Economics (0455) | The role of markets in allocating resources

Welcome to Section 2: The Role of Markets in Allocating Resources!

Hello Economists! This section is perhaps the most crucial part of IGCSE Economics. It explains the "engine" of any modern economy: the market. We are learning how millions of buyers and sellers interact to decide the answers to the three basic economic questions: What to produce, How to produce, and For Whom to produce. Master this chapter, and you will understand how prices are set for everything, from your favourite snack to the latest smartphone!

Part 1: The Economic Perspective (Syllabus 2.1 & 2.2)

Microeconomics vs. Macroeconomics (2.1)

Before diving into markets, we need to know the scale we are working on. Economics is split into two main branches:

• Microeconomics: This looks at the small picture—the decisions of individual units. Think of a microscope!
  Decision Makers: Individual consumers, workers, households, and single firms/businesses.
  Example: Why did the price of coffee increase? How does minimum wage affect workers in one industry?
• Macroeconomics: This looks at the big picture—the economy as a whole. Think of a map or a telescope!
  Decision Makers: Governments, Central Banks, and the entire nation's consumers and producers together.
  Example: Why is the national unemployment rate high? What policies can the government use to control inflation?

The Key Resource Allocation Decisions (2.2.2)

Since resources are scarce (Topic 1), every society must answer these three questions regarding resource allocation:

1. What to produce? Should a country produce more healthcare services or military equipment?
2. How to produce? Should a firm use more labour (people) or more capital (machines) to make a product?
3. For Whom to produce? Who will receive the goods and services? (Often determined by who can afford them).

The Role of the Price Mechanism (The Market System) (2.2.1, 2.2.3)

In a market economy, these tough questions are answered automatically by the interactions of buyers and sellers through the price mechanism.

The price mechanism works through three main functions:

1. Signalling: Prices signal to producers where resources are needed.
   If demand for Product X increases, its price goes up. This signals to producers that there is profit to be made, encouraging them to produce more X.
2. Incentive: Prices incentivize behaviour.
   Rising prices incentivize firms to produce more (rewarding them with higher profit). They also incentivize consumers to buy less.
3. Rationing: Prices ration scarce resources.
   When a product is scarce, the price rises. This ensures only those willing and able to pay the high price get the product, rationing it out.

Quick Review: The Price Mechanism uses the power of demand and supply to efficiently allocate resources using Signals, Incentives, and Rationing.

Part 2: Demand and Supply (Syllabus 2.3 & 2.4)

Understanding Demand (2.3)

Definition of Demand (2.3.1): Demand is the amount of a good or service that consumers are willing and able to buy at various prices over a specific period.

The Law of Demand: As the price of a good falls, the quantity demanded increases (and vice versa). This is an inverse relationship.

This relationship is shown by the demand curve, which slopes downward from left to right.

Movements Along the Demand Curve (2.3.2)

A change in price causes a movement along the existing demand curve.

• Extension in Demand (or Increase in Quantity Demanded): Occurs when price falls. (Movement down the curve).
• Contraction in Demand (or Decrease in Quantity Demanded): Occurs when price rises. (Movement up the curve).

Shifts in the Demand Curve (Changes in Conditions of Demand) (2.3.4)

A change in any factor *other than price* will cause the entire demand curve to shift (move right or left). These factors are called the conditions of demand.

A rightward shift means an Increase in Demand (consumers want more at every price). A leftward shift means a Decrease in Demand.

Key Conditions of Demand (T.I.P.S.):

• Tastes and Preferences: Example: If a celebrity wears a new brand of trainers, demand shifts right.
• Income: For most goods (normal goods), if income rises, demand shifts right. For inferior goods (like cheap instant noodles), if income rises, demand shifts left.
• Prices of Related Goods:
  • Substitutes: Goods that can be used instead of each other (e.g., Coke and Pepsi). If the price of Pepsi rises, the demand for Coke shifts right.
  • Complements: Goods used together (e.g., printers and ink). If the price of printers falls, the demand for ink shifts right.
• Size and Structure of Population: More consumers means demand shifts right.

Understanding Supply (2.4)

Definition of Supply (2.4.1): Supply is the amount of a good or service that producers are willing and able to sell at various prices over a specific period.

The Law of Supply: As the price of a good rises, the quantity supplied increases (and vice versa). This is a direct relationship. Producers want more profit!

The supply curve slopes upward from left to right.

Movements Along the Supply Curve (2.4.2)

A change in price causes a movement along the existing supply curve.

• Extension in Supply (or Increase in Quantity Supplied): Occurs when price rises. (Movement up the curve).
• Contraction in Supply (or Decrease in Quantity Supplied): Occurs when price falls. (Movement down the curve).

Shifts in the Supply Curve (Changes in Conditions of Supply) (2.4.4)

A change in any factor *other than price* will cause the entire supply curve to shift. These factors are the conditions of supply.

A rightward shift means an Increase in Supply (firms can produce more cheaply). A leftward shift means a Decrease in Supply.

Key Conditions of Supply (P.I.N.T.S.):

• Productivity: If workers become more productive, costs fall, and supply shifts right.
• Indirect Taxes/Subsidies: Taxes increase costs (shift left). Subsidies lower costs (shift right).
• Number of Firms: If more firms enter the market, supply shifts right.
• Technology: Improved technology lowers production costs, so supply shifts right.
• Salvageable/Input Costs: A fall in the cost of raw materials or factors of production (like oil or wages) shifts supply right.

Part 3: Price Determination and Changes (Syllabus 2.5 & 2.6)

Market Equilibrium (2.5.1)

The market is in equilibrium when the quantity demanded equals the quantity supplied. This is the point where the demand curve (D) and the supply curve (S) intersect.

The price at this intersection is the equilibrium price (\(P_e\)), and the quantity is the equilibrium quantity (\(Q_e\)). At this point, the market is "cleared," meaning there is no waste and no shortage.

Analogy: The Handshake

Think of demand and supply as two people reaching out to shake hands. Equilibrium is the exact point where their hands meet.

Market Disequilibrium (2.5.2)

If the market price is NOT at equilibrium, we have disequilibrium. The market will automatically correct itself through the price mechanism (Signalling/Rationing).

1. Surplus (Excess Supply):
   • This happens when the price is set above the equilibrium price.
   • Quantity Supplied (\(Q_s\)) is greater than Quantity Demanded (\(Q_d\)).
   • Consequence: Firms have unsold stock (e.g., too many mangoes). They will be forced to lower the price to encourage consumers to buy, moving the market back towards equilibrium.
2. Shortage (Excess Demand):
   • This happens when the price is set below the equilibrium price.
   • Quantity Demanded (\(Q_d\)) is greater than Quantity Supplied (\(Q_s\)).
   • Consequence: Consumers cannot find enough goods (e.g., sold-out concert tickets). Firms realise they can charge more, so the price is pushed up, moving the market back towards equilibrium.

Causes and Consequences of Price Changes (2.6)

Prices only change if the underlying conditions of supply or demand change, causing the curves to shift.

1. Change in Demand (Shift of D Curve)

If demand increases (D shifts right), while supply stays the same:

Result: \(P_e\) increases and \(Q_e\) increases.

If demand decreases (D shifts left), while supply stays the same:

Result: \(P_e\) decreases and \(Q_e\) decreases.

2. Change in Supply (Shift of S Curve)

If supply increases (S shifts right), while demand stays the same:

Result: \(P_e\) decreases and \(Q_e\) increases.
Example: A good harvest means more fruit is supplied, the price of fruit falls, and more is sold.

If supply decreases (S shifts left), while demand stays the same:

Result: \(P_e\) increases and \(Q_e\) decreases.
Example: A new tax on cigarettes decreases supply, the price of cigarettes rises, and less is sold.

Part 4: Elasticity (Syllabus 2.7 & 2.8)

Elasticity is a measure of responsiveness. It tells producers and governments how much quantity demanded or supplied will change if the price (or other factor) changes.

Price Elasticity of Demand (PED) (2.7)

Definition (2.7.1): PED measures how responsive the quantity demanded is to a change in price.

Calculation of PED (2.7.2)

The formula for PED is:

\[PED = \frac{\%\text{ change in Quantity Demanded}}{\%\text{ change in Price}}\]

Note: Economists generally ignore the negative sign, as the inverse relationship is assumed. We use the magnitude (absolute value) of the result.

Interpreting the Result

• Elastic Demand (PED > 1): Demand is responsive. A small change in price leads to a proportionately larger change in quantity demanded. (The demand curve looks relatively flat).
  Example: Luxury holidays, specific brands of clothing.
• Inelastic Demand (PED < 1): Demand is unresponsive. A change in price leads to a proportionately smaller change in quantity demanded. (The demand curve looks relatively steep).
  Example: Necessities like basic food staples, essential medication.
• Unitary Elasticity (PED = 1): Percentage change in price equals the percentage change in quantity demanded.

Determinants of PED (What makes demand elastic?) (2.7.3)

Don't worry if this seems tricky at first, just remember these factors that make consumers more or less sensitive to price:

• Necessity vs. Luxury: Necessities (like water) are usually inelastic. Luxuries (like expensive jewellery) are usually elastic.
• Availability of Substitutes: If there are many close substitutes (e.g., different types of chocolate), demand is elastic. If there are few substitutes (e.g., life-saving drugs), demand is inelastic.
• Proportion of Income Spent: If the good costs only a small fraction of your income (e.g., a stick of chewing gum), demand is inelastic.
• Time: In the short run, demand is often inelastic. Over the long run, consumers can find substitutes, making demand more elastic.

PED and Total Revenue (2.7.4)

Total Revenue (TR) is the total money a firm earns from sales (Price x Quantity). Understanding PED is vital for pricing decisions:

• If demand is ELASTIC (PED > 1): To increase TR, the firm should lower the price. (A small price fall brings a huge increase in sales).
• If demand is INELASTIC (PED < 1): To increase TR, the firm should raise the price. (The rise in price won't scare off many customers, so revenue increases).

Price Elasticity of Supply (PES) (2.8)

Definition (2.8.1): PES measures how responsive the quantity supplied is to a change in price.

Calculation of PES (2.8.2)

The formula for PES is:

\[PES = \frac{\%\text{ change in Quantity Supplied}}{\%\text{ change in Price}}\]

Interpreting the Result

The interpretation is similar to PED, but we look at the firm's ability to respond to price changes:

• Elastic Supply (PES > 1): Supply is responsive. Producers can easily increase output when the price rises. (The supply curve looks relatively flat).
• Inelastic Supply (PES < 1): Supply is unresponsive. Producers struggle to increase output quickly when the price rises. (The supply curve looks relatively steep).
  Example: Highly perishable goods, goods requiring rare resources.

Determinants of PES (What makes supply elastic?) (2.8.3)

• Time Period: In the immediate short run (e.g., one day), supply is inelastic (can't produce more instantly). In the long run, firms can build new factories, making supply highly elastic.
• Spare Capacity: If a factory is running half-empty (has spare capacity), they can quickly increase production when prices rise—supply is elastic.
• Ease of Storage: If goods can be easily stored (e.g., canned food), producers can hold back stock and quickly release it when the price rises—supply is elastic.
• Factor Mobility: If inputs (Labour, Capital) can be easily shifted from one use to another, supply is elastic.

Part 5: Economic Systems and Market Failure (Syllabus 2.9, 2.10, 2.11)

The Market Economic System (2.9)

Definition (2.9.1): A market economic system (or free market) is an economic system where resources are allocated based purely on the forces of demand and supply, with little or no government intervention.

Advantages of a Market System (2.9.2)

• Efficiency: Competition forces firms to use resources efficiently and keep costs low.
• Choice: Producers constantly innovate and create new products to attract consumers, leading to wide choice.
• Incentives: High rewards (profits) encourage hard work, innovation, and risk-taking.

Disadvantages of a Market System (2.9.2)

• Inequality: Only those with money or valuable skills get goods. This leads to high income inequality.
• Monopolies: Successful firms can dominate the market, leading to higher prices and less choice for consumers.
• Market Failure: Markets ignore important social and environmental costs (like pollution).

Market Failure (2.10)

Definition (2.10.1): Market failure occurs when the free market mechanism leads to an inefficient or undesirable allocation of resources. The market "fails" to provide the optimal social outcome.

Causes of Market Failure (2.10.2)

1. Public Goods:

• Definition: Goods that are non-excludable (you cannot stop someone from using it) and non-rivalrous (one person using it doesn't stop another from using it).
• Problem: Due to the "free rider" problem (people can use it without paying), private firms will not supply them because they cannot make a profit.
  Example: National defense, street lighting.

2. Merit Goods and Demerit Goods:

• Merit Goods: Goods that are beneficial, but the market under-consumes them (e.g., education, healthcare). People underestimate the true benefit.
• Demerit Goods: Goods that are harmful, but the market over-consumes them (e.g., cigarettes, excessive alcohol). People underestimate the true cost.

3. Externalities (External Costs and Benefits):

Externalities are costs or benefits experienced by a third party (not the buyer or seller) as a result of an economic transaction.

• Private Cost/Benefit: The cost/benefit felt by the consumer or producer involved in the transaction.
• External Cost/Benefit: The cost/benefit felt by society (the third party).
• Social Cost/Benefit: Private Cost + External Cost (or Private Benefit + External Benefit).

• External Costs (Negative Externalities): Cause over-consumption/production.
  Example: Factory pollution. The firm's private costs are low, but society pays the external cost of cleaning up the air/water. Social cost is greater than private cost.
• External Benefits (Positive Externalities): Cause under-consumption/production.
  Example: Vaccinations. The individual benefits, but the rest of society benefits from reduced disease spread. Social benefit is greater than private benefit.

4. Abuse of Monopoly Power: A monopoly (single seller) can restrict output and charge very high prices, which is bad for consumers and leads to resource misallocation.

5. Factor Immobility: If resources (like labour or land) cannot easily move to where they are needed, resources remain underutilised.

The Mixed Economic System and Government Intervention (2.11)

Definition (2.11.1): A mixed economic system combines the free market mechanism with government planning and intervention. This is the most common system globally.

Governments intervene primarily to correct market failure and to achieve social goals like equality and stability.

Government Microeconomic Policy Measures (2.11.2)

1. Price Controls (Maximum and Minimum Prices):

• Maximum Price (Price Ceiling): A legal limit on how high a price can be. Set below equilibrium.
  Effect: Protects consumers from high prices (e.g., rent control), but leads to shortages (excess demand).
• Minimum Price (Price Floor): A legal limit on how low a price can be. Set above equilibrium.
  Effect: Supports producers (e.g., agricultural minimum prices) or workers (minimum wage in the labour market), but leads to surpluses (excess supply/unemployment).

2. Indirect Taxation (Taxes) and Subsidies:

• Indirect Taxation: Taxes on spending (e.g., VAT, duty on fuel or tobacco).
  Goal: To discourage the consumption of demerit goods or goods with negative externalities. Raises the cost of production (shifts S left), leading to higher prices and lower consumption.
• Subsidies: Financial support paid by the government to producers.
  Goal: To encourage the production/consumption of merit goods or goods with positive externalities. Lowers the cost of production (shifts S right), leading to lower prices and higher consumption.

3. Other Microeconomic Measures:

• Regulation: Setting rules and laws (e.g., emission standards for factories, banning child labour) to control negative externalities or monopolies.
• Direct Provision of Goods: The government produces goods directly, usually public goods (national defence, police) or essential merit goods (state education).
• Privatisation: Selling state-owned enterprises to the private sector. Aims to increase efficiency and competition.
• Nationalisation: The government takes ownership of private assets or firms. Done for strategic reasons (e.g., national security) or to ensure essential services are provided fairly.