HOW MARKETS ALLOCATE RESOURCES
Economies have to find a mechanism to allocate scarce resources because of the economic problem. The What, How, For Whom questions are central to the operation of this mechanism. To recap from the economic system lesson, the mechanism used by different systems:
Command economy: Planning mechanism as dictated
by the state
Free Market economy: Price mechanism as dictated by consumer
spending
Mixed economy:
A mixture of state planning and the market mechanism.
Central to this module is an examination of the operation of the market economy, and how the price mechanism works to answer the what, how and for whom questions.
Market: a mechanism which brings buyers and sellers together to trade if they are both happy.
Different types of markets can exist, all operating along the same principles:
Product:
the market for goods, eg market for oranges
Factor: the
market for resource inputs, eg the labour market
Capital: the
market for finance, eg the market for bank loans
We will start off with examining the operation of a competitive market,
where the buyers and sellers trade under equal conditions, and look how the
price mechanism works to influence resource allocation.
The essential role of prices is to transmit information to different
agents in the market place. Changes in price will result from changes in
supply and demand conditions and will signal information about the state
of the market which will influence the allocation of resources.
On the consumer side, changes in price perform a rationing function, transmitting
information to them about whether they can afford to buy a product and how much
they could buy at a particular price with a given amount of income. If the price
of a product were to rise, consumers would be rationed out of the market,
because their spending power would go down, ie they could not buy as much with a
set amount of income. Conversely, if prices fell, consumers would be rationed
into the market because their income could buy more goods.
On the producers side, changes in price perform an incentive
function, signalling to them whether they should produce more or less of a
good. If prices rise, a signal would be sent to producers to make more (meaning
allocating more resources to the production of the good) with the aim of earning
more profit. Conversely a fall in price would discourage production reducing the
amount of resources allocated to that good, since profits would be assumed to be
falling.
Consumer sovereignty: in a market economy consumers will have the power
to influence resource allocation. Their spending decisions will send signals to
the producers about what goods to produce and how many to produce. All this will
by done through the workings of the price mechanism, eg
Consumers decide to buy less carrots. This fall in demand will result in falling
prices. In response to falling prices, producers will see reduced profits and
will allocate fewer resources to the growing of carrots. If consumers decide to
buy more peas, prices of peas will rise and this will encourage producers to
allocate more resources to pea production. Therefore the spending
patterns of consumers will dictate to producers what they will make, since their
motive is profit, and they will not make any if they produce goods which
consumers do not want.
The way in which prices are set in the market place will be looked at in the
next few lessons.
Go to the lesson on the interrelationship between markets to
explore how prices allocate resources between different markets.
Questions
Define the terms: price mechanism, purchasing power, mixed economy, competitive market, incentive function
Explain in your own words with an example, how the rationing function of the price mechanism works
Go to http://news.bbc.co.uk/hi/english/business/newsid_1965000/1965770.stmand
discuss how changes in house prices may have rationed house buyers and
provided incentives to sellers and affected resource allocation in the UK