ECON 1.2

• Resource allocation


  How resources are distributed among producers and how goods and services are distributed among consumers
• Incentives on economic agents for resource allocation

  • Economic agents respond to incentives, which can allocate scarce resources to provide the highest utility to each agent
  • For the entrepreneur in a firm, the incentive for taking risks is profit
  • Rewards are positive incentives which will make consumers better off, whilst penalties make them worse off
  • Where incentives are not given properly, resources will be misallocated
  • Prices in market economies provide signals to buyers and sellers, which is an incentive to purchase or sell the good
  • A high demand and high price for a good will give an incentive to firms to allocate more resources to producing that good
  • 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
  • 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
• 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
  • In reality, governments usually intervene by implementing laws and public services, such as property rights and national defence
• Market economies

  • What to produce: determined by what the consumer prefers
  • How to produce it: producers seek profits
  • For whom to produce it: whoever has the greatest purchasing power in the economy, and is therefore able to buy the good
• Advantages of 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. Therefore, overall output of the economy increases
  • 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 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 economy


  This is where the government allocates all of the scarce resources in an economy to where they think there is a greater need. It is also referred to as central planning
• Planned economies


  • What to produce: determined by what the government prefers
  • How to produce it: governments and their employees
  • For whom to produce it: 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 economy


  • This has features of both planned and market economies and is the most common economic system today. There are different balances between command and free economies in reality, though. The UK is generally considered quite central, whilst the US is slightly more free (although the government spends around 35% of GDP) and Cuba is more centrally planned
  • 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
• Mixed economies


  • What to produce: determined by both consumer and government preferences
  • How to produce it: determined by producers making profits and the government
  • For whom to produce it: both who the government prefers and the purchasing power of private individuals
• Productive efficiency


  When resources are used to give the maximum possible output at the lowest possible cost
• Allocative efficiency


  When resources are allocated to the best interests of society, where there is maximum social welfare and maximum utility
• Conditions for productive efficiency

  • Firms minimise their average total costs
  • Firms produce at the lowest point on the average cost curve
  • MC = AC is a point of productive efficiency
  • All points on the PPF curve are productively efficient
• Conditions for allocative efficiency

  • Resources are distributed to the goods and services that consumers want, which maximises utility
  • P = MC, which means that consumers pay for the value of the marginal utility they derive from consuming the good or service
  • Free markets are considered to be allocatively efficient