2.2 The role of markets in allocating resources

Chapter Objective:

By the end of this chapter, you will be able to able to:

> define the market system

> explain the key questions about resource allocation in a market system

> explain how the price mechanism allocates resources.

Key decisions about resource allocation

All economies face the basic economic problem of scarcity of resources. All economic systems (see also Chapters 13 and 15) must address three key economic questions about determining resource allocation:

1 What production should take place? This question is about deciding which goods and services should be provided in the economy. For example, is it better for the economy to have more roads and airports or to have more schools and hospitals? As resources are limited in supply, decision makers realise there is an opportunity cost (see Chapter 3) in answering this question.

2 How should production take place? This question is about the methods and processes used to produce the desired goods and services. For example, decision makers will have to decide which combination of factors of production (land, labour, capital and enterprise) should be used in the production process.

3 For whom should production take place? This question is about which economic agents receive goods and services. For example, should any goods and services be provided free to everyone in the economy, irrespective of their willingness and ability to pay for them? Or should goods and services only be produced for those who can pay?

In a market system, the decision about what, how and for whom production should take place is determined by the forces of demand and supply. See Chapter 13 for more details on this.

Introduction to the price mechanism

The price mechanism refers to the system of relying on the market forces of demand and supply to allocate resources. In this system, the private sector (see Chapter 13) decides on the fundamental questions of what, how and for whom production should take place. For example, wage rates are determined by the forces of demand for labour (by private sector fi rms) and supply of labour (by workers who offer their labour services).

Features of the price mechanism include the following:

» There is no government interference in economic activities. Resources are owned by private economic agents who have the economic freedom to allocate scarce resources without interference from the government.

» Goods and services are allocated on the basis of price — a high price encourages more supply whereas a low price encourages consumer spending. Goods and services are sold to those who have the willingness and ability to pay.

» The allocation of factor resources is based on fi nancial incentives — for example, agricultural land is used for harvesting crops with the greatest fi nancial return, while unprofi table products are no longer produced.

» Competition creates choice and opportunities for fi rms and private individuals. Consumers can thus benefi t from a variety of innovative products, at competitive prices and of high quality.