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?
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.
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.
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.
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.