The allocation of resources

2.1 Microeconomics & Macroeconomics

Microeconomics: study of particular markets & sections of economy

Individual firms, consumers, & markets making individual decisions within the economy
g. effect of a price change on the demand/supply of a good

Macroeconomics: study of economic behavior & decision making in whole economy

Aggregates (total supply/demand for g/s in an economy at a particular time)
g. level of inflation, national spending, national output, economic development etc.
Decisions are made by government in managing the economy as a whole

2.2 The role of markets in allocating resources

Resource allocation – the way in which markets decide what goods & services to provide, how to produce them & who to produce them for

Price mechanism

Prices respond to shortages & surpluses
Price rises: consumers ration
Reduces amount they are willing/able to buy
- Tells producers there is excess supply in the market
Gives suppliers incentive to decrease supply
- Shortages causes price to rise
- Surpluses causes prices to fall

Market system – method of allocating resources through market forces of demand & supply

Goods are bought/sold in a market at an equilibrium price
Producers produce goods that consumers demand the most

Market equilibrium

Demand = supply for a good
Demand changes e.g. ↑income: people can afford more goods
Supply changes e.g. weather impacts supply (drought) = ↓ crops)
Market is more likely to be in state of disequilibrium than equilibrium
Demand & supply constantly change

Economic questions

What to produce
How to produce
For whom to produce

Price mechanism – system of relying on market force of demand & supply to allocate resources

2.3 Demand

Demand – the willingness and ability to buy a product

Effective demand: willingness to buy is backed by the ability to pay for the purchase

Quantity demand: effective demand for a particular goods

E. g. Want a phone but don’t have the money to buy (demand)
Have the money to buy (effective demand)

Individual demand: demand from one customer

Market demand: total (aggregate) demand; sum of all individual demands of consumers

Demand curve – shows effective demand

Law of demand

Increased price = decreased demand
Decreased price = increased demand

Slopes down from left to right

Demand increases as price falls (vice versa)

Movements are due to change in price

Price rise = contraction along demand curve (less demand)
Price falls = extension along demand curve (more demand)

Reasons for shifts

Consumer incomes
- Increased income = people can afford more e.g. bicycle replaced by motorcycle
Tax on incomes (more/less disposable income)
Rise/fall in the price of substitute (eg. tea & coffee)
Rise in the price of complements (eg. printers & ink cartridge)

Two products used/consumed together

As demand for 1 product increases, demand for other product increases

Successful/unsuccessful advertising
Weather
Legislation
Age distribution
Fashion/trends
Demand varies depending on age group
g. trainers are more popular amongst young people

Majority of population is young people = high demand

↓ price (80 to 60) = ↑ demand (300 to 500)

Extension in demand from A to B

↑ price (60 to 80) = ↓ in demand (500 to 300)

Contraction in demand from B to A

↑ demand (500 to 600)

↑ demand due to changes in other factors (excluding price)
Causes shift to the right (A to B)

↓ demand (500 to 400) without change in price

↓ demand for a product due to changes in other factors (excluding price)
Causes shift to the left (A to B)

2.4 Supply

Supply – the willingness of producers to supply a good or services at a given price

Quality supplied: amount of goods producers are willing to make & supply

Market supply: amount of goods all producers supplying the product are willing to supply

Supply curve

Law of supply

Increased price = increased supply
Decreased prices = decreased supply

Slopes down from right to left

Higher supply = increase in price

Movements are due to change in price

Increase in price = extension in supply (increase in quantity supplied)
Decrease in price = contraction in supply (reduced quantity supplied)

Reasons for shifts

Change in costs of production (COP)

Producers can produce & supply products cheaply

COP rises = supply falls

Changes in quantity of resources available

Resources rise = supply rises (vice versa)

Technological changes (higher productivity/output)
Profitability of other products

Producers might shift to producing more profitable products (reduces supply of initial product)

Joint supply – when a product is made as a by-product of another
Weather
Regulation/bureaucracy
Increased number of producers in the market

↑ price (60 to 80) = ↑ supply (500 to 700)

↓ supply due to changes in price (without changes in other factors)
Causes a contraction in supply

↑ supply without change in price (S to S1) due to changes in other factors (excluding

price)

↓ supply without change in price (S to

S2) due to changes in other factories (excluding price)

2.5 Price determination

Market equilibrium: quantity demanded = quantity supplied, X shortage/surplus

Equilibrium price: price at which demand curve intersects supply curve

Equilibrium quantity: quality demanded or supplied at the equilibrium price

Marginal benefit = marginal cost
Movements to a new equilibrium

Increased demand (demand curve shifts right)

Increased supply (supply curve shifts right)

Market disequilibrium

Disequilibrium price: price at which market demand & supply curves don’t meet

Revenue = Price × Quantity

2.6 Price changes

Cause – change in supply/demand

Consequences

	Effect on equilibrium market price	Effect on equilibrium market quantity
Demand shifts to the right	Increase	Increase
Demand shifts to the left	Increase	Increase

2.7 Price elasticity of demand (PED)

PED: responsiveness of demand to a change in price

Calculation

PED < 1	Inelastic	Demand unresponsive to changes in price Quantity demanded < price Eg food, electricity
PED > 1	Elastic	Demand responsive to changes in price Quantity demanded > price Eg luxury
PED = 0	Perfectly inelastic	Change in price X effect quantity demanded
PED = ∞	Perfectly elastic	Change in price leads to 0 quantity demanded
PED = 1	Unitary	%△ quantity demanded = %△ price

Determinants of PED

Availability of close substitutes – ↑substitutes → products easily replace if ↑price → elastic
Proportion of income spent on products – ↑income, △price X matter → inelastic
Cost of substituting between products – ↑substitution cost → inelastic
Brand loyalty / habit – less sensitive to △price → inelastic
Advertisement – ↓PED → inelastic
Necessity – essential → inelastic, luxury → elastic
Durability – non-durable → inelastic, durable → elastic
Time – takes time for consumers to change habits → long run → elastic

Significance of PED

Firms

Gov

Determine price strategies to max revenue
Determine if use price discrimination

(Charge different customers different price of same product coz differences in PED)

Predict impact on producers following changes in exchange rate

But – Difficult to calculate accurately as PED changes constantly

Decide products to impose taxes (usually on inelastic products)

2.8 Price elasticity of supply (PES)

PES: responsiveness of supplied to a change in price

Calculation

PES < 1	Inelastic	Supply unresponsive to changes in price
PES > 1	Elastic	Supply responsive to changes in price
PES = 0	Perfectly inelastic	Change in price X effect quantity supplie
PES = ∞	Perfectly elastic	Change in price leads to 0 quantity supplied
PES = 1	Unitary	%△ quantity supplied = %△ price

Determinants of PES

Spare capacity – if has spare capacity, can ↑supply → elastic
Level of stock – ↑stock ↑elastic
No of firms in industry – ↑no of firms ↑elastic
Ease & cost of factor substitution – if capital / labour occupationally mobile → elastic

coz resources can be mobilized to supply extra output

5. Time period & production speed – long time, firm adjust production level → elastic

Significance of PES

Firms	Gov
↑ competitive ↑ profit	Ensure everyone has access to affordable products Encourage migrant labour Relieve shortage of labour Improve PES in labour market

2.9 Market economic system

Types

Free market economy eg Hong Kong

Relies on market forces of demand & supply in private sector to allocate resources with minimal gov intervention

Adv

Dis

Competition helps firms to pay attention & respond quickly to consumers wants

→ stimulate innovation, ↑efficiency

Freedom of choice

Producers & consumers choose what to produce / consume

Income & wealth inequalities
- Richer ppl have more choice & econ freedom
- Producers meet needs & wants of rich ppl, neglect poor ppl

Environment issues

E.g. use non-renewable resources → pollution

2. Planned economy eg North Korea

Relies on gov in public sector allocating resources

3. Mixed economy eg Japan

Combination of free market & planned economy
Changes in demand & supply changes price & quantity
Allocation of resources is determined by profit motive

Adv	Dis
Freedom of choice ↓ social cost coz gov analysis social cost & benefits ↓ inequality Monopolies under close supervision	Heavy tax ↓ efficient

How gov solve market failure?

Solution	Definition	Graph	Adv	Dis
Maximum price	Gov sets price below equilibrium price		Products more affordable Encourage consumption	Create shortage ↑ tax
Minimum price	Gov sets price above equilibrium price		Producers know in advance the price they’ll receive → enable plan investment & output Encourage output of certain goods/services	Create surplus Encourage over-production
Indirect taxation	Aim to ↓ demand for demerit goods		↑ tax ↓ demand ↑ gov revenue	Great impact on low income earners
Subsidies	Payment by gov		↓production cost	↑ tax Difficult to set up appropriate subsidy coz hard to measure external benefit
Regulations	eg – complete ban – age limit		↓consumption ↑awareness	Cause black markets to provide products Ppl break rules eg fake ID cards
Privatisation	Transfer ownership of assets from public to private sector		↓gov tax & debt Private firm ↑competitive	Create monopoly Still require gov intervention → protect public interest
Nationalisation	Purchase of private sector assets by gov		Protect employment Promote economic stability	Large oppo cost
Direct provision	eg – education – healthcare		Goods/services accessible to all ppl Private benefits for individual & external benefits for 3rd parties	Oppo cost Over-consumed Long queues ↑shortage Free riders

2.10 Market failure

Market failure – occurs when market force are unsuccessful in allocating resources efficiently

Private costs: direct costs of production & consumption of a individual, firm or gov

Eg (pro) wages, (con) price paid for goods by conusmers

External costs: -ve side-effects of production & consumption incurred by 3rd parties for which

no compensation is paid

Eg (pro) air, (con) passive smoking

Social costs: private costs + external costs

Private benefit: benefits of production & consumption enjoyed by a individual, firm or gov

Eg To producer – profit received

To consumer – satisfaction gained

External benefit: +ve side effects of production & consumption experienced by 3rd parties for

which no money is paid

Eg vaccination protect surrounding ppl

Social benefits: private benefits + external benefits

Types of market failure	Definition / Cause	Example	Gov solution
1.Public goods	goods/services that are non-excludable & non-rivalrous no one willing to pay → producers lack motivation → X supply	Street lighting	Tax
2.Merit goods	goods/services when consumed create +ve spillover effects in economy	Education	Subsidy
3.Demerit goods	goods/services when consumed create -ve spillover effects in economy X gov intervention → over-produced/consumed	Cigarettes	Tax Banning
4.Monopoly	Single supplier, price maker X gov control → exploit market power		Attract foreign firms →↑competition
5. Geographical immobility			Provide public housing & transport
6. Occupational Occupational immobility			Provide more training
7. Information failure	Good where ppl unaware of long-term effects	Chocolate	Education

2.11 Mixed economic system

Mixed economy

Decisions are made by a combination of the govt & the private sector (market)
USA, India, China, Singapore, Japan etc.