Economic systems and resource allocation
Key terms
Define each term.
Multiple choice
Circle the correct answer.
In a market economy, what determines which goods are produced?
Which is a disadvantage of a planned economy rather than of a market economy?
Which characteristic most explains why a market will not supply national defence?
Worked problems
Show your working.
Tracing the price mechanism through a supply shock. A disease destroys a third of a country's coffee crop. Trace how the price mechanism reallocates resources, identifying where each of the three functions operates.
Chains of reasoning
The steps are in the wrong order. Write the letters in the order that makes a linked chain.
Why the free rider problem produces zero provision rather than merely low provision
- A A good is non-excludable, so once provided it is available to everyone regardless of payment.
- B Each individual reasons that their own contribution is too small to determine whether the good exists.
- C Not contributing is therefore the dominant strategy for every individual, whatever anyone else does.
- D Whether or not others pay, the individual is better off not paying: if the good is provided they enjoy it free, and if it is not their contribution would have been wasted.
- E No firm can collect revenue, so no firm can cover its costs, and provision is zero rather than merely insufficient.
- F Everyone is worse off than if all had contributed, so the outcome is inefficient even though every individual decision was rational.
- G Since every individual reasons identically, nobody contributes voluntarily.
Diagrams
Draw a demand and supply diagram for a good and show a leftward shift of supply. Mark the original equilibrium, the shortage that appears at the old price, and the new equilibrium. Annotate the diagram to show where rationing, signalling and incentives are operating.
Answers
Market: Any arrangement that brings buyers and sellers together to exchange goods, services or factors of production. It need not be a physical place: online markets and markets for foreign currency are markets too.
Market economic system: An economic system in which resources are allocated through the price mechanism, with production and consumption decisions made privately by firms and households rather than by the state.
B. Consumer spending determines which goods earn profits, and profits determine where resources flow. This is consumer sovereignty. Producers choose what to make, but those who make what consumers do not want make losses and exit, so the ultimate direction comes from spending patterns.
C. The information problem is the characteristic weakness of central planning: no authority can collect and process what millions of prices convey automatically. The other three are market failures, which is precisely why governments intervene in mixed economies.
B. Non-excludability produces the free rider problem: a defence firm could not withhold protection from non-payers, so nobody has an incentive to pay and no revenue can be collected. Cost is not the obstacle, since expensive private goods are supplied routinely. Defence is not a merit good; it is a pure public good.
Step 1. The immediate effect on supply. Supply of coffee falls sharply, shifting the supply curve left. At the old price, quantity demanded now exceeds quantity supplied, so there is a shortage.
Step 2. Rationing. Price rises. As it does, some consumers are unwilling or unable to pay and drop out of the market, buying tea or nothing instead. The available coffee is rationed to those who value it most highly, without queues, quotas or rules. This is the rationing function.
Step 3. Signalling. The higher price carries information. Growers elsewhere in the world learn that coffee has become more valuable relative to other crops, without needing to know that a disease caused it. The price is a summary of the situation that travels faster and further than the news does.
Step 4. Incentives. The higher price raises the return to growing coffee relative to other crops. Growers in unaffected regions plant more, harvest more intensively and bring marginal land into use. Resources move into coffee production because it is now more profitable to do so.
Step 5. The adjustment completes. Over the following seasons the extra planting raises supply, shifting the supply curve back right, and the price falls towards its original level. The shortage has been resolved and resources reallocated, with no authority having planned any part of it.
Step 3 is the one candidates omit and it is the most important economically. The price transmits information to people who could not possibly have obtained it otherwise, which is the argument for markets that planned economies could never answer.
A, B, D, C, G, E, F
- A good is non-excludable, so once provided it is available to everyone regardless of payment.
- Each individual reasons that their own contribution is too small to determine whether the good exists.
- Whether or not others pay, the individual is better off not paying: if the good is provided they enjoy it free, and if it is not their contribution would have been wasted.
- Not contributing is therefore the dominant strategy for every individual, whatever anyone else does.
- Since every individual reasons identically, nobody contributes voluntarily.
- No firm can collect revenue, so no firm can cover its costs, and provision is zero rather than merely insufficient.
- Everyone is worse off than if all had contributed, so the outcome is inefficient even though every individual decision was rational.
Step 4 is the one to state precisely: not paying is dominant, meaning it is the better choice regardless of what others do. That is what makes the failure complete rather than partial, and it is why the solution must be compulsory rather than voluntary.
Annotating the three functions onto the diagram is the habit worth building, because it converts a mechanical shift into an explanation of how resources get reallocated. The shortage at the old price is the part most often left off, and it is what actually drives the price upward.