1.2 The Allocation of Resources

• Resource allocation

  How a society makes use of the scarce resources at its disposal
• Economic agents that determine resource allocation

  • Households
  • Firms
  • Government
• Objectives of economic agents

  The motivations that economic agents are trying to achieve
• Maximisation


  The process of achieving the highest possible outcome
• Incentives and the actions of economic agents


  1. Economic agents respond to incentives, which can allocate scarce resources to provide the highest utility to each agent

  2. For the entrepreneur in a firm, the incentive for taking risks is profit

  3. Rewards are positive incentives which will make consumers better off, whilst penalties make them worse off

  4. Where incentives are not given properly, resources will be misallocated

  5. Prices in market economies provide signals to buyers and sellers, which is an incentive to purchase or sell the good

  6. A high demand and high price for a good will give an incentive to firms to allocate more resources to producing that good

  7. An entrepreneur wants to avoid loss and gain profit, which makes them want to innovate, so they can reduce their production costs, and improve the quality of their products

  8. Firms need an incentive to engage in risk taking, so they innovate. Without innovation, production will cost more and there will be a misallocation of resources
• Main ways economies have approached the coordination problem

  • The market mechanism (free market, capitalism)
  • Planning (centrally planned)
• Main economic systems

  • Command economies
  • Mixed economies
  • Free market economies
• How different economies allocate resources

  • Command / centrally planned economy
  • Free market economy
  • Mixed economy
• Free market economies

  • Also known as laissez-faire economies, where governments leave markets to their own devices, so the market forces of supply and demand allocate scarce resources
  • Economic decisions are taken by private individuals and firms, and private individuals own everything
  • There is no government intervention
  • Adam Smith and Friedrich Hayek were famous free market economists
  • Adam Smith's theory of the invisible hand of the market can be applied to free market economies and the price mechanism, which describes how prices are determined by the 'spending votes' of consumers and businesses
• Smith recognised some of the issues with monopoly power that could arise from a free market, however
• Hayek argued that government intervention makes the market worse
• What to produce in a free market

  Determined by what the consumer prefers
• How to produce in a free market

  Producers seek profits
• For whom to produce in a free market

  Whoever has the greatest purchasing power in the economy, and is therefore able to buy the good
• Advantages of free market economies

  • Firms are likely to be efficient because they have to provide goods and services demanded by consumers
  • They are also likely to lower their average costs and make better use of scarce resources – they have to keep costs low to compete
  • The bureaucracy from government intervention is avoided
  • Some economists might argue the freedom gained from having a free economy leads to more personal freedom
• Disadvantages of free market economies

  • The free market ignores inequality, and tends to benefit those who hold most of the wealth
  • There are no social security payments for those on low incomes
  • There could be monopolies, which could exploit the market by charging higher prices
  • There could be the overconsumption of demerit goods, which have large negative externalities, such as tobacco
  • Public goods are not provided in a free market, such as national defence
  • Merit goods, such as education, are underprovided
• Planned (command) economies


  • The government allocates all of the scarce resources in an economy to where they think there is a greater need
  • Also referred to as central planning
  • Karl Marx saw the free market as unstable and profits as coming from the exploitation of labour
• What to produce in a planned economy


  Determined by what the government prefers
• How to produce in a planned economy

  Governments and their employees
• For whom to produce in a planned economy

  Who the government prefers
• Advantages of planned economies

  • It might be easier to coordinate resources in times of crises, such as wars
  • The government can compensate for market failure, by reallocating resources
  • They might ensure everyone can access basic necessities
  • Inequality in society could be reduced, and society might maximise welfare rather than profit
  • The abuse of monopoly power could be prevented
• Disadvantages of planned economies

  • Governments fail, as do markets, and they may not be fully informed for what to produce
  • They may not necessarily meet consumer preferences
  • It limits democracy and personal freedom
• Mixed economies

  • Have features of both planned and market economies
  • The market is controlled by both the government and the forces of supply and demand
  • Governments often provide public goods such as street lights, roads and the police, and merit goods, such as healthcare and education
• What to produce in a mixed economy

  Determined by both consumer and government preferences
• How to produce in a mixed economy


  Determined by producers making profits and the government
• For whom to produce in a mixed economy


  Both who the government prefers and the purchasing power of private individuals
• Market failure


  When a free market fails to allocate resources in the most efficient way
• Productive efficiency


  Production of goods and services by firms is achieved at the lowest possible average total cost, choosing an appropriate combination of inputs (cost efficiency) and producing the maximum output possible from those inputs (technical efficiency)
• Allocative efficiency


  The right amounts of the right products and services are produced where consumer satisfaction is maximised
• Market failure occurs when a market fails to allocate resources efficiently. This will mean the market is not productively and/or allocatively efficient. Economic efficiency is not achieved
• Efficiency in economics

  2 main types:

  • Productive
  • Allocative
• Economic efficiency


  Occurs in a market where both allocative and productive efficiency are achieved. Society is producing the balance of goods consumers wish to consume at the minimum cost.
• Inefficiency


  Any situation where economic efficiency is not achieved
• Market failure occurs when a market fails to allocate resources efficiently
• Moving from a centrally planned to a free market system

  1. Higher levels of efficiency as firms are producing what consumers want

  2. Limitations of markets and price mechanism may not result in efficient allocation without government intervention

  3. Price mechanism signals, rations and provides incentives for producers to provide goods and services consumers want
• A change in consumer preferences increases demand


  Demand curve shifts right, leading to a rise in price
• Advantages of a market economy

  • Allows consumer sovereignty, signals changes in demand, provides profit incentive for efficiency and innovation, competition gives consumers choice, workers have incentive to be productive
• Disadvantages of a market economy

  • Potential for market power, lack of provision for public/merit goods, failure to account for externalities, resource immobility, benefits high-income consumers more
• Most economists accept the need for some government intervention to correct market failure
• Centrally planned economic system

  • Central government can achieve social and national objectives more efficiently