Unit -2

Allocation of Resources

Microeconomics and Macroeconomics

 Microeconomics

It is the study of particular markets, and segments of the economy. It looks at issues such as
consumer behaviour, individual labour markets, and the theory of firms.

It involves supply and demand in individual markets, Individual consumer behaviour, and
individual labour markets.

Example - A consumer considering his options while buying a production

 Macroeconomics

Study of the whole economy. It looks at ‘aggregate’ variables, such as aggregate demand,
national output and inflation.

Involves decisions made by the government regarding, for example, policies.

Example - Governments deciding on the tax rates

 The role of markets in allocating resources

The Market System

 A market economy is an economic system in which economic decisions and the pricing
of goods and services are guided by the interactions of supply and demand- the market
mechanism.

Key Resources Allocation Decisions

The basic economic problem of scarcity creates three key questions

 What to produce?
 How to produce?
 For whom to produce?

Introduction to the Price mechanism

 It aids the resource allocation decision making process. The decision is made at the
equilibrium point where supply and demand meet.

Features of Price Mechanism

 Private Economic Agents can allocate resources without any intervention from the
government.
 Goods and Services are allocated based on price (Higher Price means more supply and
lower price means more demand)
 Allocation of Factors of Production is based on financial returns.
 Competition creates choices and opportunities for firms, private individuals and
consumers.
 Demand

 Demand refers to how much of a product or service is desired by buyers

Higher price of good = less people demand that good, hence, demand is inversely related to
price

Factors that affect demand

 Price
 Advertising
 Government Policies
 Consumer tastes/preferences
 Consumer Income
 Prices of substitute/ complementary goods
 Interest rates (price of borrowing money)
 Consumer population (population increase = demand increase)
 Weather

The individual demand is the demand of one individual or firm

The market demand represents the aggregate of all individual demands
 Supply

Supply represents how much the market can offer

Higher price of good = higher quantity supplied, hence quantity is directly proportional to
price.
Price ∝ Quantity supplied

Factors that affect supply

 Cost of factors of production
 Prices of other goods/services
 Global factors
 Technology advances
 Business optimism/expectations

The individual supply is the supply of an individual producer

The market supply is the aggregate of the supply of all firms in the market
 Price Determination

Market Equilibrium
When supply & demand are equal the economy is said to be at equilibrium.

At this point, the allocation of goods is at its most efficient because amount of goods being
supplied is the same as amount of goods being demanded & everyone is satisfied
 Price Changes

In this diagram, two disequilibrium prices are marked- 2.50 and 1.50.
At price 2.50, the demand is 4 while the supply is 10. There is excess supply relative
to the demand.
When the price is above the equilibrium price, a surplus is
experienced. (Surplus means ‘excess’).
At price 1.50, the demand is 10 while the supply is only 4. There is excess demand
relative to supply.
When the price is below the equilibrium price, a shortage is
experienced.
(This shortage and surplus is said in terms of the supply being short or excess
respectively).
 PRICE ELASTICITY OF DEMAND (PED)

The PED of a product refers to the responsiveness of the quantity demanded for it to changes
in its price.
PED (of a product) = % change in quantity demanded / % change in price For example,
calculate the price elasticity of demand of Coca-Cola from this diagram. PED= [(500-
300/300)*100] / [(80-60/80)*100] = 66.67 / 25 = 2.67
In this example, the PED is 2.67, that is, the % change in quantity demanded was higher than
the % change in the price. Which means, a change in price makes a higher change in quantity
demanded. These products have a price elastic demand. Their values are always above 1.

When the % change in quantity demanded is lesser than the % change in price, it is said to
have a price inelastic demand. Their values are always below 1. A change in price makes a
smaller change in demand.

When the % change in demand and price are equal, that is value is 1, it is called unitary price
elastic demand.
When the quantity demanded changes without any changes in price itself, it is said to have an
infinitely price elastic demand. Their values are infinite.

When the price changes have no effect on demand whatsoever, it is said to have a perfect price
inelastic demand. Their elasticity is 0.

What affects PED?

 of substitutes: If a product has many substitute products it will have a elastic demand.
For example, Coca-Cola has many substitutes such as Pepsi, 7 Up etc. Thus a change in
price will have a profound effect on its demand (If price rises, consumers will quickly
move to the substitutes and if price lowers, more consumers will buy Coca-Cola).

 Time period: Demand for a product is more likely to be elastic in the long run. For
example, if the price rises, consumers will search for cheaper substitutes. The longer
they have, the more likely they are to find one.
  Proportion of Income spend on commodity: goods such as rice, water (necessities) will
have an inelastic demand as a change in price won’t have any significant effect on its
demand, as it will only take up a very small proportion of their income. Luxury goods
such as cars, on the other hand will have a price elastic demand, as it takes up a huge
proportion of consumers’ incomes.

Relationship between PED and Revenue and how it is helpful to producers?

Producers can calculate the PED of their product and take a suitable action to make the
product more profitable.

Revenue is the amount of money a producer/firm generates from sales, i.e., the total number of
units sold multiplied by the price per unit. So, as the price or the quantity sold changes, those
changes have a direct effect on revenue. If the product is found to have an elastic demand, the
producer can lower prices to increase revenue.

If the product is found to have an elastic demand, the producer can lower prices to increase
revenue. The law of demand states that a price fall increases the demand. And since, it is an
elastic product (change in demand is higher than change in price), the demand of the product
will increase highly. The producers get more revenue. If the product is found to have an
inelastic demand, the producer can raise prices to increase revenue. Since quantity demanded
wouldn’t fall much as it is inelastic, the high prices will make way for higher revenue and thus
higher revenue.
 PRICE ELASTICITY OF SUPPLY (PES)

The PES of a product refers to the responsiveness of the quantity supplied it to changes in its
price.

PES of a product= %change in quantity supplied / %change in price.

Similar to PED, PES too can be categorized into price elastic supply, price inelastic supply,
perfectly price inelastic supply, infinitely price elastic supply and unitary price elastic supply.
(See if you can figure out what each supply elasticity means using the demand elasticities above
as reference, and draw the diagrams as well!)

Types OF Price Elasticity Of Supply

1. Elastic supply

Supply is Price Elastic when the percentage change in quantity supplied is more than the
percentage change in Price of the comoditity. PES is more than 1.
2. Inelastic supply

Supply is Price Inelastic when the percentage change in quantity supplied is less than the
percentage change in Price of the comoditity. PES is less than 1.

3. Unitary price elasticity of supply

Supply is equally responsive to a change in price. PES is 1

4. Perfectly inelastic supply

There is no change in supply no matter what the price i.e. in cinema even if the demand
increases seat capacity cannot be increased in short run. PES is 0

5. Perfectly elastic supply

There is no change in the price no matter what the supply is.

PES = infinite

What affects PES?

 Time of production: If the product can be quickly produced, it will have a price elastic
supply as the product can be quickly supplied at any price. For example juice at a
restaurant. But product which take a longer time to produce, example cars, will have a
price inelastic supply as it will take a longer time for supply to adjust to price.

 Availability of resources: More resource (land, labour, capital) will make way for an
elastic supply. If there are not enough resources, producers will find it difficult to adjust
to the price changes, and supply will become price inelastic.
 MARKET ECONOMIC SYSTEM

In a market economic system or free market economic system, all resources are allocated by
the market – private producers and consumers; that is, there is no government intervention or
involvement in resource allocation. (There are virtually no economies in the world who follow
this- there is a government control everywhere, though Hong Kong does come close.

Features:

 All resources are owned and allocated by private individuals. No govt. control exists.

 Thus, profit is the main-motive

 The demand and supply fixes the price of products. This is called price mechanism.

 What to produce is solved by producing the most-demanded goods for which people spend a
lot, as their only motive is to generate a high profit.

 How to produce is solved by using the cheapest yet efficient combination of resources–
capital or labour- in order to maximise profits.

 For whom to produce is solved by producing to people who are willing and able to pay for
goods at a high price.

Advantages:

 A wide variety of quality goods and services will be produced as different firms will compete
to satisfy consumer wants and make profits. Quality is ensured to make sure that consumers
buy from them. There is consumer sovereignty.
 Firms will respond quickly to consumer changes in demand. When there is a change in
demand, they will quickly allocate resources to satisfying that demand, so as to maintain
profits.

 High efficiency will exist. Since producers want to maximise profits, they will use resources
very efficiently (producing more with less resources).

 Since there is no govt. control, there are no taxes on goods and services and income. So
consumers have more income to consume, and producers can cheaply produce.

Disadvantages:

 Only profitable goods and services are produced. Public goods* and some merit goods* for
which there is no demand may not be produced, which is a drawback and affects the
economic development.

 Firms will only produce for consumers who can pay for them. Poor people who cannot spend
much won’t be produced for, as it would be non-profitable.

 Only profitable resources will be employed. Some resources will be left unused. In a market
economy, capital-intensive* production is favoured over labour- intensive*
production*(because it’s more cost-efficient). This can lead to unemployment.

 Harmful (demerit) goods may be produced if it is profitable to do so.

 Negative impacts on society (externalities) may be ignored by producers, as their sole motive
is to keep consumers satisfied and generate a high profit.

 A firm that are able to dominate or control the market supply of a product is called a
monopoly. They may use their power to restrict supply from other producers, and even charge
consumers a high price since they are the only producer of the product and consumers have no
choice but to buy from them.
 Due to high competition between firms, duplication of products may take place, which is a
waste of resources.

*Public goods: goods that can be used by the general public, from which they will benefit. Their
consumption can’t be measured, and thus cannot be charged a price for (this is why a market
economy doesn’t produce them). Examples are street lights and roads.

*Merit goods: goods which create a positive effect on the community. Examples are schools,
hospitals, food. The opposite is called demerit goods.

*Subsidies: financial grants made to firms to lower their cost of production in order to lower
prices for their products.
 MARKET FAILURE

Before we dive into what market failure, let’s familiarize with some termsrelated to
market failure:

 Public goods: goods that can be used by the general public, from which theywill
benefit. Their consumption can’t be measured, and thus cannot be charged a price
for (this is why a market economy doesn’t produce them).
Examples are street lights and roads.

 Merit goods: goods which create a positive effect on the community. Examples are
schools, hospitals, food. The opposite is called demerit goods.External costs
(negative externalities) are the negative impacts on the society (third-parties) due
to production or consumption of goods and services.
Example: the pollution from a factory.

 External benefits (positive externalities) are the positive impacts on the society
due to production or consumption of goods and services.
Example:better roads for the society due to the opening of a new business.

 Private costs are the costs to the producer and consumer due to production and
consumption respectively.
Example: the cost of production.

 Private benefits are the benefits to the producer or consumer due to

production and consumption respectively.
Example: the better immunity received by a consumer when he receives
Vaccines.

Social Costs = External costs + Private Costs

Social Benefits = External benefits + Private benefits
Market Failure:

Market failure occurs when the price mechanism fails to allocate resources effectively.
This is the most disadvantageous aspect to the market economy.

Causes of market failure are:

 When social costs exceed social benefits. (Especially where negativeexternalities

(external costs) are high)

 Over-provision of demerit goods (alcohol, tobacco).

 Under-provision of merit goods (schools, hospitals, public transport).

 Lack of public goods (roads, bus terminals, street lights).

 Immobility of resources. When resources are not used to the maximum.

 Information failure: When information between consumers, producers and the

government are not efficiently and correctly communicated. Example: a cosmeticsfirm
advertises its products as healthy when it is in fact not. The consumers who believe the
firm and use its products might suffer skin damage.

 Abuse of monopoly* powers: Monopolistic businesses may use their powers tocharge
consumers a high price and only produce products they wish to, since they know
consumers have no choice but to buy from them.

*Monopoly: a single supplier who supplies the entire market with a particular product,
without any competition. Example: Microsoft is very close to being a total monopoly, with
hardly any competitors.
 MIXED ECONOMIC SYSTEM

In a mixed economic system, both the market and government intervention co-exist.
Examples include almost all countries in the world (India, UK, Brazil etc.). This is because
it overrides all the disadvantages ofboth the market and planned (govt. only) economies. It
identifies the importance of the price mechanism in operating an efficient resource
allocation and also the role of the government in correcting (any) market failures

Features:
 both the public and the private sector exists
 planning and final decisions are made by the govt. while the market system can
determine allocation of resources owned by it, along with the public organizations.

Advantages:
 the govt. can provide public goods, necessities and merit goods. The private businesses
can provide most-demanded goods (luxury goods, superior goods). Thus,everyone is
provided for
 the govt. will keep externalities, monopolies, harmful goods etc. in control
 the govt. can provide jobs in the public sector (so there is better job security)
 the govt. can also provide financial help to collapsing private organizations, so jobsare
kept secure.

Disadvantages:
 taxes will be imposed, which will raise prices and also reduce work incentive
 laws and regulations can increase production costs and reduce production in the
economy
 public sector organizations will still be inefficient and will produce low qualitygoods
and services.
 The specific ways in which the government, in a mixed economic system,can correct
market failures of the market:

 legislation and regulation – the government can make laws that regulate marketactivity,
for example, prohibit smoking in public (which would cause a negative externality). One
important kind of legislation the govt. can undertake is price controls – setting a
minimum price or maximum price on goods.

Minimum price or price floor is set to control a decreasing tendency of price. The minimum
wage laws in many countries is an example of minimum price. The government sets the
minimum wageabove the existing market equilibrium wage, to ensure that all workers get a
basic minimum wage to sustain them. But even as low-income workers now get better wages,
the higher wage will cause the demand for labour to contract, as shown in the diagram to the
left. There will also be higher supply of labour (workers who want work) because of higher
wages. A reduced demand and increased supply will cause excess supply of labour i.e.,
unemployment.
Maximum price or price ceiling is set to control an increasing tendency of price. It is usually set
on rent (this is calledrent control), to ensure that low-income tenants can afford to rent homes.
But as a result of the lower rent, landlord will stop renting more homes, causing supply to
contract, as shown in the diagram to the left. At the same time, lower rent will increase the
demand for homes. A reduced supply of homes and higher demand forthem will cause a
shortage of supply in relation to demand.

 Direct provision of merit and public goods – since there is little incentive forthe price
mechanism to supply these goods, government usually provide them. For example, free
education, free healthcare, public parks. One way the govt. can do this is by nationalising
certain products it considers essential to be provided by a governing authority, rather
than the market. For example, in India, the government the government operates the
only railway network because only it can provide cheap services to its millions of poor,
daily passengers.

 Taxation on products – imposing a tax on products (indirect taxes) with negative

externalities can discourage its production and consumption. For example, a tax on
tobacco will make it expensive to produce and consume. In the diagram below, a tax has
been added on a product, causing its supply to shift from S to S1. The pricerises from P
to P1 because of the additional tax amount, and the quantity traded in the market falls
from Q to Q1.
 Subsidies – a subsidy is a grant (financial aid) on products that have a positive
externality. Subsidising, for example, cooking gas for the poor, will increase the living
standard of the population. In the diagram below, a subsidy has been imposedon a good,
causing its supply to shift from S to S1. It results in a fall in price from Pto P1 and
subsequently, an increase in the quantity traded in the market from Q to Q1.

*Note: movements along a demand or supply curve of a good only happens as a result of a
direct change in price of the good; changes caused by any other factor,tax and subsidy
included, is represented by a shift in the curves.
 Tradeable permits – firms will have to buy permits from the government to do
something, for example, pollute at a certain level, and these can be traded among
firms. Since permits require money, firms will be encouraged to polluting less.

 Extension of property rights – one of the main reasons for pollution in public spaces is
that it is public – it does not harm a private individual – the resource is thegovernment
who cannot charge compensations easily. So the government can extend property right
(right to own property) of public places to private individuals.This will effectively
privatise resources, create a market for these spaces and thenindividuals can be fined for
polluting.

 International cooperation among governments – governments work together onissues

that affect the future of the environment.