Microeconomics | Resource Allocation | 1

SCARCITY AND RESOURCE ALLOCATION

The basic economic roblem is that o! scarcity " the cometition bet#een unlimite$
#ants an$ limite$ resources% &ence' resources ha(e to be allocate$ in such a #a) to
romote the t#o main microeconomic aims " e*cienc) an$ e+uit)%
The three basic economic +uestions that arise out o! the roblem o! scarcit) are thus
1% ,hat to ro$uce
-% &o# to ro$uce an$
.% /or #hom to ro$uce%
The Production Possibility Curve is the 0rah that sho#s ma1imum attainable
combinations o! t#o 0oo$s or ser(ices that can be ro$uce$ in an econom) #hen all
resources are use$ !ull) an$ e*cientl)' at a 0i(en state o! technolo0)
Productive Efciency re!ers to the absence o! #aste in the ro$uction rocess% 2&o#3
All oints on the 44C are ro$ucti(e e*cient' oints insi$e the 44C are ine*cient
reresentin0 either unemlo)ment 2not all a(ailable resources bein0 use$3 or
un$eremlo)ment 2resources not en0a0e$ !ull)3
/or ro$ucers' all oints on the LRAC are 4E
/or consumers' onl) the MES 2lo#est oint on the LRAC3 is 4E
Allocative Efciency is the situation in #hich societ) consumes a combination o! 0oo$s
an$ ser(ices that ma1imi5es its #el!are " i%e%' ma1imum utilit)% Onl) one oint on the 44C
is allocati(el) e*cient 2,hat3
AE is achie(e$ #hen 4 6 MC
AE is achie(e$ #hen MS7 6 MSC
Distributive Efciency is achie(e$ #hen 0oo$s an$ ser(ices are ro$uce$ to those #ho
#ant or nee$ them " not a8ecte$ b) an econom)9s osition on the 44C 2/or #hom3
MAR:ET SYSTEMS
In $i8erent economic s)stems' the three basic +uestions are sol(e$ $i8erentl)%
In a laissez faire or free market' the) are sol(e$ b) the interaction o! the mar;et
!orces o! $eman$ an$ sul) " ;no#n as the rice mechanism " settin0 an e+uilibrium
rice an$ outut le(el% The rice mechanism #or;s as consumers an$ ro$ucers are
moti(ate$ b) sel!<interest an$ ro=t< an$ utilit)<ma1imi5ation%
,hat to ro$uce> Determine$ b) consumer so(erei0nit)
&o# to ro$uce> Determine$ b) the relati(e rices o! !actor inuts
/or #hom to ro$uce> Determine$ b) urchasin0 o#ers o! in$i(i$uals or
househol$s
In a command or planned economy' the roblems are sol(e$ b) a central lannin0
bo$)%
The mixed economy stri;es the balance bet#een the e1tremes an$ uses both !ree
mar;et !orces as #ell as 0o(ernment inter(ention to ans#er these +uestions% 2See notes
on Mar;et /ailure an$ ?o(ernment Inter(ention3
Microeconomics | Resource Allocation | -
DEMAND AND SU44LY
/ACTORS A//ECTI N? MAR:ET DEMAND
Poulation A8ects the number o! otential customers " the si5e o! the
mar;et
An absolute increase or $ecrease in total oulation'
A chan0e in comosition o! the oulation'
Interrelate$ 0oo$s Chan0e in rices o! substitutes or comlements
Taste @ 4re!erences /a$s ma) lea$ to su$$en an$ temorar) increases or $ecreases
in $eman$
Ne# in(entions an$ technolo0) ma) lea$ to a ermanent
$ecreases in $eman$
Seasonal chan0es Climatic con$itions' or !esti(itiesAholi$a)s ma) lea$ to increases
in $eman$ !or articular 0oo$s 2li;e Bo#ers on Calentine9s $a)3
E1ectations o! the
!uture
Chan0es as a result o! e1ectations o! !uture rice chan0es
Income 23 An increase in income lea$s to an increase in sen$in0 on
lu1ur) 0oo$s' an$ a $ecrease in $eman$ !or in!erior 0oo$s
/ACTORS A//ECTI N? MAR:ET SU44LY
Costs Chan0es in costs o! ro$uction $ue to chan0es in rices o!
!actor inuts li;e RMs' !uel an$ o#er #ill cause the sul)
cur(e to shi!t
!elate$ ro$ucts'
rices o!
A8ecte$ $een$in0 on #hether the 0oo$ is in Doint or
cometiti(e sul) #ith other ro$ucts
Inno(ations Imro(ements in techni+ues o! ro$uction #ill lo#er ro$uction
costs an$ shi!t the sul) cur(e ri0ht#ar$
"atural !actors /a(ourable climatic con$itions lea$ to increase in sul)' #hile
natural catastrohes #ill $ecrease the sul) o! a0ricultural
ro$uce
#o(ernment olicies Ta1ation an$ subsi$) olicies a8ect the cost o! ro$uction
Subsi$ies $ecrease the minimum rice at #hich
ro$ucers #ill sul)
Ta1es' on the other han$' increase the minimum rice
E1ectations o! the
!uture
Chan0es as a result o! e1ectations o! !uture rice chan0es
NTERRELATED DEMAND
?oo$s in $oint demands are comlements
E%0% etrol an$ cars
?oo$s in competitive demand are
substitutes
E%0% beer an$ ale
Derived demand re!ers to the $eman$ o!
a !actor o! ro$uction !or a 0oo$
E%0% steel !or cars
I NTERRELATED SU44LY
?oo$s in Doint sul) are ro$uce$
to0ether
E%0% bee! an$ leather
?oo$s in cometiti(e sul) are ro$uce$
at the e1ense o! each other
E%0% mil; an$ leather
Microeconomics | Resource Allocation | .
ELASTICITY CONCE4TS
4RI CE ELASTI CI TY O/ DEMAND
PED measures the $e0ree o! resonsi(eness o! the E
DD
o! a 0oo$ to a chan0e in its rice
<
F
F
4
GE
G4 E
H
Determinant
s
Availability of
substitutes
Type of
#ood
Proportion of
income spent on
%ood
Time period
&ore
inelastic
/e# substitutes
Not (er)
substitutable
Necessit) Small roortion Short run
&ore elastic
Man) substitutes
Euite substitutable
Lu1ur) Lar0e roortion Lon0 run
'sefulness of PED
?o(ernment ta1ation olicies
Either aim to raise re(enue' $iscoura0eAencoura0e consumtion
4ED #oul$ la) some art in $eterminin0 success!ulness o! olicies
Raisin0 re(enueAincreasin0 consumtion
o
In$irect ta1es shoul$ be le(ie$ on 0oo$s #ith inelastic $eman$
o
Increase in 4 I Decrease in E
DD
Decreasin0 consumtion
o
In$irect ta1es shoul$ be le(ie$ on 0oo$s #ith elastic $eman$
o
?reater e8ect on E
DD
4ricin0 olicies o! =rms
4olicies #ill be hel!ul as lon0 as TR I TC
E8ect on rices stabilit)
4ro$uct $i8erentiation
A =rm9s ro$ucts can be chan0es so that 4ED is more elastic
o
?i(es the =rm the abilit) to increase rices to increase TR
I NCOME ELASTI CI TY O/ DEMAND
ED measures the D%O%R% o! the DD o! a 0oo$ to a chan0e in consumers9 income <
F
F
Y
GE
GY E
H
'sefulness of ED
4ro$uction lans
:no#le$0e o! YED is can allo# =rms to ascertain the nature o! their ro$uct
2in!erior' necessit) or lu1ur)3 an$ lan !uture outut accor$in0l)
o
,hen the econom) is !a(ourable' =rms shoul$ e1an$ their ro$uction o!
normal 0oo$s #ith hi0h YED 2lu1uries3 an$ cut bac; on in!erior 0oo$s
Tar0etin0 $i8erent income 0oo$s
A 0oo$ can be a lu1ur) an$ lo# income le(els' an$ an in!erior 0oo$ at hi0h
income le(els
:no#le$0e o! YED allo#s =rms to se0ment their mar;et into $i8erent income
0rous to ro$uce the aroriate rice an$ income ran0e to cater to $i8erent
customers
Interpretation of ED
Not resonsi(e to income chan0e
IN/ERIOR
?OOD
NORMAL ?OOD
NECESSITY LUJURY
F 1
Microeconomics | Resource Allocation | K
CROSS ELASTI CI TY O/ DEMAND
CED measures the D%O%R% o! the DD o! 0oo$ A to a chan0e in rice o! 0oo$ 7 <
A 7
7 A
GE 4
G4 E
H
'sefulness> 4ro(i$es =rms the e8ects on their ro$ucts9 $eman$ #hen !ace$ #ith a
chan0e in the rice o! a ri(al9s ro$uct or comlementar) ro$ucts% I! t#o 0oo$s ha(e a
hi0h ne0ati(e CED' the t#o =rms sellin0 them can come to0ether to sell the 0oo$s Dointl)%
Interpretation of CED
Unrelate$ 0oo$s
COM4LEMENTS SU7STITUTUES
STRON? ,EA: ,EA: STRON?
() * )
4RI CE ELASTI CI TY O/ SU44LY
PES measure the $e0ree o! resonsi(eness o! the E
SS
o! a 0oo$ to a chan0e in its rice <
F
F
4
GE
G4 E
H
Determinant
s
Time
period
+actor
mobilit
y
"umber of
,rms
Spare
capacity-
stocks
Production
period
&ore
inelastic
Short run Lo# /e# Una(ailable Lon0
&ore elastic Lon0 run &i0h Man) A(ailable Short
'sefulness of PES
E8ects on rice stabilit)
A44LICATIONS O/ D@S /RAME,OR:
I NCI DENCE O/ TAJES AND SU7SI DI ES
Tax Subsidy
Inelastic
PED
Inci$ence !alls more on
consumers
Consumers recei(e a hi0her share o! the
subsi$)
Elastic PED Inci$ence !alls more on
ro$ucers
4ro$ucers recei(e a hi0her share o! the
subsi$)
E//ECTS O/ 4RI CE /LOORS AND CEI LI N?S
&inimum price " set abo(e mar;et
e+uilibrium
&aximum price " set belo# mar;et
e+uilibrium
4rotection o! the #el!are o! certain
ro$ucers or #or;ers
o A0ricultural suort rices an$
the minimum #a0e le0islation%
Ma) #ant to create a surlus #hich can
be store$ in rearation !or !uture
shorta0es
Set to achie(e some !orm o! e+uit) to
rotect consumers
o 4rice control !or basic 0oo$s in
#artime
o Rent control
Lea$s to a ersistent surlus> continuous
accumulation o! stoc;s
Misallocation o! resources> allocati(el)
ine*cient
Misinterretation o! rice si0nals>
creates illusion o! a lucrati(e mar;et
o 4ro$ucers become comlacent
o Ma) brin0 in ne# ro$ucers'
creatin0 0reater surluses
Resultant shorta0es create roblems
Misallocation o! resources> allocati(el)
ine*cient
4rices no lon0 ser(e as si0nals to
$istribute scarce resources
o Alternati(e allocati(e
mechanisms> ballotin0' rationin0
Emer0ence o! the blac; mar;et
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Stoc; stora0e 6 #aste o! mone)