a low price.
• Capital intensive use of more machines
compare to Labour Is called capital intensive
Labour intensive use of more Labour compare
two machines is called Labour intensive
The other two types of economic system

• The other two types of economic system are a

market economic system and a mixed
economic system. This chapter focuses on the
market economic system. (Chapter 15 looks at
the mixed economic system.)
 6.3 A market economic system
An economy which operates a market
economic system is known as a market
economy or a free enterprise economy. It is
one in which buyers, also known as
consumers, determine what is produced. They
signal their preferences to sellers through the
price mechanism .
 Market economic system
• system which is own and controlled by private
people and all the decisions are taken by
market forces such as demand and supply .
 Market economic system
• In a market economic system, government
intervention is minimal. Land and capital are
privately owned. Private sector firms decide
how to produce the products consumers want
to buy. Some firms, for instance steel firms,
may employ large amounts of capital relative
to labour.
 Capital-intensive
• They are said to be capital-intensive. Others, for
example hotels, may use a relatively high number of
workers in comparison with the amount of capital used.
They rely mainly on labour and so are described as
labour-intensive. In making their decision on which
factors of production to employ, firms will seek to
achieve the lowest cost method of production. while
producing the highest quality of products This may also
involve the use of new, more productive capital
equipment. to replace older equipment.
 Market economic system
• In a market economic system, those who earn
the highest incomes exercise the maximum
influence on what is produced Those workers
whose skills are in highest demand and are
the most successful entrepreneurs will be able
to buy more products than those whose skills
are in low demand and are unsuccessful
entrepreneurs.
 Answer
1 a Consumers signal to producers what they want to
be produced by the amount they are willing and
able to pay for different products.
B Those producers who use the lowest cost method
of production to produce the highest quality
products will do well, while those who use a higher
cost method of production and/or produce low-
quality products are likely to go out of business.
C Those consumers who have the money to back up
their wants will receive the products produced.
6.4 The role of the price mechanism
In a market economic system, resources move
automatically as a result of changes in price. In turn,
price changes are determined by the interaction of the
market forces of demand and supply. Resources switch
from products that are becoming less popular to those
which are becoming more popular. Consumers signal
to producers their changes in demand through the
prices they are prepared to pay for different products.
Fig. 6.1: Changes in resource allocation in a market economy
 Answer
1 a The price of a ticket to the final of the football World
Cup will be higher. This is because more people will want
to see the World Cup Final. The competition among
potential buyers for the tickets will push up the price.
B The price of gold will be higher. The demand for gold
relative to its supply is greater than the demand for rice
relative to its supply.
C The price of the services of a dentist is higher than those
of a cleaner. This is because there are more people
capable of working as cleaners than working as dentists.
 Multiple choice questions
1 What are me three questions faced by all economies?
A What to produce. when to produce it and who
receives it
B What to produce. how to produce it and who receives
it
C Where to produce, how to produce and when to
produce
D Where to produce, when to produce and why to
produce
 Multiple choice questions
2 What encourages firms to produce what
consumers demand?
A The chance to earn a high profit
B The chance to experience high unit costs of
production
C The desire to attract new firms into the
industry
D The desire to keep revenue as low as possible
 Multiple choice questions
3 How are resources allocated in a market
economy?
A By directives
B By the price mechanism
C By directives or the price mechanism
D By directives and the pnce mechanism
 Multiple choice questions
• 4 What is meant by market forces?
A The interaction of demand and supply
B The interaction of firms and the government

C The po.ver of producers

D The power of the state
Answer Multiple choice questions
• 1B
• These are the three fundamental economic
questions.
• 2A
• Firms are motivated by profit. To earn high profits,
firms seek to keep costs low and revenues high.
Firms would not try to encourage rivals to enter
the market, as their entry would make it more
difficult for the existing firms to earn high profits.
Answer Multiple choice questions
• 3B
• Resources are allocated by the price mechanism in a market
economy. If a product becomes more popular, consumers will
be willing to pay more for it and hence more resources will be
devoted to its production. Directives allocate resources in a
planned economy. Directives and the price mechanism are
used in a mixed economy.
• 4A
• Market forces are the factors that determine the price of a
product in a market. These factors are demand and supply.
They push up price when demand increases or supply
decreases.
 Four-part question
A Identify two key resource allocation decisions.
(2)
B Explain the difference between market
equilibrium and market disequilibrium. (4)
C Analyse the functions of me price mechanism.
(6)
 Answer
A Any two from: what to produce, how to
produce it and for whom to produce.
 Answer
B Market equilibrium is where demand and supply
are equal. In this situation, there is no reason for
price to change. This is because the market clears
with no products left unsold and no willing buyers
unable to purchase the product. In contrast,
market disequilibrium occurs when demand and
supply are not equal. There is either a surplus or a
shortage. This lack of balance between demand
and supply causes the price to change until
demand and supply are again equal.
 Answer
C The price mechanism has three main
functions. It acts as a rationing device. When
demand exceeds supply, price is driven up.
The rise in price reduces demand until it again
equals supply. Those who receive the product
will be those who are still willing and able to
buy the product at this higher price.
 Answer
The price mechanism provides producers with
useful information about changes in consumer
demand. It signals to them which products are
becoming more popular and which are
becoming less popular. If consumers demand
more of a product, its price will rise. Similarly,
if they demand less of a product, its price will
fall.
 Answer
As well as providing producers with
information about changes in consumer
demand as well as changes in supply, it also
gives them an incentive to respond to those
changes. Producers can earn more profit by
producing products in high demand whereas
they may make a loss if they make products
people do not want to buy.