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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 time: 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 directives. 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 production. 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 pay. 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.