The allocation of resources

Microeconomics Macroeconomics
Study of individual markets Study of the economy as a whole
Analyses demand and supply Analyses total employment in the
economy
Deals with household and firm decisions Deals with aggregate decisions
Studies individual income and prices Studies national income & overall price
levels
Analyses demand and supply of goods Analyses total demand and supply
Producers & consumers make the The government makes the decisions
decisions

The resource allocation problem

1. What to produce – since society cannot produce all it desires due to limited
resources; it must decide what goods and services it is going to produce

2. How to produce – the economy must decide which method of production is

going to used; capital intensive or labour intensive.

3. For whom to produce – the economy must decide whether it is going to

produce for all people or only for those who have money.

Economic systems
The institutions, organisations and mechanisms that influence
economic behaviour and determine how resources are allocated.
Market economy
An economic system where consumers determine what is produced, resources are
allocated by the price mechanism and land and capital are privately owned.
In market economy, there is no govt. involvement in economic matters. The
economic problem is solved by private sector firms and consumers based on price
mechanism. All decisions are made by producers and consumers. The profit
motive in private sector encourages them to develop new production methods.
Consumers are free to choose the goods and services they buy, workers are free
to choose the occupation they want and producers are free to choose the goods
they supply.
Private property is another feature in market economy.
There is no provision of public goods and merit goods, and the production and
consumption of harmful goods are encouraged as there is no govt involvement in
market economy.

The market system and the economic problem:

In a free market economy, there is no govt involvement in economic matters. The
economic problems such as what to produce and for whom to produce are solved
by price mechanism. Price mechanism is the forces of demand and supply.
The problem of what to produce is solved by private firms based on price
mechanism. As their main aim is profit maximisation, firms would only produce
those goods and services at a given price.
The problem of how to produce is solved by private producers who produce goods
and services at a high price. They allocate scare resources to maximise their profit.

Advantages
o A wide variety of goods and services are produced to satisfy consumer
wants.
o Firms respond quickly to changes in consumer’s tastes and spending
patterns.
o The profit motive of firms encourages them to develop new products and
use the most efficient methods of production.
o There is no tax on income and wealth.
o There is no public sector in market economy.
Disadvantages
o In a free market economy, there are no public goods or merit goods.
o It encourages production and consumption of harmful goods such as drugs
and alcohol.
o Social effects of production may be ignored.
o There will be no equal distribution of wealth.
o Firms will only supply to consumers who are able to pay for them.
In a market economy, what to produce is determined by consumer preferences,
how to produce is determined by producers’ seeking profits and for whom to
produce is determined by purchasing power.

Command / Planned economy

an economic system where the government makes the crucial decisions, land and
capital are state-owned and resources are allocated.
In a planned economy, economics decisions such as what to produce, how to
produce and for whom to produce are taken by the government. There is no
private ownership of property. Government has the power to fix the price. Firms
would aim to produce what government wanted.
There would be more equal distribution of income and wealth. The main aim of
the govt is the welfare of the people. Social effects of production may be
considered. In a planned economy, there no profit motive.
In a planned economy, what to produce is determined by the government
preferences, how to produce is determined by the government and employees
and for whom to produce is determined by government preferences.
Mixed economy
an economy in which both the private and public sectors play an important role
A mixed economy is a mixture of market economy and planned economy. It
included public and private sectors together. The govt provides public and merit
goods whereas private sector includes consumer goods. The cost of production,
such as pollution, may be prevented.
In a mixed economy. people may be able to stop the production and consumption
of harmful goods by making them illegal or imposing excise duties (tax). There will
be equal distribution of income and wealth by imposing direct taxes on incomes
of rich people and use their money to help the poor people.
What to produce is determined partly by govt and consumer preferences, how to
produce is determined partly by govt and producers seeking profits, and for whom
to produce is determined partly by govt and purchasing power.

Market equilibrium
Equilibrium price is the market price where the quantity of goods supplied is equal
to the quantity of goods demanded. This is the point at which the demand and
supply curves in the market intersect. A disequilibrium price is either above or
below the equilibrium price. A price below the equilibrium price creates a
shortage, and a price above creates a surplus of goods. A disequilibrium is any
price that doesn’t achieve a balance between market prices of demand and
supply.

Demand
The want or willingness of consumers to buy a product at a given price.
To be an effective demand, a consumer must have enough money to buy the
product.
The law of demand states that an increase in price leads to a decrease in demand,
and a decrease in price leads to an increase in demand. (inverse relationship)
Individual demand is the demand from one consumer, while market demand is
the aggregate demand for the product, or the sum of all individual demands of
consumers.
 According to economic theory, the demand for a product is determined by;

 Change in consumers income: The demand for goods is influenced by

the change in consumer income, which can either increase or decrease
the quantity demanded.
 Change in tax income: The demand for goods and services can fluctuate
due to changes in tax income, with increased tax leading to decreased
demand and vice versa.
 Change in price of substitute goods: The price of substitute goods, which
can be replaced with other goods, directly correlates with the quantity
demanded.
 Change in price of complementary goods: The price of complementary
goods is inversely related to the quantity demanded, as they are used
together to satisfy a specific want.

Supply
The willingness and ability of firms to make a product available to consumers.
As price rises, the quantity supplied by producers increases because production
becomes more profitable whereas when price falls, producers reduce quantity
supplied as it becomes less profitable.
The law of supply states that an increase in price leads to an increase in supply,
and a decrease in price leads to a decrease in supply. (price and supply are
positively related)

Price Elasticity of Demand

The measure of the responsiveness of demand to a change in price
PED = % change in quantity demanded / % change in price
Relatively elastic demand: The percentage change in price is proportional to the
percentage change in quantity demanded
Unitary elastic demand: Changes in price do not affect the quantity demanded
The PED is greater than 1 for relatively and unitary elastic demand.
Perfectly elastic demand: Any changes in the price will lead to quantity demanded
being zero

Inelastic demand
 PED lower than 1
 The necessity of the product is high – it is either essential or habitual
 A change in price has little effect on the change in demand

Price elasticity of Supply

The measure of the responsiveness of quantity supplied to change in price.
PES = % change in quantity supplied / % change in price

Elastic supply Inelastic supply

PES more than 1 PES less than 1
A large price change A large price change
will have a large will have little effect
effect on the on the amount
amount supplied supplied.