The Allocation of Resources

Markets and demand

A market is any arrangement bringing buyers and sellers together — a fruit stall or a stock exchange — where buyers create demand and sellers create supply, and price alone coordinates them.

Individual and market demand

An individual’s demand curve shows how much of a good one buyer plans to purchase at each possible price. Market demand is the horizontal sum of every individual demand curve — at each price, add together the quantity every buyer would purchase. The curve slopes downward: as price falls, quantity demanded rises, because buyers can afford more (the income effect) and the good becomes relatively cheaper than substitutes (the substitution effect).

Movements along the demand curve

A change in the good’s own price, and nothing else, causes a movement along a fixed demand curve. A fall in price causes an extension of demand (quantity demanded rises); a rise in price causes a contraction of demand (quantity demanded falls).

Shifts of the demand curve

A change in any factor other than the good’s own price shifts the whole curve. Demand increases (shifts right) following a rise in income, a rise in the price of a substitute, a fall in the price of a complement, a change in taste or fashion in the good’s favour, population growth, or effective advertising; each cause reverses to give a decrease (shift left).

Supply

Supply is the mirror image of demand — the higher the price on offer, the more producers are willing to sell.

Individual and market supply

An individual producer’s supply curve shows how much of a good that producer plans to sell at each possible price. Market supply is the horizontal sum of every individual producer’s supply curve — at each price, add together the quantity every producer would sell. The supply curve slopes upward: a higher price makes production more profitable, so existing producers supply more and new producers are drawn into the market.

Movements along the supply curve

A change in the good’s own price, and nothing else, causes a movement along a fixed supply curve. A rise in price causes an extension of supply (quantity supplied rises); a fall in price causes a contraction of supply (quantity supplied falls).

Shifts of the supply curve

A change in any factor other than the good’s own price shifts the whole curve. Supply increases (shifts right) following a fall in production costs (wages, raw materials, energy), an improvement in technology, a government subsidy, favourable weather for a harvest, or more producers entering the market; each cause reverses to give a decrease (shift left) — including a new tax on the good, or a poor harvest.

Price determination

Bring demand and supply together on one diagram and a single price emerges — with no buyer or seller having chosen it directly.

The price mechanism

The price mechanism is the process by which changes in price, driven by demand and supply, allocate scarce resources without central planning. Rising prices signal that a good is scarce relative to demand, drawing resources toward producing it (answering what to produce); falling costs of one factor encourage producers to use more of it (how to produce); and price rations output to whichever buyers are willing and able to pay it (who to produce for).

Market equilibrium

Plotting a demand schedule and a supply schedule on the same axes, the two curves cross at exactly one price: the equilibrium price, with its matching equilibrium quantity. At this price, quantity demanded equals quantity supplied, so there is no pressure on price to move further — the market clears.

Market disequilibrium: shortages and surpluses

At any price other than the equilibrium price, the market is in disequilibrium. A price set below equilibrium (P1) creates a shortage: quantity demanded exceeds quantity supplied, so unsatisfied buyers bid the price back up. A price set above equilibrium (P2) creates a surplus: quantity supplied exceeds quantity demanded, so producers cut price to clear unsold stock. Both cases push price back toward equilibrium.

Price changes

Every price change traces back to a shift of demand, a shift of supply, or both — and each combination moves price and quantity in a predictable direction.

Causes of price changes

Because price is set where demand meets supply, any shift of either curve changes both the equilibrium price and the equilibrium quantity traded:

If demand and supply shift at the same time, the direction of the price change depends on which shift is larger — but the diagram, not guesswork, always shows the answer.

Consequences of price changes: effect on sales

The diagram below illustrates a bumper coffee harvest: supply increases from S1 to S2, moving the market from its old equilibrium (E1) to a new one (E2). Price falls and the quantity actually sold rises — consumers gain from the lower price, while individual farmers now sell at a lower price per unit, even though total quantity traded across the market has increased.

Price elasticity of demand

Not every good responds to a price change the same way — PED puts a precise number on just how much quantity demanded moves.

Calculating PED

Price elasticity of demand measures the percentage change in quantity demanded caused by a one percent change in price.

PED = %Δ quantity demanded ÷ %Δ price. It has no units — it is a pure ratio — and is reported as a positive value.

Worked example: PED of a bus fare rise

A bus operator raises its fare from $2.00 to $2.40. Weekly passenger trips fall from 5,000 to 4,400.

Step 1. %Δ quantity demanded = (4,400 − 5,000) ÷ 5,000 × 100 = −12%. Step 2. %Δ price = (2.40 − 2.00) ÷ 2.00 × 100 = +20%. Step 3. PED = 12% ÷ 20% = 0.6 (ignoring the sign). PED = 0.6, so demand is inelastic.

Interpreting PED values

Determinants of PED

PED and firms’ revenue

Whether raising price is good or bad for a firm’s revenue is not a matter of guesswork — it is decided entirely by PED. Total revenue (TR = price × quantity) moves differently depending on PED. In the bus-fare example (PED = 0.6, inelastic): raising the fare from $2.00 to $2.40 raised revenue, from $10,000 to $10,560 per week, since the 12% fall in trips was smaller than the 20% fare rise. Had demand been elastic instead, the same rise would have cut revenue.

Significance of PED

PED shapes decisions across the economy: consumers can predict spending on inelastic necessities will barely change if price rises; firms with an inelastic good raise price to raise revenue, while a firm with an elastic good competes on price or quality instead; workers face more stable employment where demand for their product is inelastic; and governments raise the most tax revenue, with the smallest fall in output and jobs, by taxing inelastic goods.

Price elasticity of supply

PES asks the same question as PED, from the seller’s side: how much does quantity supplied move when price changes?

Calculating PES

Price elasticity of supply measures the % change in quantity supplied caused by a 1% change in price.

PES = %Δ quantity supplied ÷ %Δ price. It has no units — it is a pure ratio — and is always positive.

Worked example: PES of avocados

Avocado price rises from $0.90 to $1.45. A farm raises weekly supply from 110 to 120 units.

Step 1. %Δ quantity supplied = (120 − 110) ÷ 110 × 100 = 9.1%. Step 2. %Δ price = (1.45 − 0.90) ÷ 0.90 × 100 = 61%. Step 3. PES = 9.1% ÷ 61% = 0.15 — growing time limits how fast supply can respond. PES = 0.15, so supply is inelastic.

Interpreting PES values

Determinants of PES

Market economic system

Take the price mechanism from price determination and let it run the whole economy, with no government involvement at all, and you have a market economic system.

What is a market economic system?

In a market economic system (also called a free market economy), individuals and private firms own the factors of production, and resource allocation is decided entirely by the price mechanism — rising and falling prices signal scarcity and surplus, directing resources toward whatever consumers value most. Firms are free to decide what to produce and how; workers are free to choose their employer; and self-interest — firms maximising profit, consumers maximising satisfaction — drives the whole system, without any of the three basic economic questions being answered by the state.

Advantages and disadvantages of a market economic system

Market failure

The market economic system works well only where price captures every cost and benefit of a transaction — where it doesn’t, the market fails.

Costs and benefits: private, external, social

Public, merit and demerit goods

Monopoly

A monopoly is a market with a single dominant seller, facing no close competition. Free from competitive pressure, a monopolist can restrict output and charge a higher price than a competitive market would allow, which is itself a form of market failure — consumers pay more and receive less than the socially optimal outcome.

Causes of market failure

Left alone, a free market consistently gets five things wrong — and each one has a predictable, misallocated consequence.

Consequences of market failure

Mixed economic system

No real economy leaves resource allocation entirely to price, and none plans it entirely from the centre — every economy sits somewhere in between.

What is a mixed economic system?

A mixed economic system blends the price mechanism with government intervention: individuals, firms, and the state all own factors of production and make resource-allocation decisions. Governments intervene mainly to correct the market failures described above, to raise revenue for public spending, to redistribute income toward poorer households, and to support strategically important industries. Countries differ only in the extent of intervention — the United States and Singapore lean closer to the market end of the spectrum; Norway and China intervene considerably more.

Advantages and disadvantages of a mixed economic system

Price controls

Rather than shifting a curve, a price control fixes price directly by law — and each type creates its own permanent imbalance.

Maximum price

A maximum price is set below equilibrium to keep an essential good affordable, e.g. a cap on staple food prices or controlled rents. Because it sits below the price that would otherwise clear the market, it creates a persistent shortage: quantity demanded permanently exceeds quantity supplied, which can lead to queuing, rationing, or a black market.

Minimum price

A minimum price is set above equilibrium to guarantee producers a higher, more stable price, e.g. a price support for a farm crop. Because it sits above the price that would otherwise clear the market, it creates a persistent surplus: quantity supplied permanently exceeds quantity demanded, often requiring the government to buy and store the unsold surplus.

Indirect taxation and subsidies

Rather than fixing price directly, a tax or a subsidy changes producers’ costs — and lets the market find a new equilibrium around them.

Indirect taxation

An indirect tax (e.g. on tobacco, fuel, or sugary drinks) raises producers’ costs, shifting supply left. Price rises and quantity traded falls. It raises government revenue and discourages consumption of demerit goods with external costs, correcting the over-consumption described under market failure — but it is often regressive, taking a larger share of a poor household’s income, and can push consumption toward untaxed black markets.

Subsidies

A subsidy (e.g. for public transport, or renewable energy) lowers producers’ costs, shifting supply right. Price falls and quantity traded rises. It encourages consumption of merit goods with external benefits, correcting the under-consumption described under market failure, and can support producers who might otherwise struggle to compete — but it carries an opportunity cost to the government budget, and can encourage inefficiency if producers come to rely on it indefinitely.

Other intervention tools

Not every government intervention works through price — some tools change who owns resources, or what is legally allowed, directly.

Regulation

Regulation is a legal rule governing how firms or individuals may behave, e.g. safety standards, pollution limits, or advertising bans on demerit goods. It can protect consumers, workers and the environment without needing government spending, but compliance raises firms’ costs, and excessive regulation can discourage investment and innovation.

Privatisation and nationalisation

Privatisation moves an organisation from government to private ownership, typically to introduce competition, raise government revenue, and improve efficiency through the profit motive — though a privatised monopoly may still exploit consumers if there is no effective competition. Nationalisation moves an organisation the other way, into government ownership, to protect jobs, secure supply of an essential service, or capture profits for the state — though state-run firms can lack a profit incentive and become inefficient.

Direct provision of goods and services

The government itself supplies a good or service, e.g. public healthcare, state education, or street lighting, ensuring public and merit goods are provided even though a private firm has no incentive to supply them. The opportunity cost is funded through taxation, and state provision may be less responsive to what users actually want than a competitive private market.

Quotas

A quota is a legal limit on the quantity of a good that may be produced or extracted, e.g. a fishing quota or a limit on extracting a natural resource. It can conserve a scarce or environmentally sensitive resource for future use, but it restricts output below what the market would otherwise supply, which can raise price and encourage illegal production beyond the limit.