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Chapter 6: The Role of Markets in Resource Allocation
Allocative Decisions:
Economies are changing and therefore ask themselves the following three questions from time to
1. What to produce?
2. How to produce it?
3. For whom to produce?
Firms have to decide what to produce because of scarcity – infinite wants but finite resources. So,
with the given resources, they can only choose to produce a certain amount of products
Firms also have to decide how to produce – they can either employ more labor, or they can use
more capital goods in the production process.
They must also decide for whom to produce – help required here by teacher.
The answers to the above questions differ in different economic systems.
An economic system covers the institutions, organizations, and mechanisms in a country that
influence economic behavior and determine how resources are allocated.
Different Economic Systems:
There are three main economic systems:
Planned Economic System – an economic system where the government makes the
crucial decisions, land and capital are state-owned, and resources are allocated by
Mixed Economic System – an economy in which both the private and public sectors play
an important role.
Market Economic System – an economic system where consumers determine what is
produced, resources are allocated by the price mechanism, and land and capital are
privately owned.
Market Economy in Detail:
In a market economy, consumers determine what is produced by signaling their preferences
through the price mechanism.
Private firms decide how to produce, depending on the type of product. A steel factory might
employ more capital equipment, and therefore its production would be capital-intensive.
However, a hotel might employ more workers for the job, so it would be labor-intensive
In a market economy, those with the highest incomes influence what is being produced, since
they can pay more, and private firms are always aiming for higher profits.
The Price Mechanism:
In a market economic system, resources move from less popular products to more popular ones
due to demand and supply which is influenced by consumers and the prices they are willing to
The price mechanism incentivizes producers to respond to changes in the market. This
mechanism largely benefits consumers – if they want more of a product, they will be willing to
pay more for it. Higher prices will increase production of the certain product and will, in turn,
give more profit to firms.
The allocation of resources continues to change from time to time. This is due to the consumers’
demand and the cost of production.
It is important to note that market disequilibrium moves to market equilibrium after changes
made in the allocation of resources.
For example, if the supply of potatoes decrease, consumers will be willing to pay more for it due
to the shortage. Firms’ profits will increase, so they will produce more of the product, resulting in
more supply of potatoes. In this way, market disequilibrium has moved to market equilibrium.